As posted in ASIA MONEY's article - November 2004.
India is growing strong and has the potential to become one of the world's most vibrant economies. But the country still faces challenges: rampant poverty, a burgeoning budget deficit and a new government. Asiamoney asked three Indian experts - a leading CFO, a fund manager and an investment banker - about the recent elections, reforms and the future of India and its capital markets.
- Amit Chandra (AC), joint managing director, DSP Merrill Lynch.
- Arindam Bhattacharjee (AB), fund manager, Emerging Markets Management.
- Mohandas Pai (MP), chief financial officer at Infosys.
What are the major themes in India's financial markets?
MP: The one major issue that people are talking about is the movement of interest rates. They have bottomed out and could move up despite having adequate liquidity in the market place. The key issue with...rates is what corporates should do if and when they move. Second is consumer demand and growth and what India's growth rate will be for the next four to five years. It could be 7 per cent to 8 per cent p.a. for the next five years (We_d_living: As per C K PRahalad, Research PRfoessor at Michigan Ross University,USA - 10-10 is success formula for India i.e. 10% must be the growth of INDIA )and people are excited and discussing expansion plans for industries like the steel and metals, construction, pharmaceuticals, automobiles, heavy engineering, textiles and the IT industry, where the global market is opened up. Also, everyone agrees that India needs to invest more in infrastructure.
AB: The big issues are: will the new government continue and/or accelerate the economic reform programme and peace initiatives with Pakistan followed by the previous government. And secondly, how quickly will we see interest rates reverse. Finally, after a sharp revival in economic growth led by agricultural production and manufacturing growth, will we see a repeat or a return to 4-6 per cent growth rate?
AC: While the long-term story of strong growth and returns seems to be intact, over a short- to medium-term perspective, the market is being overshadowed by the volatility in flows to emerging markets, the high crude prices and rising inflation, developments in China, and the issue of [the] introduction of turnover tax.
After the elections, there was hundreds of millions of dollars of redemptions by foreign investors out of the Indian stock market. How did this affect the market and has the situation improved? Did you sell down your Indian positions following the elections - have you since re-invested those funds in India?
AC: The stock market did see a sharp 20 per cent plus correction post the elections on the back of a sell-off by both domestic and international investors. However, I don't think the sell-off is something to be over concerned with considering the fact that the Indian markets had nearly doubled over the previous 18 months and that most emerging markets were also under pressure since the beginning of the year, driven by the change in global flows. The situation since then has improved and markets have risen more than 10 per cent from their lows as investors realise that reforms are going to continue and economic growth is expected to remain in the 7-8 per cent range.
AB: The post-election sell-off seemed a bit premature and [a] reversal of the 'froth' that had built up in the markets thanks to a number of new hedge funds and global funds gaining exposure in India. The market has stabilized but remains one of the worst performing emerging markets year to date. We did not sell down our holdings although we have not increased our exposure either.
The government has made an about-face on its privatization policies - what impact is this having on investor sentiment? Does this matter when trying to attract foreign capital?
AB: It is a major negative for attracting foreign capital into India. The government has also slammed the door shut on a significant source for financing its budget deficit (running at close to 10 per cent on an aggregate level, i.e. including [the] states) since it is unlikely to be able to make any concessions on the expenditure side. If economic growth slows this year, affecting tax collection, they could truly regret this decision based on pressure from the Left Front.
MP: The impact has been slightly negative on investors. It is important for foreign investors because the major issue facing India is infrastructure and the government has to invest. They are unfortunately running up a fiscal deficit of 9 per cent of GDP and it could be unsustainable. They need to sell public-sector holdings and use [the money] for infrastructure. Dismantling the public sector creates better efficiencies in the economy - just [as it has] in telecommunications. Oil and gas needs more competition and some areas of manufacturing need momentum for growth. These are two big areas that are important for investors, both in India and abroad.
AC: The new government's policy on privatization has largely impacted the valuations of public-sector companies. However, I believe that the fears are overdone since the government has, through the proposed NTPC offering, already signalled their desire to continue to pursue the sale through [the] capital market route, which was the preferred route even for the previous government. Undoubtedly, India would attract a lot more capital, especially FDI, if privatization through strategic sales were permitted. However, it is very difficult for any government to ignore the political reality and the common man today prefers that the government retain control of most public-sector enterprises. Perhaps we need to wait for the benefits of the past strategic sales to become a lot more evident before the opposition to such sales reduces.
Inflation is hovering around 6 per cent, which is creating negative bond yields. Is this harmful to the development of the bond market - or just part of an economic process?
