Indian dream

As India approaches the 60th year of it\'s independence, it looks well on the way to becoming a major economic power. But look a little deeper and the story appears somewhat different, according to Sunil Jagtiani, reporting from Mumbai.

In the month India celebrates her 58th birthday as an independent nation, she is f鳥d by foreigners in distant shores perhaps as never before. Her perceived diplomatic and economic standing has risen to levels few expected a decade or so ago. This changed perception has created a new narrative for India, focused on the country’s growing power and overall potential.

That new narrative has, in turn, attracted foreign investors in their droves to the Indian stockmarket, which has soared to a record high. Over the last three years the MSCI India index has risen 140%, well ahead of the 80%, 70% and 40% rise in MSCI’s Emerging Market, China and World indices respectively.

Official data from India’s Securities and Exchange Board reveal the scale of the jump in foreign purchases of Indian securities. So far in 2005 foreign institutional investors have made net purchases worth about $6.2bn (3.5bn). This is already 73% of 2004’s full-year net investment figure, which came to $8.5bn, and roughly the same as 2003’s full-year figure. In 2002 net investment was just $740m.

Separate data from fund analysis firm Lipper shows the proportion of assets invested in India by Asian equity and global emerging market funds has increased substantially. In June 2002, Asia Pacific (excluding Japan) and Asia Pacific (including Japan) funds, on average, invested 1.3% and 0.7% of their assets in India. The figure for global emerging markets funds was 3.5%. This had risen to 2.3% by June this year for each of the Asia Pacific categories, and to 5.4% for global emerging markets funds.

So what are we to make of the “India story” and investors’ response to it? Is the explosive performance of the stockmarket a structural phenomenon, auguring a multi-year bull market, or does disappointment lie ahead? To answer these questions, it is necessary to look more closely at the “India story”. This, hopefully, will provide a context in which to evaluate the recent surge in India’s financial markets.

The latest embellishment to the new Indian narrative materialised last month, when the Indian prime minister Manmohan Singh was accorded a state visit to America. Commentators were quick to point out it was only the fifth time George W Bush had hosted a state visit during his presidency. India was cast as a democratic ally and counterpoint to China, whose growing might is seen as a threat to American hegemony.

At the summit the US president pledged to assist India’s civilian nuclear power programme. President Bush said he would try to convince American lawmakers to lift sanctions imposed on India for conducting nuclear bomb tests in 1998, so that the two countries could share nuclear technology. India’s newspapers labelled the development “historic”, coined the soubriquet “Atomic Singh” for the bespectacled, softly spoken Indian prime minister and generally collapsed into an orgy of back-slapping and celebration.

India, it was implied, had begun to occupy its rightful place in the world. In time permanent membership of a reformed and enlarged UN Security Council would follow. So would membership of an expanded G8. Indeed, prime minister Singh’s presence at the G8 meeting held in early July in Gleneagles represented India’s first-ever invitation to the Group’s deliberations.

This apparent increase in India’s diplomatic clout is, of course, partly the result of the country’s improved recent economic performance. Official figures show the Indian economy posted real gross domestic product growth of about 7% over the financial year 2004/5, which runs to the March. Specialist Asia brokerage CLSA says the Indian economy’s potential annual growth rate has risen from 3-5% to 6-8% in the last 15 years. This follows reforms initiated by prime minister Singh in the early 1990s, when he was finance minister.

In June, Singh said Indian growth had averaged 6.5% in the first three years of the country’s Tenth Economic Plan, intended for the period 2002-2007. He forecast 7-8% annual expansion for the remainder of the plan. Several independent forecasters broadly agree and argue the Indian economy’s trend rate of growth now sits at about 6.5%. They expect India’s economic performance to outstrip the Asian average significantly this year, with China the only country likely to register faster GDP expansion.

For instance, in a research note released last month, Barclays Capital said it expected India would continue to be a “star performer” in emerging Asia, partly because of the strength of India’s domestic demand. “The country is undergoing a structural change following reforms in recent years,” the investment bank said. “This in turn is helping to underpin strong growth in both corporate investment and private consumption. We expect GDP will rise by around 7% this year.”

