Hype, hope, expectation

What a difference a year makes. In fact, this time around last year, amid chest-beating about policy paralysis and an alarming current account deficit, the rupee was rebounding from its all-time low of about 70 against the dollar and the market was pinning its hopes on the new Reserve Bank of India governor Raghuram Rajan to work his magic. Like most things Indian, there was a twist. Rajan was the icing; the cake came later in the form of the decisive election victory of the BJP led-National Democratic Alliance.

With the hype around the historical mandate yet to die down, the hope now is that the Sensex will go even higher as the BJP government does what is expected of it. To gauge how much of it will come through, we have made our way to The Pierre Hotel in New York, which sits across the city’s evergreen landmark, Central Park. The 85-year-old Pierre has a colourful history and among many things, has witnessed the Great Depression, an infamous heist, the filming of a classic tango and multiple changes in ownership. Once owned by billionaire tycoon Jean Paul Getty, whose formula for success, much like fellow mega-billionaire John Davison Rockefeller, was, “Rise early, work hard, strike oil”, the Pierre was acquired by the Indian Hotels Company in 2005, a year when nothing could go wrong, not just in India but across the world. The late 2008 credit crisis, for many, was still undreamt fiction. Since then fiction did play out in its strangest form and many QEs later, investors still fondly recall the go-go years that lasted from 2003 to 2008.

Cut to the present. About 9,000 sq ft of unadulterated opulence awaited investors who had gathered at the Grand Ballroom for the 10^th annual India Investment Forum organised by international finance publisher Institutional Investor. Given such an extremely over-auspicious build-up, the forum, in its 10^th edition, was expected to be the most well-attended yet, but attendance thinned once it became known that finance minister Arun Jaitley would be skipping the event owing to health reasons. Surface transport minister Nitin Gadkari also failed to surface as campaigning for the Maharashtra assembly elections had gathered momentum; maybe he had an inkling of the impending break-up of the 25-year old BJP-Shiv Sena alliance in the state. Coal minister Piyush Goyal’s absence was attributed to the upcoming Supreme Court judgement on coal block allocations. As it turned out, the next day, the apex court cancelled almost all the licences allocated since 1993.

The ministers and bureaucrats playing hookey did act as a dampener. For the organisers, it must have felt like déjà vu. The same had happened during the last India Investment Forum in September 2012, when many UPA-II ministers pulled out at the last moment fearing a government collapse (the conference was not held last year, given the dismal sentiment).

Naturally, as the attendees gathered in the Garden Foyer, the early morning conversation centered on the need for more forthright communication on part of Indian ministers and bureaucrats, who take many things for granted. This informal chat about lack of protocol led to a fixed income investor recounting the temerity of a former RBI deputy governor, who arrived late for a meeting with a group of foreign investors. After he was seated, without apology, he boasted, “You know what is so great about India…we have the highest number of PhDs.” One of the investors, clearly incensed by the delay, interjected, “Then why are your stats so bad?” Amid all-round guffawing, Oliver Fratzsche, who was among the panelists at this year’s forum and whose company advises institutions investing in emerging markets, mentioned how there was not much difference between the recommendations made by the IMF in 1991 and 2014 with respect to improving India’s fisc.

Double jackpot

The rupee has appreciated 9% while Brent crude has fallen 21% over the past year

The more things change in India, the more they stay the same was a much-repeated refrain. Veteran India hand and Omega Capital chairman Raju Panjwani did not pull any punches either. “You need 16 licences for the simplest business that you want to set up in India. Why would somebody in America, who can set up a company online in 20 minutes for $200, even think about India? In the few India conferences that have happened here recently, there hasn’t been much attendance despite the change in government. There isn’t any perceptible change in mood. It is more like, ‘Here comes India again. Let them demonstrate change before I come in and listen to all these lectures again’.”

