Gemologist

India: the last real emerging market

For professional investors only www.hermes-investment.com

Key pointsIndia continues to juxtapose the medieval with the hypermodern. Under the progressive influence of Prime Minister Narendra Modi, promising structural reforms are being introduced that should enable this emerging market to blossom

Administrative, legislative and supply-side reforms are taking place at a national level, but India’s federal system means that progress within states is key. Modi’s attempts to foster ‘co-operative federalism’ to spur state-driven projects are gaining traction

India’s impressive growth is largely being generated through greater investment in agriculture and national and state infrastructure. However, the nation is still constrained by weak industrial production, corporate credit, exports and freight traffic

Progressive India favours well-run, quality companies that are focused on innovation and are exposed to structural trends. Conglomerates relying on subsidies or short-term cyclical drivers may prove to be risky investments as the country emerges

Excellence. Responsibility. Innovation.

Newsletter, Q1 2017

Hermes Emerging Markets

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Newsletter, Q1 2017

The futuristic architecture and glass towers of Shanghai and Seoul defy old stereotypes about emerging markets. But investors heading into Mumbai from the airport, confronted with searing poverty and pollution, could be forgiven for questioning the talk of Asia’s economic miracle taking root in India. We would encourage them to take a broader view: although corruption and inequality remain endemic, there are signs of profound long-term change. In this issue of Gemologist, we assess India’s ability to modernise and truly emerge.

Neither minnow nor whaleA market which is still emerging, being built on solid foundationsIndia is no longer a minnow in the sea of global liquidity, but neither is it a whale – yet. The country’s presence is felt in Asia as a strategic counterweight to China and its voice in the G20 is starting to be heard. Although its 8.5% weight in the MSCI Emerging Market Index remains modest, this masks the significance of the many Indian companies that compete globally in reach, quality and management skill.

Although India’s emergence may appear sluggish compared to China’s, a number of factors create the potential for the kind of sustained growth that can make it a true rival to its neighbour, if only in investment terms.

India has an enviably young working-age population and a growing workforce. But unlike China, it is in no danger of getting stuck in the middle-income trap, as it lags significantly in terms of per capita income. Its low levels of urbanisation and industrialisation are potential drivers of growth, as are government initiatives to improve health and education, all of which can benefit from advancing technology.

In a commentary we wrote more than a year ago evaluating India’s progress under Modi, we concluded that although concrete achievements were modest at the time, the country was on the right path.1 We highlighted improved trends in governance, inter-state competition, infrastructure investment, rising foreign investment, an intention to level the playing field for businesses and the emergence of start-ups.

Although India has underperformed the emerging markets universe this year and corporate earnings have been disappointing, we think the foundations for a 21st century economy are being built. What follows is our assessment of the on-the-ground reality, reinforced by a recent research trip to the country, and what this means for the Indian stocks in our portfolio.

Politics and developmentProgressive reform and co-operative federalismIndia has grown steadily over the past 60 years, irrespective of those in power. But policies will determine the pace of that growth from here on, and whether per capita incomes can rise enough in real terms to transform the economy. Without a dynamic push to streamline the legal, fiscal and structural underpinnings of the country, foreign direct investment (FDI) will stagnate, deficits will balloon and interest rates will remain high, discouraging business growth and eroding consumers’ purchasing power. Most importantly for investors, a weak rupee would erode any gains made in the local market.

Up close, politics in India are as rough as anywhere else, but in our view the new policy framework under Modi’s Bharatiya Janata Party (BJP) is strong enough for a vigorous relaunch of economic modernisation, spurring a sustained increase in FDI, greater infrastructure investment and fiscal reform.

The opposition Indian National Congress party remains too weak at the national level to mount a real challenge to Modi’s programme. However, India’s federal system means that many states are governed by parties other than the BJP or Congress. The next major election will be held in early 2017 in Uttar Pradesh (UP), a state which is home to 221m people and is currently led by the socialist Samajwadi Party, which is riven with infighting. While the BJP is unlikely to win, a good showing would not only increase the potential for reform at the state level, but would solidify its national leadership and accelerate its momentum for the national elections in 2019.