Robust Indian domestic demand is partly explained by high levels of private sector credit growth. Both companies and individuals are borrowing to spend, encouraged by interest rates at 30-year lows. Over the year to June, for instance, commercial lending rose 32%. Richer private individuals, meanwhile, are snapping up credit cards, personal loans and mortgages. Last month, India’s central bank left its benchmark interest rates at 5% and 6%. Since the inflation rate is 6.3%, real interest rates are negative, which is thought likely to support economic growth.

Economics consultancy Lombard Street Research points out that reasonably high – if slowing – levels of export growth have also helped the Indian economy. “The average 12-month change in export growth eased to 17% in the first five months of the year,” says Raffaella Tenconi, one of the firm’s economists. “This was down from 19% in the second half of last year and 35% in the first half of 2004.

I”However, service exports, which account for a third of total exports, continue to power ahead. Total service exports more than doubled to $14bn in 2004/5, from $6.4bn the year before and $3.6bn in 2002/3. Software revenues are also soaring, recording a 41% increase and improving over the already strong 32% of the year before.”

The export performance posted by India’s service sector alludes to the country’s increased integration into the global economy. The latter development has seen India emerge as a high-profile, low-cost supplier of information technology services, English-speaking call centres and other “back office” business functions to firms in the West. India is now the world’s second biggest exporter of such services behind Canada, according to CLSA.

India’s outsourcing boom is exploring other avenues too, such as the provision of drug development services for multinational pharmaceutical firms or medical services to health service providers. Again, India’s unique selling point here is the low level of remuneration of its skilled workers. At least one private British hospital chain already flies blood samples to Mumbai, India’s commercial capital, for pathology testing. Technicians paid as little as 4,000 per year turn around the tests as quickly, but much more cheaply, than their British counterparts. The NHS is reported to be looking at the feasibility of outsourcing pathology tests to India too.

India’s integration into the global economy is apparent in other ways. For instance, Indian firms have begun to acquire companies abroad. In 2004 they spent $1.7bn acquiring foreign firms. They struck nearly $1bn of such deals in the first half of 2005. Many Indian firms are listed on international bourses too, particularly in America and Britain.

Meanwhile, at the Paris Air Show in June this year, Indian carriers unexpectedly emerged as being among the heaviest buyers of commercial aircraft, posting orders worth many billions of dollars to service an expected boom in India’s aviation sector.

These individual developments appear to provide evidence for the bold claim that India is on the path to becoming a major economic power in the decades ahead. Goldman Sachs, for instance, forecasts the Indian economy will be the third biggest by 2035, with a GDP of $8.5trn, behind America at $25trn and China at just under $20trn.

The bank says India is set to grow quickly as it closes the “development gap” with the West. It identifies India’s “demographic dividend” as its most significant economic attribute: India’s high and growing working-age population is supposed to power its future economic growth. About 50% of India’s 1.1 billion population is under 25, according to Legal & General Investment Management. Some 61% of India’s population is said to be of working age, namely 15-64 years old. That proportion is expected to peak at roughly 67% in about 2030, according to JP Morgan.

India’s other strengths are familiar ones. Chief among them is its democracy, which allows India to absorb and process changes that otherwise might cause social discontent. India’s independent judiciary, its attempts at implementing good corporate governance, its pool of outward-looking English speakers and collection of internationally respected firms are often cited as positive factors too.

This, then, gives a flavour of the India story. Growing economic and diplomatic power, and potential economic and diplomatic power, lie behind the new Indian narrative. Suddenly, India is seen as a rising economic giant marching towards modernity. Investors have found it a compelling story.

The problem is that the picture of an emerging economic superpower does not necessarily fit with all the facts, notwithstanding the genuine and commendable progress India has achieved in the last 10-15 years. To some extent, it is a misleading picture. Some of those who analyse India or invest in its stockmarket allude to the same point.