Capital account

India may not be the cynosure of all eyes yet but there is renewed interest as the policy and macro picture has improved dramatically over the past few months.(See: Double jackpot) The new prime minister is single-handedly responsible for this positive change in sentiment. Depending on how you look at it, this could either be a reason to celebrate or for concern. The force of his personality, which is reason for cheer, is also a cause of worry for a great many investors. In fact, one of the investors attending the forum did pose this question to Jayant Sinha, the ruling party’s member of parliament from Hazaribagh, who spoke on behalf of his party at the forum (more on page 40). Sinha, a Harvard Business School alumnus who got elected from his father’s — senior BJP leader Yashwant Sinha — constituency, contested the investor’s fear that the BJP does not have a B-team beyond prime minister Modi.

Partly agreeing that there was, indeed, a keyman risk, Sinha went on to say, “Mr Modi is a phenomenal leader and if something were to happen to him, we would all be worried. As for the B-team: the BJP is a meritocratic organisation with tremendous bench strength; we have a number of fairly eminent leaders and a terrific group of people coming up who are currently in their 40s and 50s. BJP, unlike other political parties in India, is capable of institutional rejuvenation and generational change.” As there was no follow-up query, it could either be that the audience might have found the answer satisfying or didn’t want to be delayed for lunch at the Pierre’s Cotillion Room. Despite hurrying along as fast as they could, they didn’t find Al Pacino doing the tango there like he did in the 1992 classic Scent of a Woman.

Hitting where it hurts

The rupee depreciation has taken a healthy bite out of the return made by long only India-dedicated funds

While the three-course lunch at the Cotillion did turn out to be appetising, investors still find the bureaucratic red tape in India hard to digest. And there are quite a few horror stories, says the New York-based Panjwani, some that he himself continues to endure. He pauses briefly as if to contain his anger at what he is being made to go through at his Indian software exports company. “We have been filing returns for the past seven years but have not got back the first assessment year’s TDS (tax deducted at source) because the officer is saying today’s rate is 25%. A 25% kickback for what? It is my own money and you have sat on it for six years. When the guys in the US hear war stories like this, nobody wants to invest,” he fumes.

Along with Panjwani’s grouse about ridiculously excessive paperwork in both FDI and portfolio investments, Pashupati Advani attributes the geographic divide to be another contributing factor for the disinterest of US investors who have stayed away from Indian equities. “As a debt player, I am happy to get a 5-7% dollar-denominated return but as an equity investor, I may be doing better here, as the US market has done well over the past couple of years. Here, the process is easier; you just press a button and it is done. In India, you have to dance and get this paper and that paper done,” says Advani, whose firm Global Foray advises institutional investors wanting to invest in India. “From the US, India seems very far. My experience is that in the US, the emerging market money tends to stay in this time zone, so it stays in South America rather than coming to the east. And a lot of money that comes to the east is driven by guys sitting in Hong Kong and Singapore, who work for US firms,” he adds.

Fixing terra firma

The line between regulation and excessive control in India is a blur and it is control that enables you to seek rents. They may not know a paratha from a chapati or be able to differentiate between Hunan and Sichuan sauce, but for most foreign investors in India and China, baksheesh and huìlù are familiar terms. Hence, while the macro picture does look good for now, there is a need for tweaking at the micro level; grassroots corruption is something that the prime minister will have to fix.  “At the lower level, people do not have any taxing or spending authority. Their way of gaining power is to apply a personal tax on every transaction. The solution is to get incentives right at the bottom in a way that leads to economic growth. That is a much bigger transformation that needs to happen in India. Right now, the states are very powerful and the cities are incredibly weak,” says William Antholis, managing director, The Brookings Institution.

Besides pushing through a mindset change at the ground level, the other major challenge for Modi is getting non-BJP states to realign with his vision of making India an economic power. Reform is going to be very difficult and it is very important that national reforms mirror at the state level. Antholis points out, “In India, power and water are handled at the state level. For now, the prime minister does not have a mandate in the upper house; his party controls only five states and is at loggerheads with the state governments in the south and the east. He is going to face this tension as he goes about trying to transplant the Gujarat miracle.”