National reforms can only paint part of the picture, as India is a union of states in which each wields its own power. Inter-state competition for investment was one of the key trends we highlighted last year, and we are encouraged to see further progress in this regard. The World Bank and India’s Department of Industrial Policy and Promotion (DIPP) announced recently that 17 states have implemented just over 50% of national business reforms – only seven had attained this same level last year – with 16 now past the 75% mark. Moreover, a 340-point business reform plan is being implemented at the state level, with ease of doing business a priority. Of course, some states are lagging and India is still ranked a lowly 130 by the World Bank for overall ease of doing business – up only one place from last year. But the recent passage of the bankruptcy law and the national goods and services tax (GST) should improve India’s position.

1 “Modi’s long road is the right one,” by Kunjal Gala, published in November 2015. Available at: www.hermes-investment.com/.

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Figure 1. India’s improving global competitiveness ranking

Global competitiveness ranking, India2006

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Source: World Economic Forum, Morgan Stanley Research as at November 2016.

Figure 2. India isn’t an easy place to do business – yet

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Source: World Bank, Morgan Stanley Research as at November 2016.

Interestingly, while seven of the top 10 states ranked by the World Bank are administered by the BJP, the top two are not, indicating that states are rising above political infighting to pursue a development agenda. One example is the recently opened 302km-long six-lane Agra-Lucknow expressway – which was completed in an astonishingly narrow timeframe of less than two years – in a non-BJP controlled state.

ReformsThe BJP’s current broad-based reforms can be categorised as administrative, legislative and supply-side programmes:

1) Administrative Bureaucratic reform to expedite approvals for businesses, combat corruption and improve transparency, digitise processes and enable government delivery of online services

2) Legislative Opening up business sectors to private investment, liberalising FDI, updating bankruptcy laws and driving through tax reforms including the nation-wide GST

3) Supply side Investment in physical infrastructure – including roads, railways, power transmission, rural infrastructure, warehousing and ports – and a gradual reduction of subsidies

Here we delve into each of these reform areas, highlighting specific policies that should help modernise India’s economy.

Anti-corruptionThe level of informality in the Indian economy is as high as 85%, and associated corruption and tax collection problems remain extreme, but measures to address this are reaping rewards. These include:

�� Issuing 1bn unique identity cards

�� Opening 200m online bank accounts to formalize more business transactions

�� Cancelling 35m fake accounts

�� Direct paying of subsidies on LPG and kerosene to beneficiaries’ accounts

�� Planned digitalising of 500,000 ration shops for food subsidies by March 2017, and

�� Demonetising 500 and 1000 rupee notes

Targeted stimulusNo-one knows for sure if India is really growing at 7.5%, although an analysis of individual factors like industrial, electricity and steel production, corporate credit, exports, real corporate sales and freight traffic all imply a considerably slower rate of growth. Offsetting these constraints is rising agricultural production, national and state pay hikes, and an increase in government spending on infrastructure, which aims to crowd-in private sector investment. The real estate and construction sectors are very weak, with as much as four years of inventory accrued in cities other than Mumbai and Chennai. But tractor manufacturers and motorcycle makers like Hero MotoCorp, and auto-parts suppliers like Motherson Sumi Systems, are starting to enjoy a recovery in demand.

Motherson Sumi SystemsMotherson Sumi Systems, a holding in our portfolio, is a leader in automobile wiring, which is well placed to benefit from the ongoing electrification of cars. Since 2008, the company has grown its European business by acquiring distressed but strategic tier-one vendors to original equipment manufacturers (OEMs) like Volkswagen, Audi and Daimler, usually at their behest in return for attractive long-term contracts.

With the turnaround of acquired companies largely complete, Motherson Sumi has expanded its global footprint by adding 17 factories recently, and it is prepared to address its €12bn order book. Since the company earns 50% of its profits from its Indian operations, road-building and a more comprehensive national 4G mobile network (and, in time, 5G) will steadily improve traffic flow, allowing more cars on the road.

BankingPublic-sector banks provide about 75% of total credit in India, but remain undercapitalised and suffer from levels of non-performing loans that may be as high as 20%. Meanwhile, capital spending has slumped as a consequence of excess industrial capacity and commercial banks’ focus on resolving legacy stress through recoveries instead of evergreening their loan portfolios. The new bankruptcy law is giving the banks powers to repossess collateral, enabling them to repair balance sheets.

