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Emerging Market Equities: India turns a corner

Joseph Mariathasan finds that political and central bank governance could be at a positive turning point in India, as could corporate governance at company level

India is a conundrum for foreign investors.  The rupee fell over 20% against the euro from the end of May 2013 to the beginning of September in reaction to Fed Chairman Ben Bernanke’s comments on the ‘tapering’ of quantitative easing (QE).

Investors may be hoping that Raghuram Rajan, the former IMF chief economist, who has been appointed as governor of the Reserve Bank of India, may be able to find a solution to the ‘trilemma’ that India faces: no economy can simultaneously maintain fixed exchange rates, an independent monetary policy, and capital movements.

Yet investors would also be foolish to write off Indian equities, or at least the large-cap indices such as the BSE Sensex, which reached an all-time high in early November.

“I do believe the Indian market has run a little ahead of itself, which doesn’t mean I don’t think it can run up a little more,” says Gaurav Mallik from State Street Global Advisors’ global active quantitative equity team. “The appointment of Raghuram Rajan is one reason – you have to bear in mind that India went through years of Duvvuri Subbarao, the previous RBI governor, who could not make up his mind between inflation and growth and kept on sending wrong signals to the marketplace.”

In September 2013, this all came to a head: the rupee was getting crushed so the authorities made the decision to curtail all kinds of imports.

“The economy slowed down – and India showed the biggest improvement of its current-account deficit of any country,” Mallik observes.

The authorities had also made the decision earlier in the year to cut back on oil price subsidies. Rajan then came along and made a clear call on fighting inflation at the expense of sacrificing growth in the short term. India’s deep-seated infrastructure issues have been given to the government to sort out, and Rajan has entered into swap lines that mean oil importers do not have to buy dollars, relieving pressure on the currency.

The other factor that has led to equity strength is the possibility of the BJP’s Narendra Modi coming into power. He is a controversial figure thanks to accusations of complicity in the anti-Muslim pogroms of 2002 in his home state of Gujarat while he was chief minister. But he is also recognised as having been a very effective politician who managed to reduce poverty and boost development in Gujarat, achievements India sorely needs spread more widely.

Once an investor has bought the India story, the next decision is about how to invest in it. A recent paper by Ila Patnaik and Ajay Shah, The Investment Technology Of Foreign And Domestic Institutional Investors In An Emerging Market, may offer some important insights on that score.

The authors point out that while there are over 5,000 listed firms in India, in 2011 there were only 703 firms where foreign investors owned over 5% of the publicly-traded market value. Their analysis of the differing strategies and performance of foreign institutional investors (FIIs) verse domestic institutional investors (DIIs) suggests that firms chosen by FIIs have exuberant growth in fixed assets in the proceeding three years, but that their output growth is not commensurately strong – there is some evidence of a decline in productivity.

In terms of stock-market performance, these firms underperform over those three years. Firms chosen by DIIs are strikingly different. They seem to be firms that are retrenching: both capital and labour drop slightly, but output grows and there is productivity growth. In terms of stock-market performance, these firms outperform by 18 percentage points over the proceeding three years.

Patnaik and Shah argue that these results suggest that foreign investors’ lack of access to information, and inability to process that information, adds up to poor security selection. In contrast, DIIs – who are present in India and are more likely to have ample information about portfolio companies – fare better. The average foreign investor needs to either amplify their efforts in securities selection, so as to achieve strong information and information processing on Indian firms, or not attempt selection at all.

Some of the explanation may also lie in the fact that corporate governance can be an issue. Most firms in India have a dominant manager or shareholder, typically a family or family member, who retains strategic control of the firm in the long run – the so-called ‘promoter’. Patnaik and Shah find that the median firm has promoter ownership of 50.03% – in other words, full control.

Moreover, Shah argues: “In my opinion, in the 2000s a certain kind of Indian entrepreneur started producing companies that look good to foreign investors.” But, he adds, you can’t fool all the investors all the time. “I think many investors are now more circumspect. Wall Street is changing course, and this is changing incentives for entrepreneurs. When finance rewards honest businessmen, more honest businessmen will show up asking for capital from the financial system.”

For all investors in India, that can only be a good thing.

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