Not much legroom

Tax harassment is a hassle not only for investors like Panjwani but even for multinationals such as Vodafone. The telecom major might have recently got a favorable Bombay high court ruling in its FY10 transfer pricing dispute against the income tax department but, given the demand involved (₹3,200 crore), it is unlikely that the department will not appeal the ruling in the Supreme Court. Incidentally, Vodafone has been a favorite whipping boy and the government is in multiple disputes with it as a result of its retrospective amendments. 

Broader ain't much better

If one ignores dividends and changes in the broader Nifty index, dollar return has been decimated by half

Tax terrorism is a natural outcome when the state is fiscally challenged and the witticism that went round after retrograde retrospective amendments started taking place regularly was: “The future was always uncertain but now, in India, even the past has become uncertain.” Investors are edgy about the fact that there has been no clear commitment on withdrawal of extra territorial amendments. They continue to take solace in the fact that the finance minister himself is a lawyer and would possibly be sympathetic in the FY16 budget. That may seem rational but there is not much latitude on the fiscal deficit front as for FY15, government borrowing has already reached 75% of the Budget estimate. The market might well be discounting a fiscal deficit of 4.5% instead of 4.1% for FY15 but is equally eager to see a realistic revision of the FY16 target of 3.6%.

While the finance minister has started inviting suggestions and estimates for the FY16 Budget from various ministries, it is the final draft which the market is keenly waiting for. If the right commitments are made, the honeymoon period being enjoyed by the BJP government could well be extended for another year at least, assuming stability in the global market. But global stability is not a given, cautions Sarvjeev Sidhu, head, emerging markets, Aegon USA Investment Management. “A combination of rising rates in the US (as happened in the 1990s) and rising leverage in the corporate sector (1997 in Asia) could derail emerging markets. There has been explosive issuance of corporate debt in emerging markets in recent years. As U.S. interest rates start rising that could cause refinancing challenges for the corporate sector, and a possible repeat of what happened in Asia in 1997,” says Sidhu. 

The fall in the price of gold and crude reflects the fear of a rising interest rate in the US and an unwinding of carry trades. Brent crude is trading at its lowest over the past four years and that is making India’s current and fiscal account deficit look extraordinarily good. It may portend low global growth but, for now, investors are more focused on the improving macro. The argument goes thus: even if we lose out on exports to Europe or China, the net balance of payments still works in India’s favour. What is possibly getting ignored is the sentiment aspect or the fact that crude producers could taper their supply as the current price of $90 is not enough to support their expenditure budgets.

Teresa Barger, managing director, Cartica Capital, which has 20% of its $2.8 billion portfolio in India, feels that policymakers should feel lucky about what is happening and take advantage of it. “The geopolitical situation is on fire; what happens if Russian supply comes off? It is possibly a delayed reaction, as there was during the 1973 war between Egypt and Israel, when the price shock didn’t come in till months later. I think oil under $100 a barrel is not something that we can count on.” 

The currency, too, has been relatively stable but, lately, the RBI has been experiencing strain on account of the dollar’s overall appreciation. In FY14, its net buying totaled nearly $9 billion. Even in FY15 thus far, its net purchase has been just over $15 billion. It is only in August this year that it has turned a net seller and, given that the dollar has been gathering steam for the past couple of months and FII flows have been slowing, the September data, too, might show that the central bank was a net dollar seller.

Though the RBI wants movement in the rupee to be orderly, during uncertainty, the currency market trades in anything but an orderly manner. Foreign investors are extremely sensitive to rupee depreciation, as it hits their absolute return (See: Broader ain’t much better). Advani thinks the volatility in the rupee holds the key to foreign institutional investors continuing to stay invested in the local market. “The question everyone is asking is where is the rupee going and what could happen that could make it fall off? Compared with the 8% that you get on an Indian bond, you get 2% in the US. If the rupee is stable, investors effectively make 6% in dollar terms. That is a critical component but so far we have lost that battle.”

