India is yet to have its day in the sun

The financial markets’ reaction to the onset of tapering has been to pull out of India but the Asian giant is still a growing economy and a hasty retreat could be a bad move in the long run, reports Rodrigo Amaral

India is a big, complex country which runs a large deficit, presents plenty of hurdles to business and is constantly plagued by volatile politics. In the eyes of many an investor, such a wealth of sources of uncertainty amounts to an automatic “sale” label attached to Indian assets any time that risk aversion takes hold.

That is at least the impression that financial markets transmitted earlier this year as they reacted to suspicions that the US Federal Reserve could tighten its monetary policies. But giving up on India could be a bad move in the long run. After all, the South Asian giant still is a growing economy which has just started to tap into the potential of the second largest population in the world. Not long ago, India was growing by an average of more than 8 per cent a year. Soon, the enthusiasts claim, the country will bounce back to its recent, fast growing ways.

Granted, the last argument sounds like a hard sell today. India is a nation that has for centuries enjoyed a reputation in the West of hosting a million mysteries. One thing that is not mysterious at all, however, is that the Indian economy is struggling. Ever since it posted a puny 3.2 per cent rate of GDP growth in 2012, the age of continuous neck breaking performances looks like a thing of the distant past. Plagued by inefficiencies, halted reforms, stifled investments and a frightening current account deficit, India’s economy has spooked investors even more than other large emerging markets that have suffered with market volatility of late.

In the first half of the year, India’s currency, the rupee, plummeted against the dollar, while inflation became an ever bigger worry. Investors have worried about exchange rate risk and have got rid of Indian assets as fast as they can. Economic sectors such as infrastructure and construction have struggled mightily to make any money as a weak government has failed to take decisive actions to reverse the course.

India has become a byword for the flaws of emerging markets that now appear incapable to deliver the results expected by investors, and pessimism has seized multilateral organisations too. In its latest global economic update, released in early October, the IMF slashed India’s GDP growth forecast for 2013 by 1.8 point, and now expects the country to close the year with a 3.8 per cent expansion rate. In 2014, the number should be a juicier 5.1 per cent, but that is still 1.1 points below the fund’s previous forecast. Even the Indian government has been forced to temper its GDP growth expectations, although it still believes that the economy will end 2013 about 5.3 per cent bigger than 2012.

“India’s economy has developed quickly in the last decade, improving living standards and experiencing strong growth in such critical sectors as ICT,” stressed the Organisation for Economic Cooperation and Development in a report released in October. “In recent years, however, circumstances have become less conducive to growth: macroeconomic conditions in the developed economies point to a prolonged external slowdown, while domestic constraints such as high inflationary pressures and rising fiscal and current account deficits have emerged.”

The Sensex, India’s main stockmarket index, reflects the uncertainty. Its chart this year looks like the back of a stegosaurus, reaching as as low as 17,905 points in August and as high as 20,646 points the following month. By early October, the Sensex was up a meagre 4.34 per cent for the year, a disappointing performance in a rallying market, especially if compared with the 18.85 per cent achieved in the same period by the S&P 500.

To compound it all the ratings agency Fitch has mooted a downgrade of India’s sovereign debt, and its rival Moody’s stated that the country is, along with Indonesia, the Asian economy most exposed to a tightening of monetary policy in the US.

The numbers may fail, however, to provide a more comprehensive view of a country where so much change is taking place that Nobel prize winner VS Naipaul gave to a book about India the title A Million Mutinies Now.

Fund managers that closely follow the country, for instance, tend to have a more nuanced view of the perspectives for the economy. “Things are not as good as they were before,” concedes Avinash Vazirani, the manager of the Jupiter India fund. “But let’s not forget that the economy is still growing at 4.5 to 5 per cent a year.”

Several factors have contributed to India’s fall from grace this year. Some are domestic problems that analysts believe could be tackled by a determined government that comes to power with a working majority in Parliament – admittedly a huge “if” in India. Others are the outcome of external factors that have haunted emerging markets as a whole and can be at best mitigated by government or central bank action. India has been working on both, although the intensity of the efforts being deployed is a matter of debate.

“A lot of the problems are self-inflicted,” Vazirani says. “Infrastructure projects have stopped because the government either did not give permissions in time, or people did not seek permissions properly. The government is weak in the sense that it is a minority coalition, so it has not been able to pass legislation through. There have been question marks raised by the courts concerning licenses given to mining companies, and the government has not been capable of passing a law to ratify the concessions.”

He notes that sights like half-finished roads and other kinds of unfinished projects are not uncommon in India. They are the most visible side of a deeper malaise which is the inability of Indian officials to create an economic environment that would be more friendly to business and would make it easier to achieve stronger rates of growth.

In the World Bank’s latest Doing Business report, India ranks abysmally in areas like enforcing contracts (184th out of 186 countries), dealing with construction permits (182nd) and starting a business (173rd). Even more worryingly, the country has lost positions in the ranking in recent years.