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Newsletter, Q1 2017

Administrative Legislative Supply side / infrastructure

Anti-corruption

�� 1bn unique identity cards issued

�� 200m online bank accounts opened

�� 35m fake accounts cancelled

�� Direct payment of LPG and kerosene subsidies to beneficiaries’ accounts

Monetary and banking

Demonetisation of 500 and 1000 rupee notes to combat the black market

Rail

$130bn to be invested by 2020:

�� 400 train stations to be privatised

�� Creation of Western Dedicated Freight Corridor between Delhi and Mumbai

�� $6bn investment by GE in locomotive manufacturing facility

Labour

New initiatives designed to streamline paperwork and minimise red tape:

�� Digitisation of labour law compliance

�� Self-certification for companies

�� More efficient compliance procedures

Labour

Planned reforms to:

�� Wage laws – a proposed Wage Code Bill would guarantee minimum wages across the country and streamline wage definitions by combining four existing laws

�� Rationalisation of 44 labour-related acts into four codes covering wages, industrial relations, social security and working conditions

Roads

Sector growing at 8% per year:

�� Road construction rate almost doubled in two years to 22km/day in Q2 2016. The official target is 41km/day

�� Contracts for constructing 25,000km of roads to be awarded

�� 178,000 villages to be connected by March 2019

Digital

�� Digitisation of land records

�� DigiLocker cloud-based file storage

�� e-Governance mobile apps

�� Electronic delivery of services, including government procurement

Fiscal

�� Introduction of national Goods and Services Tax (GST), creating a common Indian market and reducing the cost and complexity of trade in goods and services between states

Digital

Flagship ‘Digital India’ programme to create digitally empowered knowledge economy:

�� Low-cost broadband for 500,000 villages

�� Universal mobile access with 55,000 villages to be connected by 2018

�� Public internet access – wi-fi being rolled out across 100 train stations

Business

�� 340-point business reform plan to create competition regarding ease of doing business at the state level

Legal

�� New bankruptcy law streamlines a plethora of rules for administering struggling companies and recovery. It encourages time-bound resolutions

�� The national government has given states the freedom to liberalise land laws in accordance with their circumstances

Municipal

�� Improvements to water supply, sewers and local roads

�� 30 metro networks to be built by 2025, with 9 already under construction

Private investment

Deregulation to allow private investment under the ‘Make in India’ programme:

Defence

�� Purchase of Rafale fighter jets from France – up to 50% of contract value from India

�� Discussions with Lockheed Martin and Saab about manufacturing fighter jets

Digital

�� Intel, HP, Apple, Microsoft and Google backing key ‘Digital India’ initiatives

Power

�� DISCOM (Distribution Company) Assurance Scheme to transfer debt to individual states

�� Power Development Scheme to develop underground cabling, end-to-end metering and IT-enabled energy accounting

�� 32 new solar parks by 2020

�� Additional 175GW of renewable energy by 2022

�� 12,000 villages to become electrified by 2018

Figure 3. Modi’s matrix: administrative, legislative and supply-side reforms aiming to transform the Indian economy

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Hermes Emerging Markets

Opinions differ, but most commentators expect it to be several years before public-sector banks resume lending. While the Indian government has limited funding with which to recapitalise the banks and is not keen to do so, they are unlikely to let public sector banks fail. In contrast, most private-sector banks are in better shape, as illustrated by the following stock examples.

ICICI Bank and HDFC BankICICI Bank, a holding in our portfolio, has a relatively high level of non-performing loans among private-sector banks, though we believe these are peaking. The sale of Essar Oil to Rosneft should help lower its volume of stressed assets over the next few quarters, and ICICI is prioritising loan quality over quantity with an increased focus on retail borrowers, whose balance sheets are in good shape.

HDFC Bank, another holding, remains untroubled by bad loans and continues to compound earnings at 20% a year. Prudent lending, unencumbered by a requirement to finance the pet projects of local governments, accounts for the majority of the difference in credit quality between private- and public-sector banks. Meanwhile, technology is increasingly important for Indian lenders. ICICI is implementing ‘software robotics’ in more than 200 business processes, while HDFC has been a pioneer in leveraging technology to expand its franchise in the vast but nascent customer base of rural India.

