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The aftermath of India's 9/11

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As the great asset bubble unwinds, investors are focusing on capital preservation, driving returns on risk-free investments towards zero. Liquidity is still being generated through life insurance premiums, pension contributions and personal saving. Pension and annuity obligations and insurance claims cannot be met with zero returns so there comes a point at which risk appetite has to be increased. Asset-backed structured investments and their sundry derivatives have destroyed wealth on an heroic scale and a huge volume of issuance has disappeared from the capital markets. Governments are gearing up to provide debt-funded fiscal stimulus packages which will feed the fixed-income markets but equity investment must surely return to favour.

India stands out as an equity investment opportunity in the medium term because of several distinguishing characteristics.  Home to one sixth of the world’s population, one-third of whom still exist at the poverty line, India survives as the world’s largest democracy. It enjoys the benefit of a common law jurisdiction with an independent judiciary as well as stock markets with more than a hundred years’ history of trading. For almost twenty years it has been emerging from the shelter of its post-independence shell as a “reserved” economy. It enjoys two distinct benefits as legacies of this “reserved” era: a domestic demand-driven economy and a tightly-regulated financial system.

Thanks to the first of these the economy is not as exposed to contagion from a world recession as emerging economies dependant on export-led growth. Only 13% of GDP is exported and 14% imported. By comparison, Chinese exports alone represent more than 35% of GDP. The Indian economy is not wholly insulated, as the cost of imported goods and reduction in foreign investment in particular may reduce real growth from its 8% trend level to something closer to 6% this year. With inflation declining comfortably into single figures, however, this should still allow corporate earnings to grow by double digit rates.

Thanks to the second legacy, the Indian banking sector has been protected from itself by the Reserve Bank of India (RBI). Had they enjoyed regulatory oversight as lax as that applied in the UK, US and the Eurozone, you can be fairly sure that competition would have spurred Indian banks into the same parlous state as their developed markets’ peers. Their activist central bank, however, deploying a full range of monetary and regulatory armament has ensured that the Indian banking sector is better capitalised and more solvent. Capital flight by fleeing foreign investors has presented a significant liquidity challenge but the RBI is managing this with due caution.

To provide a complete background tapestry, some darker economic features need to be added before we paint in the dawn. India has an acute balance of payments problem, brought into sharp relief by the spike in oil and other commodity prices earlier this year. This problem was accentuated because powerful portfolio inflows in 2007 accelerated Rupee appreciation and damaged export competitiveness. The reversal of commodity-price inflation since July 2008 has reversed this pattern but the global recession negates the export advantage.

India also has a fiscal deficit, which had been declining sharply due to accelerating company profits tax collection and urban income taxes and looked set to reach a comfortable 2.5% of GDP. The commodity price-spike undid this trend and the combined effect of fuel and fertilizer-price subsidies, not to mention a slowdown in tax receipts sent the deficit climbing back towards 5-6%. Domestic fuel prices were increased but the damage is being ameliorated now by the commodity-price reversal.

The RBI has been responding to the threat from global recession by aggressively loosening monetary policy on all fronts: interest rates, bank cash reserves and strategic reserves. It has responded to the liquidity problem of flight capital with aggressive open market operations and the addition of liquidity facilities. The banking system is flush with cash and policy is being directed to stimulate priority credit availability.

The missing ingredient now is fiscal stimulus and timing is a problem. The government is restricted in implementing direct economic stimulus by India’s famous democracy. No such policy may be adopted while elections are in progress and there are elections under way in six states, until early December. Thereafter, a general election must be held before May 2009, so the window for action is narrow. Then there is the big question: how can a fiscal stimulus be squared with a rising fiscal deficit, without undermining the economy through lax fiscal management. Well, this is where we embroider in a new dawn for India.

The G7 countries are busily developing fiscal stimulus packages with no other medium term prospect than higher taxes to re-finance the debt. After the capital destruction wrought by the western banking system and the need to adjust economic capacity to real demand, the prospects for recovery in GDP growth are restrained, to say the least. Excess productive capacity, constrained credit availability and inevitably higher taxes suggest a slow recovery for the developed countries.

Meanwhile, liquidity is concentrated in short-term, low-risk investments, with capital preservation a priority. The price of capital preservation, in terms of lost yield, will eventually drive investors to increase their risk appetites again. With confidence in non-government fixed-income markets compromised by the securitization disaster, a recovery in equity investments seems inevitable.

Multi-national brand-name comapnies with low debt and high cash-flow will remain the core of global portfolios but for added-value investors should look to India for an early recovery. India can afford a fiscal stimulus and can recover higher trend growth early because of a visible transformation event: India will have its “North Sea Oil” moment. Commercial hydrocarbon production by Reliance Industries (RIL) from the Krishna-Godaveri (KG) Basin next year and by Cairn India in Rajasthan a little later have significant macro- and microeconomic implications. Another commercial discovery has recently been announced by ONGC in shallower waters in the KG Basin, closer inshore. Most importantly, however, these developments offer a visible limit to risk from fiscal stimulus.

The investment in production and supporting infrastructure for the KG Basin deepwater field is almost complete. Oil and natural gas will be landed and distributed through pipelines for use according to national priorities: power generation, fertiliser production and city gas distribution. At the macro level, the benefits will flow in terms of reduced hydrocarbon imports, substitution of cheap domestic raw material and fuel for more expensive and volatile imports and the reduction of subsidies for fuel and fertiliser in the fiscal balance. At the micro level, RIL faces the prospect of dealing with the cash flow from 550,000 barrels a day of oil equivalent, mostly natural gas. The Cairn onshore field and the latest ONGC KG Basin field will each add 150,000 barrels a day of crude oil.

The Indian government has just awarded 44 more licenses for hydrocarbon exploration blocks and other existing discoveries are being tested for commercial viability. RIL has proven itself capable of developing deepwater discoveries and simultaneously has developed a new refinery with leading edge production technology in Gujarat. ONGC and RIL are active in overseas exploration and development as well. Far from being a resource-poor country as long represented in western school textbooks, India is on the cusp of self-sufficiency.

Driven mostly by domestic demand, with GDP growth sustained at about 6% this year and slightly higher next, as well as its transforming hydrocarbon event India stands out as an investment opportunity. Now that the “de-coupling” argument has been debunked, there is a risk of a mass retreat from emerging markets. In the case of India, this would surely be to throw the baby out with the bathwater.

The recent terrorist attacks in Mumbai were a tragic reminder of the security risks presented by a determined minority intent on causing disruption and mayhem with no concern for human life. They have elevated India to the same level of terrorist risk as the UK, US, Spain and any country that draws attention or presents a soft target for terrorists. In India, as elsewhere, the local reaction has first been revulsion at the attack and sympathy for the victims; this was followed by a determination that the event should not be allowed to disrupt daily life and divert the energy that is driving the national ambition. Our sympathy goes out to all of the victims and their families and we are thankful that our own associates and colleagues have been spared, though they all will have been touched somehow. We support their determination to put this tragedy behind them and remain committed to investing in India in the long-term.

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