The IMF noted in its latest global outlook that infrastructure and regulatory bottlenecks prevent supply to be boosted in India to a point where it could meet continuously growing demand. It is estimated that power shortages alone have a cost of $68bn a year to the economy.

Varizani notes that India used to be the third largest exporter of iron ore, but now, owing to obstacles to production, has to import it. The difference between what India earned in iron ore exports and what it spends now importing the same stuff is a whopping $42bn, he points out.

Dealing with these kind of problems require passing through Parliament delicate measures that meet deep rooted opposition from several sides. They include much needed reforms like the simplification of arcane rules about land transactions and the unification of the tax system via the creation of a nationwide VAT-like levy. However political wrangling has prevented reforms to move forward.

India expert Teresita C Schaffer, from the Brookings Institute, has noted that the tax reform is accepted by all political parties as an urgent necessity, but the opposition is unwilling to hand prime minister Manmohan Singh a victory with general elections set to take place in the first half of 2014.

“As the election approaches, there is very little chance that the government will implement the reforms that the economy needs,” says Marco Ravagli, the manager of the DWS Invest Global Emerging Markets Equities fund.

Things could change if a party comes out of the vote with a working majority in Parliament, but that is not looking likely at the moment. Adrian Lim, a Singapore-based senior investment manager at Aberdeen, doubts that a government with a straight majority will emerge from the urns, but still sees reasons to be optimistic about it.

“Whatever government is voted in, it should have a stronger mandate than the current one enjoys,” says Lim. He adds that political volatility is a pattern of India, and investors should
be prepared to live with it.

One problem the current government has tried to tackle was the hole in the country’s finances that ranks among the main stats haunting investors. Luck, however, has not been on its side.

“At the beginning of the year the Ministry of Finance tried very hard to reduce current the fiscal deficit by cutting subsidies on fuel,” Ravagli says. “But the efforts were basically useless mainly because the rupee depreciated sharply.”

Also, the government itself concedes that the federal budget contains more subsidies to food and fuel than it can afford, an unbalance that bodes ill to the public purse, as reducing either is tantamount to drinking political poison.


For its part, the current account deficit is a problem because, differently from other emerging markets, India is mostly an importing economy, rather than an exporting one. The country buys from abroad not only large amounts of oil, but also of gold, a metal that is ingrained in the habits and traditions of Indians.

Middle class, urban dwellers, for their part, have dollarised themselves by embracing the consumption of Western articles like European spirits, Swiss chocolate and even imported fruits, despite the fact that India is the world’s largest producer of fresh fruits and vegetables, Vazirani points out. The sharp deterioration of the rupee after 22 May, when Ben Bernanke gave the willies to markets with his now infamous speech in the US Congress, stressed the potential for further deterioration of the current account position of the country, as well as for fueling rampant inflation.

“India has been one of those economies with a large current account deficit,” says Sam Mahtani the manager of the Offshore F&C Global Emerging Markets Portfolio. Other emerging markets in the same group, like Indonesia and Brazil, have also got the stink eye from investor of late. But the situation could be improving in India, he notes.

“The latest data have come much better than expectation. Trade deficit has improved and the current account deficit too,” Mahtani says. However he warns that it is no time for relaxing despite the improvement.

“When markets go in a tailspin, countries like India will get included in that basket of economies that suffer with higher risk aversion,” he says. “At the moment India is financing its current account deficit, but it is the kind of structural sort of problem that needs to be addressed in the middle to long term view.”

The view appears to be shared by the president of the Reserve Bank of India, Raghuram Rajan, a former chief economist at the IMF who took over in mid-September amid much expectation. Rajan, who before taking the reigns of the central bank was a professor at the very orthodox University of Chicago, has been advertising the improvements that the government believes that the economy has achieved in recent months. But he was also quick to raise interest rates at the first opportunity despite the flagging economy.

In October, rates were cut again, but the message for many analysts was clear. Inflation, not GDP growth, will top the list of priorities of the central bank. He has also urged politicians to make use of the respite granted by the latest twist of the Fed tapering saga to prepare the economy for the tighter US policies that at some point in the future will surely come around. The rupee has in fact recovered a bit since Rajan started at the head of the central bank. But most of the appreciation of the currency has been probably related to the subsiding of fears about tapering by the Fed, rather than Rajan’s soothing effect on markets.

“He has fantastic experience and he is doing the right things,” Vazirani says. Rajan and other officials like finance minister P Chidambaram have been trying to convince investors that the situation as not as bad as the Cassandras portent. They have highlighted statistics showing that the ratio of public debt to GDP has fallen from 73.2 per cent in 2007 to 66 per cent this year, or that India’s reserves in foreign currency, equivalent to 15 per cent of GDP, are enough to fund the deficit for several years. Others like to point out the sheer magnitude of the domestic market.