InfrastructureModi’s government has brought a significant, and welcome, change in the focus of federal spending, moving from benefits and subsidies to investment in long-term assets – particularly infrastructure.

In a move that is emblematic of Modi’s intent, competent ministers have been appointed to oversee a significant increase in road, rail and energy-infrastructure spending. All road transportation, highway and shipping projects have been consolidated under one minister and coal, power and renewable energy initiatives under another. This is helping to offset sluggish industrial orders and credit creation, although at some point domestic and foreign private-sector investors will need to pick up the baton. Rules limiting FDI have been relaxed; there is little evidence as yet of substantial foreign investment in real estate or defence projects, but there is keen foreign interest.

After peaking in the 2008-09 financial year, the combination of policy paralysis, complacency and implementation headaches led to a year- on-year decline in new infrastructure and private investment projects, persisting until the current administration took charge. The downward trend has since reversed and the pace of project completions is rising too (see figures 4 and 5). Nevertheless, unfavourable market conditions and the lack of private-sector interest are preventing the investment cycle from achieving its full potential, which is a common theme worldwide (and one also likely to constrain infrastructure plans in the US).

Figure 4. More new infrastructure projects are being confirmed

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Source: Centre for Monitoring Indian Economy, Citi Research as at 4 October 2016.

Figure 5. More infrastructure projects are being completed

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Source: Centre for Monitoring Indian Economy, Citi Research as at 4 October 2016.

The scope of the projects being undertaken is expansive. Here we highlight key infrastructure initiatives that should benefit India’s economy in the long term:

RailLess than $65bn has been invested in the rail sector in the past decade. Modi’s government plans to double that figure in less than half that time to $130bn by 2020, with the first phase of high-speed rail construction due to start in March 2017. Meanwhile, a programme to privatise 400 railway stations has begun alongside a $6bn locomotive manufacturing facility being built by General Electric.

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Newsletter, Q1 2017

Figure 6. Key Indian infrastructure (existing and planned)

1 The Indian Government definition of a smart city is a densely populated urban area with technological solutions for e-governance, energy, water and waste management, mobility, education and commerce.

2 Multi-modal logistics park.

CHINA

NEPAL

MYANMAR

SRI LANKA

BANGLADESH

PAKISTAN

Paradeep

MMLP = Multimodal Logistics Park

Kolkata

Lucknow

Pantnager

Haridwar

Quila Raipur

Palanpur

Udaipur

NihanNaya Raipur

Karimhagar

Kalinganagar

Budhapank

Guwhati

Jabalpur

Bhubaneswar

Kakinada

Coimbatore

Davanagere

Belagavi

SolapurPune

Surat

AhmedabadBhopal

Indore Jharsuguda Haldia

Krishnapatnam

Sriperumbuthur

Visakhapatnam

Delhi

Gurgaon

Ludhiana

Jaipur

Mumbai

Kandla

HyderabadNagulapalli

Khodiyar

Khatuwas

Bengaluru ChennaiEnnore

Tuticorin

Mangalore

Goa

JawaharlalNehru Port

Cochin

Delhi-Mumbai Industrial Corridor (DMIC)Proposed industrial parks in the DMICSmart city development1

Metro network (existing or under construction) Port (state-owned)Concor's operational MMLPs2

Concor's proposed MMLPs2 Agra-Lucknow Expressway (road)Western Dedicated Freight Corridor (rail)Eastern Dedicated Freight Corridor (rail)Proposed dedicated freight lines (rail)High-capacity transmission corridor (electricity)

AFGHANISTAN

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The rail investment programme’s flagship development is the Western Dedicated Freight Corridor (WDFC), which is on track for completion in 2019. As well as quadrupling available freight capacity, the WDFC should win back industrial customers who had avoided India’s previously unreliable rail transport in favour of trucks.

Container CorporationContainer Corporation (Concor), one of our holdings, is a prime beneficiary of the WDFC, setting up multi-modal logistic parks (MMLPs) along the length of the corridor to serve as hubs for customer storage, customs clearance, cargo aggregation and disaggregation, and intermodal transfers. The MMLPs will also provide value-added services such as packing, re-packing and supply-chain services, with the ability to handle specialised cargos such as liquids, automobiles and cement.

