December-January 2016

INDIA HEAD-TO-HEAD: No big bang, but a thousand steps

Funds Europe brought together two authorities on India for a head-to-head discussion on Modi’s reforms, corruption in government and the sustainability of growth. Chaired by George Mitton in London. Praveen Jagwani Chief executive, UTI International Private Amul Pandya Head of business development, Ocean Dial Asset Management Funds Europe: What is the outlook for the Indian economy in the year ahead? Do you think a growth rate of 7%-plus is sustainable? Amul Pandya, Ocean Dial: It’s helpful that India already has a template of what unsustainable 7%-plus growth looks like. After the global financial crisis, interest rates in India came down from 9% to about 4.75%. The government pump-primed the economy with aggressive welfare schemes and growth bounced back. The politicians were smug. They thought, ‘Look at India, it’s insulated from the global economy, aren’t we clever?’ What followed was that inflation picked up, corruption scandals showed the gross misallocation of capital that took place during the period of high liquidity, and the economy went through a painful period over the last three or four years, which it’s still suffering from. However, we’ve now got a central bank which says inflation is the most important thing for sustainable growth. It won’t cut interest rates without meaningful efforts from the government on fiscal discipline and structural reforms. The government itself is focused on making the operating environment for businesses better and is committed to bringing down the fiscal deficit. The currency has been stable and India is shining brightly among its peer group. Praveen Jagwani, UTI: Even after the IMF tapered down some of the expectations, India remains the fastest-growing large economy in the world at 7.3% for this year. At the current growth rate, India will outpace Brazil and Russia in terms of aggregate GDP next year. It will be a bigger economy than France and UK before end of this decade. India is already the third-largest economy in the world on PPP [purchasing power parity] terms. India’s relevance to global investors is unmistakable. Having said that, sustainable growth means having a balance across the three major pillars – agriculture, manufacturing and services. To have 7% growth balanced across all sectors, you need a lot of investment in infrastructure and a transition from services into manufacturing and agriculture. The ‘Make in India’ and the ‘Digital India’ programmes launched by [prime minister Narendra] Modi are essentially designed to create the balance of growth which hopefully will lead to a sustainable 7% rate with a good distribution of wealth throughout the country. Funds Europe: “Chinese firms have succeeded because of the government. Indian firms have succeeded despite the government.” Is this a fair assessment of Indian corporates as compared to Chinese ones? Jagwani: I can draw an immediate parallel to the grapes that grow on the slope of a hill as against the ones in the valley. The ones in the valley have it easy because all the nutrients and the moisture is readily available, while the ones on the slope have to dig deep and fight. Indian firms are like the grapes on the slope. Their struggle has made them resilient. China’s economy is driven by the state, which acts as a backstop for many industries, as we’ve seen in the recapitalisation of the financial sector. In India, businesses look to the government to create a regulatory framework that is not unfavourable. What drives the Indian economy is the spirit of the Indian entrepreneur to overcome such hardships of the business environment. Pandya: China and India are both so enormous, it’s difficult to make generalisations. But it is clear that the Chinese Communist Party plays a central role in deciding which sectors and companies receive capital and which will expand. And that makes or breaks fortunes. India, meanwhile, operates in an environment where the government is almost on its back and industry has to carry it along to grow and expand. China has some fantastic entrepreneurs. Jack Ma [founder of Alibaba] is a good example. But where India stands out among the emerging markets is that it has high-quality businesses across a range of sectors. It is globally competitive in automobiles, in IT services, in hospitality, pharmaceuticals
and engineering.
In contrast, the Russian stock market is dominated by commodities. In Brazil, by commodities and financials. In Taiwan, by technology. India’s entrepreneurship across a wide range of sectors allows investors to build portfolios that can survive economic volatility. Funds Europe: Are inter-national investors under-allocated to Indian assets?  Pandya: Absolutely yes. If you talk to the majority of institutional investors, let’s say endowments in North America or pension funds in Scandinavia, the majority are not even close to having a dedicated India position in their portfolios. This is a mistake. As Warren Buffett said, you want to skate to where the puck’s going to be, not where it is now. India is 0.8% of the MSCI All Country World index. Is it going to be 0.8% in three or four years’ time? No. Part of the problem is that regulations encourage investors to think it’s risky to go into a single country emerging market fund. Investors think, ‘I don’t know which country is going to do well, so I’ll let my emerging market fund manager decide.’  The reality is, flows from emerging market funds generally go to the same seven or eight stocks in India – the top capitalised companies. There are 6,000 listed companies in India. It’s a stock-picker’s paradise. By indexing yourself against an emerging market basket, you’re missing
out on the growth potential in
the smaller, mid-cap part of
the economy.