“There has been a big change in the way that India is perceived abroad,” says Kaushik Basu, a professor of economics and international studies at Cornell University, in New York state. “India is doing better and perceptions have kept pace with that – but perhaps they have outdone that too.”

Sanjiv Duggal, an adviser to the $3.1bn HSBC GIF Indian Equity fund, is blunt in his assessment of the situation. “People do have an improved perception of India,” he says. “But I think their view may now be a bit too rosy. People aren’t expecting any hiccups. But India has never really been a smooth story. There’s always been some obstacle along the way. It may be that people have an overly positive viewpoint.”

Vijay Tohani, manager of First State Investments’ Indian equity portfolios, broadly concurs. “Perceptions of India abroad have changed a lot in the last two years. The country now appears a more attractive place to invest. What concerns me is that all this may have gone a bit too far. Investors are seeing India through rose-tinted glasses. They need to see the negatives too and may be getting carried away. India has great potential, but it has yet to realise it.”

So what are the facts which suggest that, to some extent, the “India story” is flattering to deceive? For a start, looking more carefully at India’s apparent diplomatic progress reveals a different picture. India’s push for the lifting of sanctions to allow civilian nuclear cooperation with the US was based partly on the fact that her stock of nuclear fuel could run out by the end of 2006, according to a BBC report last month. Thus underlying the apparent diplomatic strength was weakness. Moreover, India’s aspiration to secure a permanent seat on the UN Security Council was simply dismissed by America and looks set to remain an aspiration. The US move puts claims about India’s new-found diplomatic clout into proper perspective.

At the level of the real economy, it is worth remembering the World Bank still classifies India as a poor country alongside nations like Sudan and Somalia. India’s gross national income per head is still only $530, half that of China’s and far below Western levels. For example, the British GNI per head is $28,350, while America’s figure is $37,610.

Various social indicators remain troubling. For instance, more than 25% of India’s population – roughly 300 million people – still live in abject poverty. About 40% of the population is illiterate. The female illiteracy rate is 52%. Over 600 million people live in rural areas, eking out a living in the agricultural sector, which accounts for about a fifth of the Indian economy. Services make up over half the economy, while industry’s share is roughly 25%.

Unemployment and underemployment remain major problems, despite the recent economic boom. Indeed, some commentators go so far as to label the boom a “jobless” one. They argue India’s service-led economic growth, particularly in the outsourcing sector, has generated relatively few jobs for higher-skilled Indians. The manufacturing sector, meanwhile, employs roughly the same number of people as it did 15 years ago.

Hence the worry is that the pattern of India’s economic growth has failed to spark a big increase in organised employment. Unless it does so, the demographic dividend spoken of so highly by Goldman Sachs and others could turn into a liability, as ever-increasing numbers of men and women struggle to find jobs.

Estimates of unemployment in India vary greatly, from about 7% according to government figures, to roughly 9% according to America’s Central Intelligence Agency, rising as high as 28% according to calculations by the Mumbai-based Research Unit for Political Economy.

But in essence, the problem is that India has yet to find a way to create jobs for the masses. The solution, according to a number of economists, is to promote labour-intensive industrialisation in India. They say India should take the necessary steps towards becoming a low-cost manufacturing hub feeding international and domestic demand.

“I think there is a legitimate concern about the so-called “jobless growth” problem,” says Cornell’s Professor Basu. “But you have to keep two things in mind. Firstly, growth in the outsourcing sector increases demand for other goods. This boosts the domestic economy and should create more jobs.

“Secondly, there are some manufacturing sectors which, for the first time, are showing signs of life. This includes the textile industry, where India is arguably the second best performer behind China. The number of jobs created by the textile industry is very high. These are the low-paid jobs India needs to create for the masses. It is the jobless poor who are of concern in India.”

First State’s Tohani makes a similar point. “India’s demographic boon could easily become a liability unless all those young people are employed,” he says. “India needs employment, and it needs the policies to encourage that. India’s boom in outsourcing has been hugely impressive, but it won’t be enough to mop up all the young people who need jobs. There needs to be greater encouragement for less service-orientated industries.”