Concor is also likely to benefit from the GST, which is due to be implemented in 2017. This will eliminate the cascading duty payments of the current indirect tax regime and thereby increase the attractiveness of a third-party logistics business model. Concor customers have shown interest in scalable logistic facilities and are considering outsourcing some of their supply chain functions to the business.

RoadsRoad construction in India is currently growing at 8% per year, reaching 22km per day in Q2, up from 11.9km per day in 2014-15, but still well short of the targeted 41km per day. Accompanying this progress, the number of stalled projects has dropped from 384 in the 2014 financial year to only 15 today. Contracts for 25,000km of new highways are expected to be awarded this year, with plans to connect 178,000 villages by March 2019, although it remains to be seen if this target is realistic.

PortsThe unloading of goods and connectivity remain the key problems for ports. However, overall performance is rapidly improving, accompanied by a steady rise in operating profit. Container volumes at India’s major ports rose 6.3% year-on-year in the first half of this fiscal year. Ship turnaround time at Mumbai has dropped from 2.85 days to 2.01, while average output per ship berth day was 10% higher from April to September 2016 compared to the same period last year.

TownshipsMunicipal investment includes improvements to water supply, sewers and local roads. Also, nine metro networks are currently being built with a total of 30 cities scheduled to have metro rail by 2025. All but three of these projects are publicly funded.

PowerPlant-load factors, which measure capacity utilisation, are low and have scope to rise, while coal availability has improved and national transmission networks have increased the availability of power. Although there is an overall power surplus, this does not result in continuous power for all Indians and a third of rural households are yet to be connected to the grid. Under Modi, electrification has accelerated and is well on the way to linking the targeted 12,000 new villages by 2018. Across India, electricity generation is 7% higher so far this year.

Leakage from power lines has been an acute problem for India’s power grid for decades. More than 20 states have signed up to the government’s Distribution Company (Discom) Assurance Scheme, which transfers 75% of the Discom debt to the budgets of the individual states and makes them accountable for reform. The Discom Assurance Scheme is critical to improving the distribution system, which is currently leaking $15bn in electricity each year.

Only eight of these states have recorded declines in lost electricity. State-level dynamics have implications for the programme, and thus the results are mixed. But there have been some noteworthy improvements. The state of UP has reduced the gap between electricity-generation costs and sales revenue by 65% for the year ending March 2016, while Jharkhand saw commercial losses halved in Q2 2016 compared with Q2 2015. Another recently launched initiative, the Power Development Scheme, targets underground cabling, end-to-end metering and IT-enabled energy accounting in order to stop future leakage. Thus progress is being made to stop energy wastage, but there is still a long way to go.

Renewable energy is another area of focus. India currently generates 42.6GW, or 14% of its total energy capacity, from clean sources. This is not bad by global standards, but by 2022 the government aims for about 220GW to be generated from renewables. India’s solar capacity was only 3.7GW as at the end of March 2015, but by 2020, 32 new solar parks in 20 states are planned, adding 20GW and increasing capacity six-fold.

Power Grid Corporation of IndiaWe hold Power Grid Corporation of India, a company tasked with the expansion and strengthening of India’s inter-state transmission networks, in our portfolio. Its work is essential in connecting states with power surpluses or deficits. The company has an order backlog of $20bn, which it will act on over the next four-to-five years. Interestingly, the creation of what Power Grid describes as ‘renewable energy corridors’ in north-west and south India aim to ensure that standalone projects can transmit electricity without a thermal power plant to providing baseload energy.

LandDespite India’s vast territory, the lack of available land for business has been a key hurdle for new investment and projects. However, having failed to convince parliament to rationalise the Central Land Laws, the national government opted to give states freedom to modify land laws at the local level with approval from the centre. Consequently, between the 2014 and 2016 financial years, the citing of land availability as a reason for stalled projects has halved from 16% to 8%.

A project to digitise national land records was launched in 2008 and was recently merged into the wider Digital India programme with a two-fold increase in budget. The use of aerial surveying, satellite imagery and drones should help to complete the project by 2021. At the same time, existing land records are being verified, linked to landowners and disclosed online. This will provide clear records of title, which should simplify disputes and expedite transactions. Similarly, processes for environmental and forest approvals have moved online, providing a barrier against corruption and enabling quicker response times.