Jagwani: Every investor around the world is at a different stage of their evolving trajectory. Those who have emerging market exposure may be struggling with timing issues or whether to allocate to emerging markets in general or by country. And then there comes a question of active or passive. Taking an exposure to India through an ETF [exchange-traded fund] seems to have been the preferred route. Our objective is to graduate the people along this evolutionary curve and help them to understand the benefit of including India in the context of overall portfolio allocation.  Exposure to India remains low because investors, for a variety of reasons, are restricted by their own investment mandates or by their consultants. Often, forward-looking allocation based on GDP growth rates is shunned for reasons of career risk. Funds Europe: What is your outlook for rupee-denominated bonds? Is the rupee a good bet compared to other emerging market currencies? Pandya: Indian bonds are very attractive from a return point of view. Though interest rates are coming down, they are still high, and a lot is being done to encourage overseas investors to take part in that. However, despite positive starts, nothing much concrete is happening yet. For example, ‘masala bonds’, offshore rupee-denominated bonds that copy the Chinese ‘dim sum bonds’, have yet to take off.  The Indian fixed income market has some issues in terms of trading, settlement, liquidity and price discovery. We are still a long way away from bonds becoming a meaningful source of capital raising for Indian corporates. In terms of the rupee, it’s difficult to make short-term forecasts but the current account has come under control and the Reserve Bank of India governor has the confidence of the markets. India was the biggest recipient of FDI [foreign direct investment] in the first half of 2015. It’s tough to see India underperforming versus emerging markets. Jagwani: By virtue of Indian interest rates and inflation being higher than that of the US, the Indian rupee will invariably depreciate over time. That is fundamental economics. However, Indian bonds still offer a rupee-decline-adjusted return which is superior to most of the developed world. Half the countries in Europe have a negative yield on their sovereign bonds. Pension funds in the UK are buying 50-year bonds which are inflation-adjusted and yield minus 1%. Even if you were to hedge the Indian ten-year bond, you still end up getting about 1.1%. The Indian interest rates have been counter-cyclical to that of the developed world ever since the financial crisis of 2007. For a global bond investor, you typically want to invest in a market with declining interest rates so you can enjoy the capital appreciation, rather than being in US treasuries, where there’s an interest rate hike scenario looming. For those reasons, the Indian bond market is relatively attractive for the global investor. However, the bond market is not growing or developing at a pace that can accommodate the global interest. Modi wants an infrastructure spend of about
$1 trillion. Infrastructure is typically funded with 30% equity and 70% debt, of which half comes from bank finance and half from bonds.
Let’s say half of that is raised onshore and the other half raised offshore. You would need foreign investment into Indian bonds of $175 billion. Today, all foreign investors put together can buy Indian bonds to the tune of $83.5 billion. Thus there exists a tremendous opportunity for opening up this asset class of Indian bonds in the next
few years. 
Funds Global: India is a major centre for IT, and yet most technology innovation occurs in places such as California. Will India ever have its own Silicon Valley? Pandya: In terms of IT, I don’t see anything on the horizon comparable to Silicon Valley. India’s IT strength is driven by an education system that churns out highly competent engineers, and labour costs in the US and Europe which have spiralled upwards. It’s a labour cost arbitrage. Where India does have cutting-edge innovation is in the pharmaceutical sector. For example, there’s a company called Biocon which is developing a drug in the oncology space for cancer patients in the head and neck area. It is at the forefront of cancer drugs globally. The issue is that these companies don’t have the distribution capacity or the capital to distribute on their own, so they’re tying up with multinationals to do that. That’s why we haven’t heard of Indian companies or India as a particular specialist in this space. We’re about five years away from India being recognised as a solo contributor to cutting-edge pharmaceutical or drug therapy. Jagwani: In the IT space, I don’t think India wants to take on the mantle of innovation. What Indian companies are good at is implementation. No matter what the next cutting-edge technology, system or protocol is, these guys learn how to implement it. That skill of integration and implementation keeps Indian IT companies insulated from the vagaries of innovation and obsolescence. That explains the rising global market share of Indian companies such as Wipro, Infosys and TCS while Nokia and Google Glass bite dust. Funds Global: Do you foresee any changes in the way international investors access Indian assets? For instance, could there be changes to the tax treatment of investment funds domiciled in Mauritius? Pandya: In the budget this year, the finance minister [Arun Jaitley] said he wanted overseas fund managers to be domiciled in India. He created a safe-harbour provision to allow foreign private equity funds to set up shop in India rather than be domiciled offshore. They wouldn’t be subject to the short-term capital gains tax that inspires foreign funds to be domiciled