However, laying the groundwork for an industrial boom in India is a giant task. India’s basic infrastructure is poor. A savings rate of about 23% of GDP provides it with less funds to invest in infrastructure and industry than many other Asian nations. Professor Basu points out the savings rate in China is much higher at 40%.

Moreover, the government’s consolidated fiscal deficit, at 10% of GDP, absorbs much of India’s financially intermediated savings. The money is used to fund current spending rather than investment, because of a shortfall in tax revenues. India’s tax collection to GDP ratio is very low, at about a third of Western levels. Only a small minority of India’s citizens pay tax, with evasion rife.

Arcane laws also hold back manufacturing, such as a two-decade-old edict that bars manufacturers with more than 100 employees from firing any of them. “I feel very strongly about the need for labour reform,” says Professor Basu. “Making it easier to fire workers will make firms hire more workers in the first place. I’m hoping that by the time a new government is elected in three or four years, it will be able to implement labour reforms after a national discussion lasting one or two years.”

For now, investors appear to have little time for the fact that India is a poor country with a pressing need for long-term reforms, increased investment and a pattern of economic development that can generate many more jobs. Nor do they seem to care too much that the level of monsoon, through its impact on agriculture, continues to play an important role in determining annual economic growth. The new Indian narrative, a tendentious story about India’s recent progress, holds sway. But people have begun to wonder how long that will last, and whether reality will bite hard.

“We remain very positive on the Indian story longer-term,” says HSBC’s Duggal. “But for now I think it has run ahead of itself.”

The stockmarket

The surge in the Indian stockmarket over the last three years has left some money managers cautious.

The stockmarket’s price/earnings ratio is about 14.5x based on forecast earnings to March 2006, according to HSBC fund manager Sanjiv Duggal.

“This puts the P/E ratio at the highest level for around four years,” Duggal says. “There’s a lot of money coming into India, particularly from Japan. Liquidity is helping to drive the market. But at some stage fundamentals will come to the fore. The supply of shares is increasing too. I think the stockmarket has maybe run up ahead of itself.”

Vijay Tohani, an India specialist at First State Investments, says any reversal in the global appetite for risk would hit the Indian stockmarket. “A lot of the Indian market’s earnings are also commodity-based,” he adds. “If things were to reverse there, then obviously that would have an impact. Generally stock valuations are by no means compelling.”

Sukumar Raja, chief investment office of Franklin Templeton’s unit in India, is more sanguine. “I’ve been positive about the stockmarket for some time,” he says. “The rally is telling us about real changes in the economy and the corporate sector, and about high levels of global liquidity.”

Meanwhile investment bank Credit Suisse First Boston argues that the Indian stockmarket’s capitalisation is much smaller than its economy warrants. It expects this to “normalise” over time, which suggests the possibility of further share price gains.

The economy

If India could achieve a real economic growth rate of 8% per year for the next decade, the country would be transformed, according to Professor Kaushik Basu of Cornell University.

But an 8% annual target over such a long period is a tough one to hit. One of the reasons why is that India does not invest enough in industry, infrastructure and other productive assets. If such investment levels were higher, the Indian economy’s growth potential would rise.

So what can be done to remedy the situation? One solution is to cut the government’s budget deficit, which absorbs savings that could otherwise be used for investment.

But another partial solution – if only it were possible – would be to wean Indians off their famous love for gold.

Research by Morgan Stanley economist Chetan Ahya indicates the opportunity cost to Indians from their proclivity for gold is that India’s economic growth would otherwise be higher by 0.3-0.4% per year, for the savings tied up in gold could be invested in more productive business assets instead.

India holds a $200bn stock of gold, equivalent to 29% of its gross domestic product. But Indians are far from sated: gold consumption rose nearly 60% in the financial year 2004/5.

“The cumulative gross domestic product value lost by parking $200bn worth of savings over the years in this not-so-productive asset would be huge,” says Ahya.