The India story is on a roll. The country’s benchmark indices are on their way to touching historical highs, aided largely by inflows from foreign institutional investors (FIIs). But Ridham Desai, managing director, Morgan Stanley (India), still thinks there’s “some reticence” in FII participation. Turning several current market theories on their head, he explains to Dipta Joshi why India and other emerging markets have been able to attract funds consistently. Excerpts:
The Indian equity markets have seen a steady rise this year. What are Morgan Stanley’s views on Indian equity markets for both the long term and the short term?
Our outlook for the next five to ten years is that the Indian markets are poised for relatively strong returns. The Bombay Stock Exchange’s index, the Sensex could compound on an annual rate of 13-14 per cent over the next 10 years. And that return is likely to be better than what most developed and emerging markets could deliver. From a 12-month perspective too, Indian equity markets look fine.
Investors are complaining about valuations. But that happens if they compare Indian equities relative to their 20- or 15-year averages. I don’t agree with that view since India’s growth rate has transitioned from the five to six per cent it was in the nineties. The valuations will always appear rich in comparison to their history. India currently trades at a 50 per cent premium to other emerging markets and will be able to sustain it because of its growth.
People believe that India’s inflation is structurally going to be high. We don’t agree with that either. India’s growth rate between 2004 and 2009 averaged 8.5 per cent with 5.5 per cent inflation (both consumer price indices and wholesale price index) on an annual basis. So, it is not that India needs to have high inflation to deliver high growth.
The last 12 months were unique and you cannot judge the future on them. India could grow at nine per cent with five to six per cent inflation over the next 12 months. Few countries can deliver 13 to 15 per cent nominal growth in the economy and continue doing that.
What then are the downside risks that global investors associate with India?
In the long run, execution is the downside risk for India. One of the key pillars for growth is execution in infrastructure. The infrastructure changes that have taken place in the last five years show that India does have the ability to deliver. If we continue with it, we should be fine.
A short-term concern is the widening of the current account deficit to around four per cent on an annualised basis of the gross domestic product (GDP), which is reflective of very strong government spending and a strong policy response from the central bank.
There were some unique factors that led to this situation. When India was hit by the crisis, the government responded with fiscal expansion while the Reserve Bank of India (RBI) lowered interest rates. Given India’s structural story, demand recovered rather quickly but the stimulus remained high (on a relative basis). Simultaneously, we also faced food supply shortages (bad rainfall and drought), which led to food price inflation. Meanwhile, the supply side response from corporations was muted since they were reluctant to add capacity after the crisis. This is all being reflected in the current account deficit.
We expect the situation to roll over in the next 12 months but while it does, India remains exposed to global events of two kinds. First, a sharp recovery in the world’s risk appetite could increase commodity prices. And India is in no position to manage or absorb a high range of commodity price inflation at this stage considering its current inflation levels. A contrasting situation could lead to risk of the second kind. Risk aversion could cause global investors to get reticent about risk anywhere in the world. This could see a fall in our capital inflows and leave our current account deficit relatively unfunded, thus slowing growth.
What kind of impact will these situations have on the India growth story?
It is not our base case that either of these things can happen. We are looking at a muddled-through world for the next 12 to 18 months as our base case and that’s something that favours India the best. We do not see a sharp recovery in global growth or US growth and we do not anticipate any sharp rise in commodity prices or, for that matter, any sharp risk aversion. So in that situation, I think India should be ok. But we have to be cognisant of these risk factors while India transitions its current account deficit to a more normalised two-and-a-half per cent.
Greece has pledged to cut next year’s budget deficit faster than what was agreed on in the bailout deal. The US Federal Reserve is also expected to tighten interest rates and withdraw the stimulus package in phases. Do you think the worst of the western world’s crisis is behind us?
We did a bit of work that shows it is not about whether western economies will default, it is about when they will default. The last 200 years show that we are actually at the low point in history in terms of sovereign defaults. History also tells us that sovereign defaults happen a lot more than what we are betting on today. Policy makers have worked hard by way of stimulus packages to avoid a default but it is bound to happen since debt levels are high. So, we may not see a default in the 6-12-month timeframe but I would not be absolutely sure of that in a three- or five- year period.
Again, we don’t see interest rates in America hardening for a while. The western world has a very difficult landscape with still very high leveraging and sub-optimal growth rates. So, we are unlikely to see a major withdrawal of stimulus from the rest of the world.
What then will be the trigger from abroad that could lead to a correction?
The triggers are the same factors we have been watching in the past few months. These include a combination of Chinese growth indicators and western economic performance. We don’t want that to tail off in a very big way. For instance, unemployment numbers in America should not worsen meaningfully. At the same time, if they improve significantly from here, it does not augur well for India’s relative performance.
With the Indian equity markets moving at a fast pace, dealers have been expecting a correction any time now. Do you agree with this and at what levels do you see the Sensex by the end of this year?
What I have learnt about corrections is that when everybody is expecting one, it rarely comes. I think there is too much caution, which is triggering an upside. You need a little more exuberance for the market to top off. You could get a five to ten per cent correction like we have had several times during the year. But I don’t see a major correction unless there is what I call, “a little more gay abandon” in the market and people flock in.
A one-year timeframe is too short but for 2011 end, our official forecast is 22,100 on a base case basis. But for investors making calls on equity, I would encourage them to take the three- to five- year perspective and expect 13 to 14 per cent annual returns.
Flows from FIIs have crossed $20 billion this calendar year. Will this exuberance continue?
I don’t think there is exuberance in FII flows yet. There is some reticence in FII participation unlike what we saw in 2007. India’s share of global flows has not changed dramatically. What is happening is a global picture. Developed market investors are coming to emerging markets where balance sheets look good. India is getting its fair share within these markets. It may have looked a little bit sharp in September but if you look at it from a 12-month perspective, India is no different from Brazil, Taiwan or Korea and the others. It is an overweight position but not a dramatic position.
The flows into the equity market have come from global funds that don’t really have a mandate to invest in India and not just emerging market funds. In that context, the flows have been quite small compared to what is available in America.
