Guest Commentary - Reform Agenda In Emerging Markets

The Reform Agenda In Emerging Markets

Matthew Vaight

A Global And Asian Emerging Markets Fund Manager At M&G Investments

Reform has been a powerful influence on emerging markets lately. In 2014, there were numerous elections across developing nations and, as is common the world over when a country’s economy is slowing, many politicians based their election campaign on a reform agenda, with pledges to revive economic growth.

The prospect of new leaders committed to change went down well with investors. The majority of those markets that held elections last year outperformed the wider emerging markets index.

India and Indonesia, two markets that were buoyed by the election of ‘reformers’, returned 24% and 27% respectively (in US dollar terms).

In contrast, Brazil was a notable laggard last year, despite being one of the countries holding a ballot. After rallying when a change of government appeared on the cards, share prices retreated when President Dilma Rousseff was re-elected. Investors had hoped a more market-friendly administration would improve Brazil’s economic fortunes, but with Rousseff’svictory the prospect of meaningful reform appeared to be greatly reduced.

While many emerging markets can undoubtedly benefit from new reform-driven governments, from an equity perspective, we need to consider how markets react to such changes in leadership and policy. Investors tend to get excited by the prospect of a new economic approach.

But delivery is much harder than promises and optimism can quickly fade if the implementation of reforms fails to live up to expectations. One year on from Prime Minister Narendra Modi’s election in India, we look at the enthusiastic reaction to his victory and draw parallels to the election of President Enrique Peña Nieto in Mexico in 2012. India: from pessimism to optimism India, the world’s most populous democracy, had a landmark election last year.

Crisis is often a catalyst for change and India was undoubtedly struggling. Economic growth was faltering, inflation was high, and investors worried about the country’s public finances. In 2013, India was highlighted as one of the ‘fragile five’ nations that could be most vulnerable to capital outflows following the removal of stimulus measures in the US. In addition, political deadlock and bureaucratic inefficiency were hampering much-needed reforms. Against this backdrop, the opposition Bharatiya Janata Party (BJP), led by Narendra Modi, swept to victory after campaigning heavily on a reform platform.

Modi had a track record of taking tough decisions and passing pro-business reforms, having transformed the fortunes of the Indian state of Gujarat, where he served as chief minister. The election revealed a clear desire for change; the BJP secured a majority in the lower house of parliament.

Winning such a large mandate was crucial for Modi to be able to pass new legislation and enact reforms. The Indian stock market rallied in anticipation of the election and continued to soar after the positive outcome. Investors bought into Modi’s ambitious plans to revive India’s economic growth, which include modernising the country’s inadequate power supplies and dilapidated infrastructure, boosting the manufacturing sector, as well as addressing India’s infamous bureaucratic delays.

The prospect of economic reforms has increased business and investor confidence, while sentiment towards India has also been boosted lately by the recent slump in the price of oil. As a major oil importer, India is undoubtedly benefiting from lower oil prices. The government’s finances are improving, while inflation has eased, which has enabled the central bank to cut interest rates. Modi: a man on a mission since his election last May, Prime Minister Modi has set about changing India’s economy in a variety of ways. On the bureaucratic front, he has introduced measures to reduce the burden of red tape and speed up the decision-making process.

In order to improve the government’s finances, he reduced fuel subsidies, a move that was helped by the fall in oil prices. The government confirmed its reform focus in the budget, raising capital expenditure on infrastructure such as railways and roads, while also committing to reduce the government deficit. Modi recently achieved his first major legislative success, raising the foreign ownership limit in the insurance sector from 26% to 49%.

This measure had been blocked for several years and the new ruling should increase investment in the industry. Other industries have seen the level of foreign direct investment (FDI) raised, including the defence and railway sectors. The government is keen to attract foreign investment, which should improve governance standards and operational practices.

Despite these achievements, there are plenty of challenges ahead. One of Modi’s priorities is ensuring that India has reliable power supplies. At present, only state-run firm Coal of India can mine commercially, but there are plans to open up the coal industry to private companies.

It is hoped that increasing competition will boost production and help end the country’s power shortages. Tax reforms would improve the government’s finances and the government intends to replace the various state taxes with a national Goods and Services Tax, which would create a single market. Another important proposal is a land acquisition measure that would speed up much needed development projects. Meanwhile, simplifying the country’s labour laws would arguably create jobs and boost productivity

High expectations

Over the longer term, the cumulative effects of Prime Minister Modi’s initiatives are likely to transform India’s fortunes and help boost corporate performance. However, implementing his most controversial reforms will not be easy. There is plenty of opposition to proposals such as land reform and a uniform sales tax.

And then there is the difficulty of passing legislation. Although the BJP has a majority in the lower house of parliament, the opposition parties dominate the upper house and have delayed several government bills. At a practical level, it will take time for the full impact of measures such as the infrastructure projects to take effect. In our view, the potential benefits of Modi’s reforms are arguably already reflected in the stock market. After a very strong rally, the MSCI India Index is now trading at a significant premium to the wider emerging markets index – double the price-to-book ratio. Although share prices have declined in the past couple of months, as investors have begun to have doubts about the delivery of reforms, we believe the Indian market looks expensive as investors’ expectations for companies’ future returns and growth are now too high.

Good for the economy, but bad for stocks

In 2014, after a long legislative struggle, President Peña Nieto managed to pas the legislation that would end the state’s monopoly on energy production. This historic measure opens the way for private companies to gain access to Mexico’s oil fields, increasing investment and production levels, which should make a significant contribution to Mexico’s economic growth.

Despite the introduction of major reforms to improve Mexico’s competitiveness and make the economy more open, the stock market has failed to make any headway. It seems that what is good for the economy is not necessarily good for the stock market. In our view, the optimism that accompanied his election in 2012 was arguably overdone and investors did not anticipate how long it would take for the benefit of the reforms to materialise.

A difference between expectation and execution Structural changes are definitely needed in emerging markets and the reform agenda is welcome. With the tailwind of rapid economic growth fading, emerging economies have to find new ways of maintaining their economic progress. These will include a wide range of policies such as investment in infrastructure, tax reforms, reduced government interference and measures to improve productivity.

But amidst the euphoria about potential reforms, we would sound a note of caution. There is a huge difference between proposals and implementation. It can take time to deliver genuine structural changes, particularly if there are vested interests opposed to the reforms.

The recent experience of Mexico illustrates how investors can be disappointed by the pace and substance of reforms. It also raises questions about the future direction of the Indian stock market, which has rallied to all-time highs following the election of Prime Minister Modi, and the Indonesian stock market. We believe it is important not to get carried away by excessive optimism about the future. Elections can be the catalyst for change, but as equity investors you buy shares in companies, not economies.

While the reforms in countries such as India and Mexico will inevitably underpin long-term economic growth, it is essential to focus on how a company’s operational performance will be affected and what is factored into the share price. Today, we would argue that, in many cases, company share prices are already reflecting the potential benefits of the reform agenda.

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