Tax reform, RBI flexibility to boost Indian market

Prime Minister Narendra Modi has restored his reformer credentials, establishing a framework (post-Goods and Services Tax; post-Bankruptcy Code; post-public- bankingsector clean-up, consolidation and re-capitalisation; and post-tax cuts) that allows corporate India to be globally competitive.

We would specifically point to the thoughtfulness in engaging the manufacturing/export sector — for new manufacturing investment capacity being set up, the effective tax rate falls further to about 17%, in line with the tax incentives being offered by China, Vietnam and Indonesia.

Modi’s explicit focus is on job creation and real income growth — India’s demographic dividend demands about 20 million new jobs being created each year. Having eschewed the path of least resistance — Modi did not devolve to mindless subsidies or budgetary gimmickry — the Reserve Bank of India (RBI) now has the room to ease further.

• Quite frankly, monetary policy has probably been too tight in an environment where growth has slowed, and the external environment (thanks to geopolitics and the tariff stand-off between the US and China) has deteriorated sharply;

• Modi’s fiscal stimulus is capex-driven — as opposed to being consumption-driven. We therefore expect inflation/inflationary expectations to remain benign; and

• The RBI has the flexibility to ease further, and after having cut rates by another 25bps last week (the fifth rate cut in a row, bringing the benchmark repo rate to 5.15%), and having scaled back growth expectation for the current fiscal year to 6.1%, we expect two or three more additional rate cuts by March 2020.

Slate of positive government initiatives

Having just returned from a week of visiting companies in India, we want to leave you with some thoughts:

• Given intentional fiscal and monetary stimulus, we expect liquidity conditions to stabilise and improve over the next two to three months, and for a meaningful revival in private sector capex over the next 12 to 18 months;

• Modi was reelected with a resounding majority, with the highest ever turnout in an Indian election. Despite reforminduced short-term pain, Modi was rewarded for his steadfast commitment to an anti-corruption and reform agenda;

• The slowdown is cyclical: monsoon deficits and the credit crunch in rural India being the primary culprits, the vulnerability of the export economy to the global slowdown, the stock market overhang from pledged shares being held as collateral, and the government’s heavy-footed response to the credit squeeze on the smaller non-bank finance companies;

• There is clear recognition that the government needs to intervene to restore corporate and consumer confidence. Over the last four weeks, the government has (1) reversed the retrograde tax surcharge on high-net-worth and foreign portfolio investors, (2) announced a significant consolidation and recapitalisation of the public sector banks, (3) extended depreciation benefits and delayed new registration charges for the automobile sector, (4) instituted specific export incentives, and now (5) Big Bang Tax Reform; and

• There is near unanimity on the ground supporting Modi’s decision to abrogate Kashmir’s semi-autonomous status — despite all the handwringing in the international press, and Pakistan’s sabre-rattling.

The key risks that we are continuing to monitor:

• Domestically: liquidity and funding constraints for the smaller banks and nonbank finance companies; any deterioration in corporate balance sheets and in consumer confidence; and rural farm distress; and

• Globally: an inverted yield curve foreshadowing global recession; a slowing China and the spectre of an increasingly aggressive response to the mass demonstrations in Hong Kong; conflict-driven spikes in crude prices; and Brexit and trade war impasse.

HDFC proxy to affordable housing

The stock we wanted to highlight this month is Housing Development Finance Corp, India’s largest mortgage finance company. With an enviable 40-plus-year track record of sustained, profitable market share gains, HDFC remains in pole position to leverage the significant nascent opportunity in affordable housing (catalysed by tax incentives for affordable housing projects, and government subsidies for salaried, firsttime house buyers).

We expect HDFC to convert its strong liability franchise, credit culture and capital allocation discipline and its operational efficiency/cost advantages into sustained, profitable loans growth. We expect HDFC to compound its loan book at an 18% compound annual growth rate over the next three years (versus consensus modelling a much more modest 12% run rate).

• Capital is a clear competitive advantage. HDFC’s standalone Tier 1 ratio of 17% (with a total capital adequacy ratio of 19%) — this is not a typo! — will comfortably support the next four to five years of loans growth, while allowing HDFC access to the short-term commercial paper markets at a significant discount to the capital-constrained peer group;

• HDFC’s brand and distribution network are a significant competitive advantage. The significant investments over the past three decades in bricks and mortar, technology and systems and processes, the consistent discipline in evaluating creditworthiness of both developers and homebuyers, and the service-orientation and transparency allowing firsttime homebuyers to evaluate their own borrowing capacity will allow HDFC to significantly scale their presence in the affordable housing segment at a time when competitors are struggling; and

• Additionally, given the extremely tight liquidity conditions for developers struggling in the aftermath of the government crackdown on nominee property accounts and the new restrictions on pre-launches (that were historically used to fund working capital), HDFC’s decades-old relationships with credible, well-capitalised developers across the country present a unique opportunity to help repurpose and finance deeply distressed projects in good locations that fit the government’s specific goals on delivering on affordable housing.

We expect earnings to compound at close to 20% annually over the next three years, versus consensus looking for low teens earnings growth.

• Simply put, we expect return on assets to track in a 2.4%-to-2.5% band (versus consensus estimates looking for ROA to compress), and for return on equity to trend towards 18% (versus market consensus looking for ROE to plateau around 13% to 14%). We expect scale benefits to translate into lower costincome ratios, while funding advantages versus the peer group will remain net interest margin-supportive. We expect credit costs to trend at about 40bps; and

• We continue to expect to see further unlocking of value through its subsidiaries, and anticipate that a potential listing of the general insurance business will be as well received by the markets as the listing of HDFC Life Insurance Co and HDFC Asset Management Co.

In conclusion, we expect to see a meaningful reset in expectations for the market — both in terms of earnings trajectory and market multiplies. India has set the stage for an alternative growth narrative for itself.

• Given the extent of the fiscal and monetary stimulus, a revival in private sector capex, the recapitalisation of the public sector banks and a more effective transmission of the RBI’s easing cycle, we believe that growth troughed in the June 2019 quarter. Modi has continued to exceed expectations in terms of the structural reforms that have been implemented over the last five years, the heavy lifting that has been done with the bankruptcy code and the consolidation and recapitalisation of the public sector banks, and now, the significant tax code reform to book-end the institutionalisation of a digital economy and GST implementation;

• We expect our base case for our portfolio holdings delivering on earnings growth compounding at 15%+ annually (on the back of sustained market share gains and strong operating leverage) to be nicely boosted by the tax “savings”; and

• The rupee is trading cheap relative to our real effective exchange rate fair value estimates of about INR70/US$, and valuations for listed equities are attractive, back-stopped by the bid from sustained domestic equity market inflows, a significant uptick in both foreign direct and strategic investments, and creeping acquisitions by controlling shareholders systematically buying back stock.

The Tantallon India Fund is a fundamental, long-biased, India-focused, total return opportunity fund registered in the Cayman Islands and Mauritius. The Fund invests with a threeto five-year horizon, in a concentrated portfolio (25 to 30 unlevered positions), market cap/sector/capital structure agnostic, but with strong conviction on the structural opportunity, scalable business models, and in management’s ability to execute. Tantallon Capital Advisors, an advisory company, is a Singapore-based entity, set up in 2003, holding a Capital Markets Service Licence in Fund Management from the Monetary Authority of Singapore.