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Newsletter, Q1 2017

LabourLabour laws have proved to be another stubborn roadblock to new investment. Change is happening at the state level and, as competition between states increases, the ability to do business should ease. New initiatives designed to streamline paperwork and minimise red tape include the digitalisation of labour-law compliance and self-certification for companies. Meanwhile, the government plans to reform wage and industrial relations laws, aiming to facilitate the ability of businesses to expand and contract.

Digital IndiaDigital India, a flagship government programme, reflects Modi’s vision of a digitally empowered society and thriving knowledge-based economy. A recent PwC Strategy1 study concluded that increasing internet access can help bring people out of poverty, and Digital India places greater broadband and mobile connectivity at the core of its vision. Global brands such as Intel, HP, Apple, Microsoft and Google are backing key initiatives, including:

�� The construction of broadband highways – Microsoft is bringing low-cost broadband technology to 500,000 villages while RailTel has installed 45,000km of fibre optic cables, which Google will use for connectivity

�� Universal access to mobile internet – 55,000 villages to be connected by 2018

�� Public internet access – Google has partnered with Indian Railways to roll out wi-fi across 100 railway stations

�� Digilocker – a new cloud-based platform for securely storing digital files

�� e-Governance – a unified mobile app for government services will be launched in early 2017

�� Electronic delivery of services – an online government marketplace for procurement

�� Electronic manufacturing

Tech MahindraIndia’s fifth largest IT services company, Tech Mahindra, offers technology solutions for healthcare, police, cyber-security and emergency response systems to governments at the state and central level. The company, a holding in our portfolio, is well-positioned to benefit from the expansion and increased sophistication of digital enterprise and services in India. It helped the nation’s financial-market regulator to digitally transform its processes and end-user experience, and was recently selected by the state government of Jharkhand as a strategic partner to facilitate its digital journey and generate employment through skills development.

The Mumbai Metro began operating in 2014 and the network is expected to be completed in 2021.

Foreign direct investmentAccording to the DIPP, India received a total of $40bn in FDI this financial year. The services sector accounted for the bulk of this, with only 6% related to manufacturing. Attempts to promote manufacturing through the wide-ranging Make in India programme have achieved some success: Xiaomi, Huawei and Lenovo have all started making smartphones in India, while GM is investing $1bn in a new global auto manufacturing and export hub. Airbus is also setting up a pilot and maintenance training centre and, as previously mentioned, GE has signed a $6bn deal with Indian Railways to manufacture locomotives. While these investments do not represent huge sums, they are indicative of a positive direction of travel.

Is Mumbai’s Chhatrapati Shivaji International Airport a harbinger of the quality of Indian infrastructure currently being planned and built?

1 “Connecting the world,”published by PwC in 2016.

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Hermes Emerging Markets

DefenceDefence is an important industry under the Make in India initiative and the sector has been opened up to full foreign ownership. The recent agreement to buy Rafale fighter jets from France will result in up to 50% of the contract value being sourced from India, while discussions are taking place with both Lockheed Martin and Saab to set up a comprehensive manufacturing facility for fighter jets, with the ultimate aim of kick-starting a domestic aircraft industry.

Bharat ForgeThe automobile industry is one sector in which India already has world-class companies that are attuned to global developments. Bharat Forge, one of our holdings, is a leading manufacturer of crankshafts for trucks, amid other forged metal components, and one of the few companies in the world with the technology for titanium forging. It has successfully transitioned from manufacturing low-cost auto components to an R&D and innovation-led business providing total solutions for companies in the commercial vehicle, passenger vehicle, railways, aerospace, manufacturing and oil and gas industries. Bharat Forge is now comprehensively upgrading its manufacturing facilities in India, adopting the principles of ‘smart’ industry and the internet of things, including the deployment of sensors, automation and advanced analytics. Bharat Forge’s advanced manufacturing capabilities place it in pole position for supplying parts to India’s growing commercial vehicle, energy and defence industries.

India’s ModinisationModi’s long road is still the right oneModi’s government has made a good start in its effort to underwrite sustainable long-term growth and modernise the country. Its substantive reforms, aiming to fix structural problems in its economy, contrast with the Chinese government’s recent tactic of short-term fixes to temporarily boost growth. Modi’s moves are excellent from a long-term perspective but the evidence from companies suggests that some of the reforms will continue to have an adverse impact on earnings in the near term (see figure 5). Nevertheless, they create solid foundations for long-term sustainable growth driven by higher productivity – and this is what really matters, in economies everywhere.

