Last year was undoubtedly a turbulent time for emerging markets with political instability, inflation and the fledgling recovery in the West all causing significant headwinds. Unsurprisingly this has led scepticism from some commentators about the prospects for these markets, including India. However, the Indian economy is showing signs it will weather the challenges of the next few years.  Whilst this may not be an easy task, as recent reaction to the Fed’s announcement showed, India has the political will to make the necessary reforms to deliver on its potential.

The Federal Reserve’s decision to start tapering its asset purchasing has caused some fallout in emerging markets although the expectation is that this will tail off in time.  Given its domestically driven economy, India is in a better position than most to deal with the post – QE world. Without the so called ‘taper tantrum’, investors in India might have focussed more on the positives in 2013, however given the overall improvements in the economy and the political outlook we feel the India story will be difficult to ignore in 2014.

One of the most significant changes in recent months has been the appointment of Professor Rajan as Governor of the Reserve Bank of India (RBI).  He is clearly part of a dying breed of central banker: That is one who actually knows how the world works!  He will make mistakes but the important thing is that he will be trying to move India in the right direction as shown by his decision to hike interest rates at the end of January.  Bond markets have reacted very well to this which shows the bank is now ahead of the curve.  Politically the BJP party looks to be gaining good momentum going into the May election. In conjunction with the appointment of Rajan as RBI governor, a BJP led government would be very encouraging in terms of getting the reform agenda back on track. There is also a lot of positive data currently coming out the RBI. Recent results showed that the Current Account Deficit (CAD) narrowed significantly to $5.2bn in Q2 2013 from $21bn in Q2 2012. Additionally, inflows to the bank have increased to $34bn which is much higher than anticipated. This gives the additional fire power to intervene in the markets if needed to counteract currency volatility.

The fall in gold imports was a major contributing factor to this reduction as was currency depreciation.  India’s exports have become more competitively priced over the last few months leading to higher exports in textiles, chemicals and leather goods. We expect CAD to remain at around 3% of GDP for the next financial year as gold imports stay low and exports increase.

There has also been an improvement in how other countries perceive India. Net Foreign Direct Investment (FDI) is stable despite some negative sentiment driven by outflows from the bond markets and banks in July and August 2013. The large changes in flows by banks on their foreign borrowings and assets require further analysis to understand their impact on increasing volatility in the Indian currency markets. NRI deposits remained strong and are likely to show an increase next quarter on the back of the Deposit Swap Window. However, overall capital flows were negative requiring the RBI to sell USD $10bn from its reserves to supply the markets with the required dollars.

This is a huge improvement on how India looked just a few years ago when the country was facing significant obstacles.  In 2010 increasing levels of inflation, growing fiscal deficits and escalating current account deficits all coupled with slowing growth rates put India in a very difficult position. In 2012 there was a realisation that the current situation could not continue and since then there has been much a greater focus on reform.

Policy mistakes have dramatically hampered India’s progress over the last few years and frustrated many investors.  However, the country is now beginning to drive a wedge between itself and the other more troubled emerging market economies and these differences we feel will continue to drive significant outperformance for India over the coming years. We are still facing some turbulent times, but at least for India we can see the dark clouds are beginning break.

As with any emerging market economy, the next few years will present challenges as well as opportunities and any investor will have to be comfortable with this.  However, India is committed to making the reforms it needs to improve its future.  The country has much better potential for growth than any developed country and is also in a much better position than its many of its EM peers. Now is the time to take advantage of all that India has to offer investors.

Arvind Chari, ACPI Investment Managers