I came across a recent research note titled “Buy chaos, sell order” put out by Russell Napier of CLSA. In the research piece, Mr Napier highlights the argument for why over the coming years India should be a far better investment destination for financial investors than China. He makes the point that India’s troubles come from tackling its most difficult problems first, and he senses a tipping point, where the structural impediments holding India back are slowly fading. He also makes the point that China’s state-imposed order will slowly disappear as its growth dynamic evolves. He urges investors to not get fooled by China’s superficial order and India’s apparent chaos.
Napier makes the point that there is little correlation between levels of economic growth and returns from equities, especially in emerging markets (EMs). One of the chief causes of this is the mercantilist policies followed by most of the EM world, involving ultra-cheap exchange rates and a near total dependence on export growth. These policies hamper equity returns as a thriving and heavily-favoured export sector is normally poorly represented on stock markets, and targeting of the exchange rate can produce extreme monetary conditions, causing severe volatility in economic cycles. A boom/bust cycle can severely damage long-term equity returns.
Today , there seems to be a broad consensus that mercantilist policies have now been maxed out. The OECD economies can no longer continue absorbing an endless supply of goods from East Asia, and this export-led growth approach cannot deliver western living standards to large economies like India and China. The pressure on China to move away from this growth dynamic will keep mounting. Napier argues that the key question for any EM investor is to determine which countries can make the transition to a post-mercantilist world, and it is here that India is better positioned.
India is far more advanced than China in developing a functioning private sector financial system, with the cost of capital being far more real and market-determined than in China. India is also a much more productive user of capital, due to its historic high cost and limited availability. He makes the point that reforming a command-economy banking system is extremely difficult and China continues to shy away from going down this road. The distortion and artificiality in the pricing of money are the key weaknesses of the Chinese system, and it is difficult to think of any command economy banking system that has transitioned into a private sector system without a crisis marking the transition.
Napier also makes the point that India is far better positioned for the post-mercantilist world than China. He bases this observation on the fact that India is far closer to a market-based exchange rate and free interest rates than China. India is also far less dependent on exports, and can move much more easily to a consumption-driven model than China. India’s banking system can also far more easily provide consumer credit to support and encourage domestic consumption. The Chinese financial system is still geared towards funding state-owned enterprises and business. The Indian economic model already has consumption as its centrepiece, while China will have to significantly rejig its economic incentives to push consumption.
He also makes some encouraging comments on India’s demographics, evolving democracy and improving bureaucracy.
Napier has strong credibility globally, and his piece will, I am sure, attract attention. One has also seen recent articles from Templeton and other large EM investors, making similar arguments and outlining the long-term case for India. Even the Financial Times has been making encouraging noises to this effect.
However, after discussion with serious long-term real money investors in the US and Europe over the past few months, one does not get a sense that they believe in Napier’s or Templeton’s conclusions. Most investors remain very enamoured of China, its execution and economic model and believe it will continue to outperform India — in economic growth numbers for sure, and implicitly in financial market performance as well. Nobody has thought about the possibility of India actually being able to outgrow China over the next two to three years, something which the Indian intelligentsia feels is a real possibility.
Almost all the investors I speak with have large, dedicated allocations to China, and they do not question the need to have a specific China allocation. The country is too big, markets too large, capital needs too significant and we need a specialist on the ground, is the usual refrain. China has clearly created a separate asset class for itself. The country is simply too important for the global economy and the commodity complex. There are signs of similar things happening for Brazil as well, with many investors incredibly optimistic about it and its long-term outlook.
For India, however, I still feel many investors have not made up their minds on the country. Many of the world’s largest and most sophisticated investors have limited specialist India exposure. They are not convinced the country deserves a full-time specialist allocation. India has not yet been able to market itself as a separate asset class the way China has. This anomaly is there despite India having a far greater investable universe than China. India’s real attraction has always been seen as being the entrepreneurship of its private sector. One would have thought that stock-picking and specialist-on-the-ground exposure would be far more important and fruitful in a market like India. Also, most LPs (limited partners) seem to have more money in India on the private equity side than on public markets’ side, another oddity considering that most private equity investors in the country are anyway investing in public markets.
All this will hopefully change over the next few years as we continue to grow, develop and confound the sceptics. The biggest fears around India remain the fiscal deficit (its sustainability), hopeless implementation skills, weak governance and corruption. Many of the changes one expects to see over the coming years — in areas like the UID project, adherence to the Finance Commission recommendations, better governance and targeting of government programmes, etc. — will go to counter some of these fears. Ultimately, investors will have to stand up and take notice. In the new post-mercantilist world, very few countries have the growth potential and economic model that India has.
If India is able to make the transition into being seen as a separate asset class, then a significant upside remains for the markets in terms of potential inflows. Being able to attract these flows remains very important to ensure our financial markets have the liquidity we need to finance our growth potential.
The author is the Fund Manager and Chief Executive Officer of Amansa Capital