Foreign investors feeling homesick in a climate where business confidence in the world’s major economies is declining is another worry. China’s central bankers, like the European Central Bank (ECB), are grappling with falling demand and high debt. “Over the past three years, fixed asset investment was fueled by direct fiscal transfers and state-owned banks lending to state-owned enterprises. Right now, the estimates of non-recoverable debt in inland China are about $3 trillion. Nobody really knows what the nature of debt is in China or if it is $3 trillion or closer to $7 trillion? If you take into account all the debt that the Chinese are taking in other places, then the number becomes even more risky,” says Antholis.

On his part, ECB governor Mario Draghi is desperately trying to fend off deflation but whether he succeeds remains to be seen as he is only in charge of monetary, and not fiscal, policy for the region. Not that this situation has not played out before; we did have a Eurozone scare in 2010 and 2011 but that can was kicked down the road, and what happened in Cyprus in March 2013 stayed in Cyprus. Now, we are back to fretting about a slowdown in Europe and nowhere is the worry reflected more than in Germany, where the benchmark DAX has hit a one-year low. Even the Dow Jones Industrial Average has given up its gains for 2014 and the Fed, too, is coming up short in its attempt to shore up inflation. Oversupply in gassupplies is not helping either. Sticker prices at US gas stations are dropping and nothing succeeds in igniting inflation as higher fuel prices do.

Clearly, historically low interest rates have not stoked inflation and a rising dollar is not helping. The Fed’s only recourse in such a situation is verbal intervention, which it did through its latest Federal Open Market Committee statement. The other option is status quo on rates, which only fuels emerging markets. 

Russia is doing badly and so are Brazil and China, and that has gone in India’s favour (See: Hot, hotter). As jitters intensify, it is hard to see why all emerging markets will not see an outflow, as investors barter higher returns for liquidity. In times of crisis, illiquidity is a clear and present danger in emerging markets and despite India being a trillion-dollar economy, its stock market is treacherously shallow. “You can’t get out in size and that has actually prevented the size investors from coming in. After 60-70 stocks, you can’t get out as there is no liquidity. Even for companies such as Hindalco, which is in the Nifty, you would have difficulty selling $20-30 million worth of stock in a single day. You would have to spread the trade over two to three days. In the US, you might make a little less money, but the impact cost is not 5%,” reminds Advani.

Heavy lifting

At this point, it may seem like we are in a sweet spot but there is a big difference this time. Global growth was great between 2003 and 2008 but that is not the case anymore. Also, during the 2003-2008 period, a virtuous cycle of lower interest rates, higher investment and savings, higher GDP growth, robust tax collection, lower fiscal deficit leading to lower interest rates was in play. 

Breaking out

The mcap to GDP discount is the lowest in four years

This time, reviving animal spirits may not be as easy, though, as shown by the August IIP number which grew a measly 0.4%. More worrying is the fall in capital goods production. It only means that existing capacity is still not being fully utilised and companies are not feeling confident enough to add new capacity. Another red flag is that credit growth, too, has not shown any sign of picking up. The dismal August IIP number is more worrying because it is well after the new government was sworn in late May. If IIP growth continues to be weak, simmering tension between the government and the RBI regarding lower interest rates may again come to the fore. The RBI has been steadfast about bring CPI down to 6% (currently at 8%) by the end of 2015. Almost everybody, right from unscrupulous real estate developers to the occupants of North Block believe that lower interest rates will get demand moving. Even suggesting any kind of demand satiation or overcapacity is blasphemy that flies in the face of the great Indian growth story. It is hard to reconcile or even think that a 4% to 6% GDP growth is the new normal for the kind of setup that we now have in terms of infrastructure and salary levels in the country. 