offshore. The issue was there were 15 pre-conditions to qualify for this safe-harbour provision and they were so onerous that not a single fund chose to opt for it. The finance ministry realised it made a mistake and will take recommendations to see how it can improve the regulation. Although progress it slow, the will is there and we will see a shift away from fund managers being based outside of India towards them being based in India. What the finance ministry could do to expedite this process is create a cultural change in the income tax department. At the moment – and we saw this with the MAT [minimum alternate tax] fiasco this year – there is an obsession with targets without thinking about practicalities. The fear of getting slapped with a tax bill five years down the line is still prevalent among Indian and overseas investors. Jagwani: The Mauritius route has come under so much suspicion over the last few years that most large investors do not want the burden of uncertainty. For long-only investments in India, the Mauritius route is on the decline, with Singapore becoming the next centre of choice. The Modi administration has been clear that it is looking to deliver transparency, stability and predictability of regulation. Jaitley made suitable attempts to control the damage caused by the MAT fiasco. And Modi himself referred to it in his recent speeches and said he is committed to not spooking the foreign investment community. Funds Europe: What are the biggest challenges that India will face in the next five years – for instance corruption, the privatisation agenda, demographic change or politics – and how can the country overcome them? Pandya: When Modi came into power, he was compared to Margaret Thatcher and Ronald Reagan. People expected a ‘big-bang’ style of government. The reality, we now know, is quite different. He would rather make a thousand small steps than five to six big-bang policy reforms.  Privatisation is a good example of this. If people have in their minds that Modi is going to privatise the entire banking and infrastructure sectors, they need to rethink their view. The BJP [the Bharatiya Janata Party, which Modi leads] has better things to spend its political capital on. On corruption, you can point to tangible success achieved by the government. In February, we saw the e-auction of coal mines to the private sector – an area that had come to a complete standstill due to a massive corruption scandal under the previous government.  Because the auction was done online, anyone could see who was bidding for what. It minimised face-to-face interaction between bureaucrats and companies, which was the great medium for corruption. Anyone who has spent time in India will know that corruption at a low level, with the ticket inspector or the policeman, is going to take a long time to change. That can only trickle down from the top.  It will, though, because this is the cleanest government we’ve had in a while. In my view, the biggest challenge facing India is liberalising the remaining two of the four factors of production, land and labour, which still operate according to a Nehruvian socialist approach.  To give an example, more than half of manufacturing firms in China have more than 200 workers. In India, only 11% do. The reason is that Indian labour laws restrict companies from building scale. The benefits of economies of scale are not being felt by Indian manufacturing. India has a great opportunity because wage increases in China leave India well-positioned to become the world’s manufacturing hub. As it stands, smaller countries such as Vietnam and Bangladesh are capitalising on that. Without reforms, Modi won’t be able to make the jobs he needs to stay
in power and to get manufacturing going.
We are seeing some progress. In Rajasthan, there have been moves to ease up hiring and firing, and to curb trade union power, but there’s a long way
to go. 
Sadly, the government doesn’t have the political power to do this from the centre. It needs to push the states to liberalise land and labour laws. Jagwani: It was Churchill who said, “India is merely a geographical expression. It is
no more a single country than
the equator.” 
India is a complex country composed of very diverse segments moving at different paces. While some people are stuck in the Nehruvian ideology of state-dominated governance, there’s a young, progressive population which wants independence and reform and wants it yesterday. The biggest challenge is getting everybody to understand and accept the differential pace of the reform process for different segments. There will be setbacks, such as the recent elections in the state of Bihar that were fought on caste and communal lines. There is a fair amount of friction that is simmering beneath the surface as the old India and the new India jostle together.  Given the fact that we are a fairly young country, the young population can be given to social unrest if not fed adequately with opportunities. In the long run, a good-quality basic education is the most enduring solution for a widespread improvement in quality of life and in the ease of doing business. Pandya: The honeymoon period is over and until these reforms kick in and start showing fruit, we’re going to have ups and downs. But the work rate of the various departments is encouraging, as is what’s happening at a state level. Some states will be left behind and they’ll realise they need to push forward to catch up with the rest of India. There will be some naming and shaming going on. The good news is that the old style of government, where big companies interact with politicians for favours and permits, is on the way out. fe

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