MP: Inflation is 5.5 per cent to 6 per cent, manufacturing inflation is 5 per cent and fuel inflation is in double digits. It is harmful as savers want positive interest rates. The problem is the financial system is very rigid. Corporate lending rates are between 10 per cent and 11 per cent with 5-6 per cent for the top corporates. There is a gap - prime lending is 10 per cent but companies that are AAA [rated can borrow] at 5-6 per cent - the top [companies] are getting cheap money. Non-prime borrowers and savers are not getting prime interest rates. This is happening because the bond market pays 5.8 per cent for a 10-year bond and regulations require 25 per cent of total deposits to be invested in government bonds. For banks, if they put 25 per cent in government bonds and another 20 per cent goes to prime borrowers at low interest rates, more than 50 per cent, including cash, needs to be lent at high interest rates.
AB: This is a temporary phenomenon. We are likely to see a steepening of the yield curve shortly as the market factors in higher borrowing requirements from the government. The budget provides very ambitious revenue collection targets that are unlikely to be met.
AC: The long-term target for inflation is closer to 5 per cent and it is likely that inflation will soon peak and then commence a reversal over the rest of the fiscal year. I think the markets are reacting normally to the inflation data, showing that the Indian debt markets are reasonably vibrant. Real yields would only have been more negative if the government were to permit greater flows of foreign capital into domestic debt instruments, so perhaps the policies are actually helping achieve a balanced approach.
What capital-raising trends are you seeing for Indian corporates? What is the most vibrant source of funding?
AB: The domestic capital markets. The larger corporates will gain access to other sources of financing - structured deals as they try to grow through acquisitions overseas.
AC: Indian companies are getting capacity constrained and therefore need for capital is increasing. Most companies are coming off a cycle wherein they operated with minimal leverage and, therefore, the preference is for tapping debt sources in the first round. A few companies are looking at raising equity, however these are really in the minority.
MP: The equity market is vibrant but it needs scale and size. There will be IPOs from telecom companies and if they want to do well, companies have to be attractive. The financial system is flush with funds and [there is] $25bn of short term surplus parket with the central bank. There are no borrowers in the market as the corporate sector is very liquid because they are trying to pay back high-cost loans taken out four to five years ago. The debt equity ratio for the entire corporate sector has come down as profits have been good for the last three years.
The rupee has come off of a long run of appreciation and actually depreciated in recent weeks. How is this affecting Indian corporates who do business in US dollars? How does this affect equity investors in India?
AB: Most exporters were worried about the rupee appreciation and should be happier. However, a number of companies have converted rupee loans into dollar loans - a small percentage of them have left these positions open expecting the rupee to appreciate further. [It] might be a shock to them but do not expect [the] rupee depreciation to be significant [enough] from here to cause a shock to the system. Equity investors are unlikely to be affected much.
MP: The 5 per cent appreciation in the last fortnight of March 2004 made people nervous. It does have implications across the economy and a lot of people are getting hurt. But now the rupee is depreciating and creating better confidence in business to be globally competitive. If the currency appreciates 8-9 per cent, it will hurt the manufacturing and export sectors. The impact on equity investors follows. For foreign investors who calculate returns in dollars, a stronger rupee obviously helps.
AC: If you carefully look at the rupee/dollar chart, all that has happened is that a spike in the rupee has corrected and the markets seem to be heading back towards the secular trend that we have witnessed over the past many years. Most Indian exporters are thrilled with the reversal since the sharp appreciation had put a lot of pressure on their margins and also put them at a disadvantage vis a vis competitive countries, particularly China. Equity investors do not seem to be over-perturbed... since they are much more focused on the underlying fundamentals of the stock market. The movements would have impacted debt markets a lot more, but considering the limited exposure on account of caps and other restrictions, we have seen minimal implications.
Now that the budget has been announced, what are your views on how the government is going to reduce the deficit and liberalize the economy? Are they on the right track?
MP: The previous government had a very good approach to opening up the economy but needed to focus more on the social sectors. The government has to look after the poorer citizens of India because without them participating in the liberalization process, the economy will not grow. The new government has said that they will focus on healthcare, education, agriculture and infrastructure. The government can do more and we need greater investment. The deficit has come down. The government can reduce the deficit further by focusing on tax reforms and downsizing the public sector. But the coalition government works under constraints. Within the constraints the budget is a good one as it enhances investment in the social sector and on infrastructure.
AC: The budget is clearly a positive surprise. It's a strong signal that this government has the will and desire to continue to pursue reforms, encourage investment (particularly FDI), and bring down the deficit. Given the severe limitation of time that the government was dealing with, I think the big bang reforms will actually follow in the coming budgets.
What effect will the introduction of a value-added tax have on the economy? What are the pros and cons?
AC: VAT is actually a win-win for the government and the Indian industry. VAT will help remove the internal barriers in the domestic markets, thereby facilitating more efficient flow of goods and services. At the same time, recent experiments have shown that [the] introduction of VAT can actually help raise revenue and help plug leakages that exist within the system.
