Sunday, August 1, 1999
This August, India celebrates 52 years of independence. This is a remarkable achievement. India has gone through over 14 rounds of general elections and has seen peaceful transitions of power every time. Except for the 1977 emergency rule, it has remained a democracy. This is quite an accomplishment for a country with 16 official languages and hundreds of ethnic groups, especially considering the political histories of neighboring countries Pakistan and Bangladesh.
Independence Breeds Prosperity
In the ‘50s, there was a continuous debate among development economists to compare China and India – two large countries "born" at roughly the same time, which had taken very different paths. After Mao’s revolution in 1949, China had adopted the Communist philosophy; India, after its 1947 independence, embraced democracy based on Ambedkar’s constitution. This constitution had embedded the best parts of the constitutions of two of the world’s greatest democracies, Britain and the US. (But, then again, it’s been said that Nigeria has the best written constitution in the world!) So what are we missing here? How can we explain India’s lack of prosperity compared to the likes of Singapore, which did not become independent until 1963; Japan, which was flattened, literally and emotionally, after WWII; and Hong Kong, which thrived even as a colony of Britain? Obviously, there is more to success than meets the eye. It was 1991 when the government began its economic liberalization program. Until then, the economy was held hostage by the Nehru experiment in socialism. Believe it or not, at one point the top marginal tax rate in India was over 90 percent! Now, it appears that the government – whether it is the Congress’ party or the Bharatiya Janata Party (BJP) – has learned that economic liberalization must go on. Sadly, it took the break-up of the Soviet Union and the enviable progress of once-poor Southeast Asian neighbors like the Singaporeans or the Chinese for India to realize its mistakes in economic policy.
Elements of Success
With all these monumental changes going on in India, why are interest rates on Indian government bonds at almost 12 percent? Why should some Indian companies trade at a single digit P/E (price to earnings ratio) and the Indian stock market have a low P/E? Why shouldn’t the Indian per capita income be about $10,000 – about the level of Portugal, one of the lowest in Western Europe, and not languish at around $300, one of the lowest in the world? If the per capita income in South Korea can grow from about the same level as India’s in 1951 to about $8,000 even after the most recent economic crisis, why can’t India’s? India has a large middle class, many highly educated citizens and a strong family-oriented culture – some of the soft elements needed for a strong country with good economic prospects. India produces more scientists, engineers and doctors than any country in Europe. Many Indians prosper outside of India – in the UK, in Singapore, and, of course, in the US. If these people can make it anywhere, then why can’t they make it in India? Perhaps there are many social and economic albatrosses, but you can say that some of these same impediments exist in other countries that are far more prosperous. So, why has India lagged? Or, is India an undiscovered land of investment opportunity?
Undiscovered Land of Opportunity
At 12 percent, Indian government bonds are yielding about 7 percent higher than the Indian inflation rate. In other words, the "real yield" of Indian bonds is about 7 percent. Compare this to about 4 percent in the US, 2.5 percent in Germany and about 2 percent in Japan. Yes, India has a larger government deficit, hovering around 5 to 6 percent. But although India’s total debt is about 55 percent of GDP, the Japanese deficit is well over India’s: 85 percent and climbing. This percentage will only get more dramatic, as Japan’s population is aging fast and the total population is shrinking. In fact, if you extrapolate current demographic trends, the Japanese population is projected to shrink by half by the end of the next century. Real yields are about as high in some other countries too, like South Africa or Brazil. Still, unlike Brazil, India is rated "investment grade" by Moody’s, and unlike South Africa, the Indian democracy is sound and enduring.
Risk Factors
Yes, currently, there is a border skirmish at Kargil. Unrest always adds some risk and increases government spending, both of which are reflected in the high yield of the Indian bonds. We also have the risk of the Indian currency, the rupee, depreciating and wiping out the yield advantage. But at the current exchange rate of Rs. 43.35, the currency has depreciated by over 20 percent in about a year and may soon be in for a period of stability. One might turn an eye to the stability of the Indian government. Technically, there is no government right now and any number of elections is not likely to produce a single-party majority government. Ironically, no government may be the best outcome for India since that would be one sure way to eliminate bureaucratic quagmires. In that respect, India has become the Italy of South Asia, with a new government every 18 to 24 months. But Italian interest rates are about 5 percent with total debt well over 100 percent of GDP. Indian bonds are not without risks, but if the government sticks to fiscal discipline, stable currency policy, and continues on the path of economic liberalization, the bonds may begin to offer attractive yield.
The Stock Market
The Indian stock market as measured by the Mumbai stock exchange index has been basically flat since 1992. The index peaked after the Harshad Mehta scandal in the spring of 1992 and then dropped to a low of 2700; only now has it begun to make a comeback. Some companies like Infosys are trading like any other high tech company with a very high P/E of 55x, but other companies in the index like the ICICI, a financial company, has a P/E of less than 4! Although ICICI may be saddled with a lot of bad debt, its price-to-book is at 0.87 – almost the low level reached by Citibank in the early 1990s. Grasim, a conglomerate that has just begun restructuring to focus on core businesses, is trading around a P/E of 12 with estimated growth rate of 20 percent. If you look at smaller capitalization companies, many companies are trading cheap. Overall, I think the Indian stock market that dropped after the BJP coalition government led by A. B. Bajpai collapsed, has begun a strong rally despite the border battles with the Kashmiri militants and Pakistan. This behavior reminds me of the US stock market at the start of the Gulf War. With all the current problems on the Indian subcontinent, the lack of government and problems with the Indian systems of justice, bureaucracy and social rigidities, Indian financial markets could offer interesting opportunities. In short, India has the potential to achieve the per capita incomes of South Korea, if not Singapore. All it needs to do is stick to the right combination of economic policy, tax policy, and fiscal discipline.
Shirish Malekar is head of Global Fixed Income Investments, and partner and portfolio manager at a leading US asset management company.