A new India is emerging, and the space once held by outdated conglomerates from the time of the red-tape ridden ‘license raj’ and the informal economy is being claimed by businesses willing to compete through innovation and efficiency. Investing in India during this transitionary phase is challenging, but identifying companies that will outperform on a long-term basis is key. We believe that well-managed, quality companies with robust financial structures will be able to endure short-term cycles, investing in order to benefit from India’s positive structural trends. These are the businesses which will succeed in the medium to long term, and which will reward patient investors.

Figure 7. Taking the long road: the near- and long-term impacts of India’s economic reforms

Reform Near-term impact Medium to long-term impact

Subsidy reform Transferring subsidies directly to the beneficiary’s bank account

Improves the government’s fiscal position as fake accounts and pilferage are eliminated

Negatively impacts consumer spending as part of the subsidy was likely diverted to discretionary spending and recycled back into the economy

Savings are used to invest in infrastructure

Banking sector reform Government and Reserve Bank of India working to clean up bank balance sheets and problematic loans

Negatively affects the banks’ ability to lend and companies’ ability to borrow, thereby impacting the private investment cycle

Provisioning and write-offs impact the bank’s earnings

Banks will be more vigilant and more risk aware

Limits reckless corporate borrowing

Banks focus more on quality loans

Supply-side reform Government focused on infrastructure spending instead of social payments

Adversely affects consumer spending Creates an asset base, improving productivity and the quality of future growth

Currency reform Demonetisation of high-value currency notes

Adversely affects consumer spending

The informal sector of India’s economy shrinks

Moves the country towards digital payment methods

Expansion of the formal or organised economy

Better tax collection as people have less incentive to transact in cash

This document is for Professional Investors only. The views and opinions contained herein are those of Hermes Emerging Markets, and may not necessarily represent views expressed or reflected in other Hermes communications, strategies or products. The information herein is believed to be reliable but Hermes Fund Managers does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This material is not intended to provide and should not be relied on for accounting, legal or tax advice, or investment recommendations. This document has no regard to the specific investment objectives, financial situation or particular needs of any specific recipient. This document is published solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Figures, unless otherwise indicated, are sourced from Hermes. The distribution of the information contained in this document in certain jurisdictions may be restricted and, accordingly, persons into whose possession this document comes are required to make themselves aware of and to observe such restrictions. Issued and approved by Hermes Investment Management Limited (“HIML”) which is authorised and regulated by the Financial Conduct Authority. Registered address: Lloyds Chambers, 1 Portsoken Street, London E1 8HZ. HIML is a registered investment adviser with the United States Securities and Exchange Commission (“SEC”).CM155893 12/16 T5085

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Hermes Investment ManagementHermes Investment Management is focused on delivering superior, sustainable, risk-adjusted returns – responsibly.

Hermes aims to deliver long-term outperformance through active management. Our investment professionals manage equity, fixed income, real estate and alternative portfolios on behalf of a global clientele of institutions and wholesale investors. We are also one of the market leaders in responsible investment advisory services.

Our investment solutions include:

Private markets

International real estate, UK commercial real estate, UK private rental sector real estate, infrastructure and private equity

High active share equities

Asia, global emerging markets, Europe, US, global, and small and mid cap

Credit

Absolute return, global high yield, multi strategy, real estate debt and direct lending

Multi asset

Multi asset inflation

Responsible Investment Services

Corporate engagement, intelligent voting and public policy engagement

Offices London | New York | Singapore

Why Hermes Emerging Markets?From top to bottom

Bottom-up analysis finds quality companies trading at attractive valuations. This is rooted in a top-down framework that identifies countries with conditions supportive of growth.

Quality and safety

Buying quality companies at a discount gives a margin of safety in a volatile asset class.

Truly active management

A concentrated portfolio with a high active share, invested with a longterm perspective.

Experience and rigour

Manager Gary Greenberg has three decades of investment experience, and is supported by a team of six.

Integrated ESG

Environmental, social and governance factors are integrated into our analysis for a comprehensive view of risk.

Multi-cap

The portfolio invests across the market cap spectrum, fully able to benefit from mid-cap exposure.