India chaos story scores over orderly China

If the government manages to prevent inflation and interest rates from going into a spiral, it can reverse the outflow of FII funds.

If India is looking for an agenda to promote growth this year, the finance minister should read the mail exchange between the heads of Asia and US equities of a leading foreign brokerage firm. The mail’s timing (February 9) is apt, as global investors are looking to sign out of emerging markets to invest in the US and Japan. However, India can still reverse this trend if inflation can be curbed from spreading to non-food categories and liquidity is eased. The mail exchange, kicked off by the US equities head, begins with the US desk asking if it is the right time to start nibbling on emerging equities. The answer from their high-profile strategist is, “Don’t step in yet, but India is the best place to consider.”

Interspersed with market strategy reports, the exchange goes on to highlight the five issues that weigh down the market’s near-term outlook. The five ills that plague markets are: Inflation, margin pressures on select domestic plays, rotation of flows towards developed markets, the government’s stance on divestment and quantitative easing of liquidity. While these issues are broadly tactical, resolution of structural issues will truly determine the road ahead. From a macro perspective, the verdict is in favour of India, as strategists at the investment bank believe that the post mercantilist world will begin in India. As an investment destination, India often suffers from comparison with China. But India’s problems, says one report from the same investment bank, come from tackling its most difficult problems first. One of its strategy reports says, “We now perceive a tipping-point where structural impediments have been sufficiently dismantled to permit a new form of economic growth. Many investors ignore the order evolving out of India’s apparent chaos, while also failing to accept that China’s state-imposed order will one day decompose.”

What this essentially means is that returns from Indian equities are likely to surpass Chinese equities over the medium and long term. With India developing its private-sector financial system and moving closer to the market rates for exchange and interest rates, it looks better than China (remember the perennial renminbi debate). It’s strange to see spread-sheet experts quoting history, but global equity specialists claim that India is beginning to resemble the chaotic democracy that the US was in the 19th century.

And, at that time, the order of the British Empire was an investment illusion.

However, it does not mean that all is well in 2011. Another strategy report says one of the key problems that emerging markets have is excessive credit growth and inflation. Responding to such problems with administrative measures is bad for capital allocation and corporate profits. What will reverse the current sentiment and prevent rotation of flows is effective management of inflation and an imminent fall in interest rates. Till then, stocks with high foreign institutional investor ownership are at risk, as rotation is not yet complete.