As the fastest-growing major economy in the world with broad financial markets and an active institutional investor base, India presents both a major opportunity and a potential frustration for global investors. Blessed by favourable demographics, a vibrant democracy and a largely domestic economy, India has to some extent skipped the recent emerging markets malaise with GDP growth recently hitting 7.5% (although this official number is higher than what most of the market believes). So how should investors take advantage of these opportunities given barriers to entry and various pitfalls?
With a GDP of nearly $2.2 trillion,1 India is the seventh largest economy in the world (and the third in purchasing power parity (PPP) terms). It is dominated by domestic services and, to a lesser and diminishing extent, the politically important agricultural sector. Alongside the large and somewhat unwieldy state sector, there exists a vibrant and highly entrepreneurial private sector. The private economy presents investors with a broad array of potential investments in areas such as technology, in the form of IT services and online businesses, the more traditional consumer sector and various infrastructure plays.
In many ways the macroeconomic outlook for India looks fair. In what can be a turbulent political scene, the Bharatiya Janata Party (BJP) government looks relatively stable and is slowly finding ways to work around a truculent opposition; the central bank, the Reserve Bank of India (RBI), under the leadership of Dr. Raghuram Rajan, has proved proactive, particularly in addressing the build-up of non-performing loans (NPLs) in the public bank sector; and with more than 50% of the population under the age of 25, demographics should be supportive. Unlike other emerging markets, India’s exposure to China is minimal with growth largely domestic-led; lower energy prices have been a massive boon, allowing the government to rein back wasteful subsidies; and the incremental reforms pursued by the current government seem to be benefiting some key areas of business.
Most of the problems of the economy are also “made in India,” to play off Prime Minister Modi’s 2014 “Make in India” initiative.2 Barriers to growth include a stultifying bureaucracy and poor regulatory framework for investors, particularly in the areas of land acquisition, labour retention and bankruptcy laws. This can be exacerbated by a federal system of government that can make central decision making problematic and ineffective. Additional issues include supply-side bottlenecks and inadequate infrastructure; twin deficits, although the current account has improved significantly with lower oil prices; uncertainty over the tax regime, including the much delayed introduction of the national Goods and Services Tax (GST)3; and more immediately, stretched corporate and public sector bank balance sheets. Progress is being made on most of these issues. The RBI is forcing public sector banks to recognise NPLs while infrastructure spending is targeting areas such as rail freight, for example. That said, many commentators are bemoaning the lack of “Big Bang” reforms and the public sector seems to be the only major driver of growth at the moment as exports, consumer spending and private capital expenditure are stagnant.
Foreign investors investing in India, either in fixed income or equities, can face a number of hurdles. India has a total of 21 stock exchanges. The Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE) are the largest and are the venues for overseas account transactions. While there are over 5000 listed stocks, the majority are micro caps and illiquid. In order to invest, foreign investors need to be registered with the regulator SEBI (Securities and Exchange Board of India) as a Foreign Portfolio Investor (FPI) or as a sub-account of an existing FPI (typically an investment bank) that will use a swap or sometimes a promissory note (P-note) structure to execute. On the short side, the only really viable way to trade is through listed Single Stock Futures (SSFs), usually on swap. In terms of liquidity, the SSF market of 173 names can trade around $7bn notional a day versus approximately $3bn for the underlying equity market in which there are in reality only 200-300 names a sizeable investor can effectively trade. This can be expensive: for futures, typically only the near month contract is liquid and rolling each month can be at variable prices (Chart 1).4 Index futures are available both onshore and offshore in Singapore; options (onshore) are also common on both indices and SSFs. Most importantly, it is critical to be aware of the need to invest through vehicles in countries with a Double Tax Avoidance Agreement with India: this has typically been Mauritius but more recently Singapore for equities (as the regulator has focused on the “substance over form” of the manager) and Cyprus for fixed income (again this has also become less common recently under regulatory scrutiny). As of May 9th, the Indian authorities announced an agreement with Mauritius (likely to be extended to Singapore) which will limit the capital gains benefits of these jurisdictions and clarify the tax situation, albeit most likely at a higher cost to investors.
Annual Roll Costs: Nifty 6.0%, RIL 7.6%, HDFCB 9.7%, ONGC 6.5%
January 2015 – December 2015
Equity Security Spread between Top & Bottom Quintile Performance5
(2006 – 2015)
Fixed income markets in India are not hugely liquid and often difficult to access: there is approximately $1.3trn USD of onshore issuance of which 83% comes from government and quasi-government issuers and 13% from financial borrowers, while of the approximately $63bn US$ offshore bond market of Indian issuers, financials again dominate with around 50% of the bonds, while a further 20% comes from the energy sector, 11% from resources companies, 6% from communications, 5% from utilities, etc. As well as the need to consider the tax structure for onshore investing, it should be noted that there is also a (generally full) quota for foreign investors in Indian onshore fixed income. Finally, hedging the currency can also be expensive – as a closed capital account the optimal way seems to be through non-deliverable forwards.
These challenges notwithstanding, there does appear to be a strong case for alpha investing in India. Dispersion across the market can be high (Chart 2) and we find a number of equity managers with strong and consistent numbers. Shorting can be a challenge, so the optimal (and cost effective) long/short approach may be a relatively concentrated equity portfolio with a simple index hedge. In addition, correlations with an equity or hedge fund portfolio can be convincing: the benchmark NIFTY Index has five-year correlations with MSCI China, TOPIX and the S&P 500 of 0.58, 0.5 and 0.53 respectively.6 As one of the few countries with positive real rates, relatively high yields and low government debt ratios, the fixed income markets can also present interesting investment options – the RBI cut the benchmark repo rate as recently as April 5th to 6.50%. The challenges of investing in India can be intimidating but the opportunities offered, in our opinion, may make the task worthwhile.
1 Source: IMF World Economic Outlook, October 2015
2 “Make in India” was launched to transform India into a global design and manufacturing hub.
3 Goods and Service Tax (GST) is proposed to be a comprehensive indirect tax levy on the manufacture, sale and consumption of goods as well as services at the national level. It would replace all indirect taxes levied on goods and services by the Indian central and state governments.
4 Source: Bloomberg. The roll costs are estimated by rolling into the next month future at the close on the last Friday (if not trading, Thursday) before expiration every month. They are gross of any costs.
5 Source: Bloomberg and PAAMCO. The four indices are SP500 (US), TOPIX (Japan), CSI300 (China), and BSE500 (India).
6 Source: Bloomberg. Through March 2016.
David Walter is a Director at PAAMCO. He serves as Head of Research for Asia. He sits on AIMA Singapore’s executive committee.
PAAMCO’s Singapore-based Portfolio Management analyst Jessica Xia made significant contributions to this paper.
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