Salman Anees Soz, a member of Parliament, has claimed that 140 million Indians were lifted out of poverty during Singh’s spell as premier minister. That is more than the populations of the UK and France combined.

“The real outlook for India as not as bad as people have been perceiving,” Mahtani says. “We spend a lot of time meeting corporates and we feel that India still presents plenty of opportunities in terms of good companies to invest in. Compared with other emerging markets, many high quality companies can be found in the country if you take a middle to long term view.”

Lim adds: “There are still some good drivers of the economy in the long term, and some companies will take advantage of them. If I had a horizon of one or two quarters in the future, I might be depressed. But we have a long term view and in the next five years we feel that some companies will do quite well.”

Among the drivers are social changes that go against commonly held views about fast growing emerging markets. For example, in India it is the rural sector that is faring better of late, while the economies of cities have struggled.

“Rural India is actually doing really well,” Vazirani says. “The monsoon was excellent this year. Production has been very high, and so have prices. They pay fewer taxes in the rural sector and receive benefits from the government. Therefore there is a lot of demand in rural India.” This is important because, as Vazirani stresses, that is where about 70 per cent of the population lives. And people are choosing to stay there or even to come back to their roots to take advantage of the good times. “Migration from rural India to the cities has slowed down,” he says.

This is the kind of trend that can create opportunities for investors, as long as they are able to identify who will be capable to explore it. Mahtani highlights ITC, India’s largest tobacco company, as a case in point. “They have an 80 per cent share in the cigarettes market and a fantastic pricing power,” he says. “Also, they sell around 40 per cent of their volumes in rural areas, where incomes are growing markedly.”  

ITC is a famous name in India’s market for consumer products, which is one of the sectors that analysts see as most likely to deliver returns in the country. “Some of the consumer stocks are expensive right now, but there still is a lot of growth to be had there,” Vazirani says.

Another sector that could benefit from higher incomes is financials, although the experts recommend prudence here as some of the stocks available are not up to scratch. “Public banks are very poorly managed and we avoid them,” Ravagni says. “Private banks on average are well run, but they are suffering from a very weak macroeconomic environment, and therefore we remain relatively cautious with them.”

Lim likes the perspectives of some banks that have exposure to mortgage markets, as long as their governance systems pass the smell test. “Even though GDP growth rates has fallen, the loan books at the better managed financial institutions are growing by around 18 to 20 per cent a year,” he says. “We do not see distressed assets in the balance sheets of the best banks and they are preserving their net interest margins.” HDFC Bank and ICICI Bank are often picked as examples of good students in this particular class.

The every-cloud-has-a-silver-lining-play might be found amid the effects of the rupees’s devaluation. Vazirani has already spotted some positive developments like a boost to domestic production in the shape of import substitution. He says that sectors like textiles and other manufactured products are benefiting as India has become cheaper than places such as Bangladesh and Sri Lanka. Jobs have already been created in those sectors, Vazirani points out.

And even if, differently from China, exporting has never been India’s strongest suit, the country has been able to produce some champions in this particular area too, and they should do well with a weaker currency. IT services and pharmaceutical are usually the industries associated with the word “exports” in India, and the experts still see potential there.

“In the IT services sector, we think that the growth will be higher than the market is forecasting,” Vazirani says. But Lim points out that, no matter the sector where one invests, picking the right stocks and playing the long game is of essence in India. “Investors need to be patient and not to compromise on the quality of the stocks that they buy,” he says.

But for India to fulfill its potential both for investors and, more importantly, its own people, it needs to act on fixing the inefficiencies that have been holding the economy back. Not the least because the tapering hecatomb may have been delayed, but is set to cause carnage in global markets soon.

“The Indian economy is very sensitive to capital inflows and outflows,” Lim says. “The way things have been going in the past few years, flows have been driven by what happens in North America, Europe and China, rather than what happens in India.”

If India put its act together, investments should pour in, attracted by the sheer magnitude of a market strong of 1.2 billion souls. Finance minister Chidambaram has been eager to stress how sectors that have been recently liberalised to some extent, such as oil and gas, telecommunication, pharmaceuticals and civil aviation, have duly attracted interest already. On the other hand, it is important to note that diluted reforms, like a half-hearted opening up of the retail sector for foreign forms, have brought little if any results.

A source of hope, in Ravagli’s view, is the emergence of a large army of young Indians that could very well show an eagerness to make their voices heard to the tune of changing the political landscape.

“The newness of the next election is that there is a whole generation that is going to vote for the first time,” he says. “The single biggest minority in India is not the Muslims anymore, but the new voters, which are some 40 million people aged around 18. They will probably look for somebody new. And if something changes in the political environment in India, that would be big news.”

And hard they should press for change too. After all, the OECD estimates that, in a best case scenario, it will take until 2058 for India to achieve the status of a high income country. That is more than three decades later than China should reach the same landmark.