AB: The introduction of VAT and [its] proper implementation will likely result in a much larger collection of taxes. The tax to GDP ratio in India is in single digits - lower than most other economies in Asia. Proper implementation, though, will be the challenge and the state governments will have to play along. Otherwise, it will not work.
MP: This is a positive - India has about 30 states and five union territories, with each having its own tax structure and borrowings. India is not a seamless national market but a market with multiple state taxes and restrictions on free movement of goods. VAT will bring in a single market and lower the tax base for many corporations because the VAT mean rate will be lower than what they are paying now and will also stop leakages in the system.
The ceilings for FDI in certain industries such as telecommunications, insurance and aviation have been raised. How important is this development to the economy and to the development of these industries? What is the long-term outcome?
AC: This is a very welcome move. Enhanced FDI will help spur investment in these critical segments, which are much needed to spur economic development and employment creation. Importantly, by enhancing FDI in these 'holy' sectors, the government is giving a strong signal that, despite all the opposition, [it] is willing to do what is right from a longer-term perspective.
AB: This was a much-needed relief for these sectors to obtain foreign funding and help them meet their growth objectives - a positive development that will hopefully attract increased FDI.
MP: It is positive because sectors such as telecoms require huge investment. By June 2004, there were 85 million phone lines for fixed and mobile, but by December 2006 India is expected to have 150 million lines. People are looking at doubling the total number of lines and this requires very heavy investment. It also requires accessing capital from all sources and liberalizing the investment cap to give companies in these sectors access to more capital. This move is a positive for these industries. The long-term outcome will be a bigger market, better services and lower costs to consumers.
What changes would you like to made see to the economic reform programme? Where is the government failing to implement positive policy changes?
AB: I would like to see the reduction of subsidies in agriculture, power-sector reforms, acceleration in the pace of infrastructure development, including ports, roads, airports etc, and the reduction of duties/import barriers. [Then there's] infrastructure development and getting private capital to flow into sectors like power, roads etc. There's been no progress on the electricity reform act, and it remains to be seen what happens. States are going back to their old ways - distribution of free power! Oil companies are being forced to carry the burden of subsidies and this creates a bad precedent for investing in government-owned companies.
MP: We need more spending on social initiatives. Every Indian should have access to education and health. The government should intervene more for infrastructure development so more foreign local investors can freely come in with private capital for everything from the airport sector to executing road and telecom projects. We need more economic freedom... with further relaxations in regulations. We need policies for the creation of a national market. We need further disinvestments for the public sector to foster competition. We need a freer land market to enable housing to grow. Further change is required in areas like the tourism sector, the aviation sector, the oil sector and areas of infrastructure. The issue is the pace of change and reform and not the direction of reform.
AC: The need of the hour is rapid simplification of the tax and legal code to enhance efficiency, reduce leakages, and result in voluntary improvements in compliance levels. There needs to be a reorientation of subsidies towards the weaker sections of society and elimination of those subsidies that are inefficient. Finally, there needs to be a continued emphasis on infrastructure development and this government needs to build on some of the good work done by the previous government. I think the government recognizes all these needs.
What changes would you like to see in the Indian market that would promise more flows of foreign investment money into the equity markets?
AC: The move to eliminate long-term capital gains tax and reduce short-term tax to just 10 per cent in lieu of the 0.15 per cent turnover tax is a very welcome move for foreign portfolio investors. Further simplification of [the] foreign investor registration process will help attract more investors. Over the longer term, I think flows will follow the success of Indian companies and as long as corporates continue to make good progress...they will continue to attract greater flows.
Is India's economic development too reliant on foreign capital? How important is domestic investment?
MP: No, India's economic development has not been reliant on foreign capital. The one area where large capital has come in is in portfolio investment. Domestic investment is important as India has a savings rate of over 25 per cent of GDP. We get $4bn to $5bn of FDI and $12bn from foreign institutional investors. But the major dominant source of money is the domestic market, and it is growing. he Indian financial market, with banking, insurance, the stock market and the government bond market, is valued at $1.2tn, thus there is a lot of money in India. The key is the cost of capital and efficiency of its use. Companies can today go abroad to raise capital cheaper. Even though the domestic market is viable, if you want to raise $2bn to $3bn, the local market cannot sustain it.
AC: Domestic capital flow, particularly into equity, is a big concern. Equity holdings of the average household are less than a measly 4 per cent of assets. With real interest rates being close to zero, investors will continue to get pushed towards equity markets over time, however a lot more needs to be done to pull them towards the market. The government needs to proactively encourage the development of domestic institutional investors such as mutual funds and banks. That, combined with the capital tax breaks now available to all investors, will spur greater flows over the long term.