Panjwani recalls the difficulty of operating in a market like India. “I myself set up Morgan Stanley’s asset management and investment banking business in India and it took them 12 or 14 years before they saw any break-even point. I was told that we should be in India for the long run. Now, is long term three or five or 20 years? When the long run is not clear, that is when it starts to get murky.” Consumer product companies will continue to invest because they will otherwise miss out on a big market. Even with them, there is frustration about the price point because you are there in the hope that pricing will change someday, he adds.

Hot, hotter, hottest

Among BRICS, India is the most expensive emerging market on all valuation parameters

Advani has been in the market for 25 years now but strains really hard when asked which legacy foreign institutional investors have consistently made money in the Indian market. “Success stories in India have been companies such as Morgan Stanley, Oppenheimer and Fidelity, who have held on doggedly despite five-10 years of losses. Again, compared with the 20 years that they have been here, they have not made a really spectacular return. So, when someone asks me to give examples of five happy FIIs, I can’t name any because they just don’t exist. Of the $200 billion held by FIIs, I would say there is probably about not more than $20-30 billion in profit that is unrealised. The 5% of the emerging markets allocation that is going to remain in India has most of the gain.”

Clearly, any exponential jump from here would need a favorable global tailwind. Sidhu notes, “India is currently growing below potential by 1.5%. Lower energy prices and structural reforms should increase India’s GDP growth. The question is, is it sustainable especially since global liquidity conditions are likely to tighten? Apart from uncertainty and turmoil, capital will likely flee due to concerns about emerging markets growth and high valuation. India’s P/E is approximately 19, that is expensive. If India becomes relatively more expensive, foreign portfolio investors will take money out.”

Even if the status quo of ebullient sentiment and liquidity continues, the contradiction at this juncture is the inability of the country to absorb capital without resulting in a valuation bubble (private equity chasing e-commerce firms in search of an Indian Alibaba) or uncontrolled currency appreciation. The ability to absorb capital in many sectors is limited and sectors like banking, infrastructure, real estate which need capital are tightly regulated and have delivered lousy return. Overnight, the government may have changed but individual companies’ balance sheets have not. Then, there is the age-old issue of governance. For Barger, “All promoters in India are guilty until proven innocent. We want to be sure that the promoter will not steal from minority shareholders.”

After India’s about turn in July at the World Trade Organisation (WTO), Barger is also worried about an autarkic mindset. “Importing things into India is necessary to create a manufacturing industry. You import unfinished goods, work on them and re-export them, and that is where the WTO is quite helpful. The Chinese weren’t caught up in autarky; they made 700 million people go from poverty to reasonable living. India’s got 700 million left to go and you are not gonna do that by defying the physics of economics. And the most important function of economics is about making people less poor,” she castigates.

Antholis contends that there is also a skill deficit that needs to be fixed. He explains, “The biggest difference in India and China with respect to being ready for manufacturing is that since the 1940s, China decided to invest in primary and secondary higher education. The population was technically proficient but intellectually starved. India was the exact opposite. Nehru’s vision was to have Oxford-style universities all across India, so you had investment in IITs and IIMs but under-investment in primary education. The exception was south India, which now has 80% to 90% literacy, as opposed to north India which has 60% to 70%.” 

Evidently, it is not just about vocalising shibboleths like Make in India; it is also about being ready at the ground level to facilitate such a transformation. The market is now awaiting implementation specifics on Make in India, Clean India and direct cash transfers through Aadhaar. Already there is some disquiet about delay in PSU bank restructuring and privatisation and there being no implementation time-frame despite the Nayak committee report. 

“Structural reforms under the leadership of Narendra Modi are expected to raise India’s growth rate and attract foreign investments, especially when China appears to be slowing down. The government also needs to create an environment to attract NRI capital, similar to what China has done successfully in the past,” remarks Sidhu. Subject to the right things being done, there is more money waiting to be deployed than India has the capacity to absorb. Potential big-moneyed overseas investors don’t want to see the prime minister sweeping, they want sweeping reforms, and this time around they are shooting for the moon but expect to land on Mars.