India today continues to be the world’s fastest growing major economy. At nearly 8% annual GDP growth, India handily outgrows its closest major competitors and neighbours such as China (at c.6.0% growth) and Indonesia (at c.5.5% growth). In addition to this fundamental shift in growth from China to India, there is another equally important shift occurring, that of risk. With India entering into a phase of increasing political and economic stability, and with the momentum of structural reforms building up at a strong pace under the Modi government, the country’s fundamental risk profile is changing at the exact moment when developments in other major markets, developed and developing, are either leading to increased risk, lower growth, or both. The United States is rapidly reaching political stasis as both the executive and legislative branches find themselves encumbered by effective resistance, while the problems of Brexit and the need to rethink the European programme are creating uncertainty in the EU and the potential exhaustion of Abenomics in Japan is leading to doubts over its economic path ahead. Meanwhile, China, after two decades of rapid growth, has moved to a lower growth trajectory with an increasing risk profile. At this stage, the global risk-reward profile is fundamentally shifting, with major regions being re-rated across both axes. India appears to be a strong beneficiary, away from the global trend-line, improving its relative positioning in terms of risk-adjusted returns vis-a-vis other major markets. It is a good time for India to continue its focus on executing the reforms that address structural and systemic risks while driving economic growth higher to potentially double digits.
India today is experiencing a structural and cyclical upswing that is driving sustained economic growth. Recent state election wins demonstrate the public appetite for major reforms like demonetisation and the nationwide Goods and Service Tax despite the associated pain. Corporate earnings, which have disappointed in the past two years, look set to recover strongly in 2017 and 2018, with consensus growth expectations of more than 15% annually.
While many international investors are uncertain on how to call the timing of coming back to India given the disappointments over the past decade, others have taken advantage of the early changes to secure their positions and returns. In the recent past, while Indian public markets saw periods of strong performance, US Dollar returns were poor due to the sharp depreciation of the Rupee. This situation was also true in private equity, where most funds left investors with poor returns for their capital relative to developed markets, despite the additional risks taken. As a result, investors’ perception of India’s risk remains elevated, particularly with regards to systemic country risk, and many investors either continue to wait on the side-lines or making only minimal country allocations. Seen through the lens of historical risk, for these investors, India simply does not offer sufficiently attractive returns for the level of risk investors are being forced to take. This perception now seems outdated given the last two years of steady change followed by a series of quite radical moves in India at the same time as a deterioration in the standing of major Western economies and their politics.
India’s Risk Re-basing
The development of major economies appears to progress in waves and it is clear that India has been growing through a number of waves of change. The post-colonial socialist wave was the first and longest at 47 years and ended with a US$1 trillion dollar economy. The second wave followed liberalisation and lasted seven years and doubled the economy to US$2 trillion. The third wave has lasted only five years but has resulted in a US$3 trillion economy. The math of growth over time illustrates why investors’ historic perception about India are worth re-visiting and why capital flows to the country have already improved quite dramatically. While the recent equities rally is the short-term result of the country’s current cyclical upturn, many are beginning to also see it as an early sign of India’s longer-term ‘re-rating’. Whether it corrects (and Indian markets do tend to periodically over-correct upwards and downwards) in the short term or not, the trend-line of value seems now set to be upwards. While a look back at the past decade in India certainly appears to justify investors’ caution to some degree, India’s risk outlook is much more optimistic across a wide range of dimensions. The key elements of this risk reduction include a range of political and economic factors of which four stand above the rest:
- Reduced Political Risk. Strong BJP Mandate Driving Political Stability.For one thing, political risk in India has declined considerably. Mr. Modi has held a stable majority in government since assuming power in 2014 while his party has made significant gains in regional elections since then, now controlling (solely or jointly) over half of India’s states. Moreover, Mr. Modi appears to be on track to hold on to power in the next general election in in 2019 (based on the results of recent state elections this seems a foregone conclusion, in so far as anything is in politics!)
- Reduced Execution Risk for Reform Agenda. Reform Track Record Building Momentum. Further, the momentum for executing necessary structural reforms has increased considerably. In addition to the many ‘smaller’ administrative reforms that have been successfully implemented, Mr. Modi’s government has also made progress on some of the big areas such as increasing financial inclusion (expanding bank account coverage in India, promoting digital payments and executing demonetisation), executing a tax-code overhaul (the introduction of the Goods and Services Bill, which replaces India’s myriad indirect taxes, with a single taxation framework) and beginning to address the banking overhang (new insolvency and bankruptcy laws were introduced in May 2016).
- Reduced Risk from Economic Fundamentals. Macro-Drivers Aligning for Accelerated Growth. Moreover, India’s macro-fundamentals have improved considerably, with several key drivers moving in the right direction to underpin further economic expansion. Importantly, inflation has reduced from 10% to under 5% and is expected to remain stable through the remainder of the decade. Interest rates are at the lowest level in six years and are expected to come down further, while the fiscal and current account position has improved considerably due to a combination of external factors and adept policy management. And perhaps the key measure, the country’s growth outlook, continues to strengthen, with 2018 GDP growth forecasts recently upgraded to just under 8%.
- Reduced Currency Risk. Past Currency Depreciation Creates Advantage for Current Investors.Following a period of significant depreciation starting 2011 which saw the Indian Rupee depreciate by more than 30% against the US Dollar, India’s currency has proven to be strong and stable in recent years, even as other emerging market currencies have depreciated further against the Dollar. While the rupee has appreciated moderately (3.9%) against the Dollar in the past year and has the potential to appreciate further, the real effective exchange rate based on a 36-country basket indicates that any currency movements are likely to be minimal.
All of this provides a case for optimism in terms of India’s attractiveness as an investment destination. With a stable risk outlook and strong economic growth, it now appears valid to believe that India can deliver improved risk adjusted returns over the medium-to long term.
India in the Context of a Global Reshuffling of Risk
At the same time as this considerable improvement in India's position, the major economies in the world are also undergoing changes to their own risk-reward position, in most cases in an unfavourable way. In the context of an ongoing demise of the current world order and as a clear sign of today’s ‘revolutionary times’ , there is a fundamental re-weighting of risk taking place on a global scale. An examination of major countries experiencing disruptions that impact risk reveals the following:
- United States – Increasing Political Risk and its Implications. Despite Republican control of the White House and both houses of Congress, political risk appears to have increased in the United States. The repeated failure of the Obamacare repeal and the inability to advance tax reform and infrastructure plans point to a fundamental disconnect within the legislature and to a ruling party which seems divided against itself. In addition, the overhang of the ongoing investigation into Russian intervention in the election has raised doubts as to whether President Trump will ever be able to effectively govern or even last a full term in office. (UK betting companies currently place a greater than 50% chance on President Trump being impeached or resigning before 2020 ). With the expected incremental fiscal stimulus, initially predicted at 2% of GDP, not taking place, the IMF has downgraded the growth outlook for the US in 2017 and 2018. On the bright side however, equity markets have risen by nearly 20% since the election, primarily on the perception of Mr. Trump’s business friendly outlook and the repeal of regulations that negatively impacted businesses (e.g. the Dodd-Frank Act). It is questionable whether this uptick will be sustainable though in the absence of meaningful achievements by the government over the medium to long term. The mid-term elections in the US also raise the prospect of an enhanced political risk that many worldwide are focused on.
- China – Continued Economic Slowdown.In China, the economic slowdown is marked. GDP growth for the year is projected at around 6.7%, a target that China will likely achieve only at the cost of significant public investment and rapid credit growth. With slowing growth and rising debt levels, China has recently seen its credit rating downgraded by Moody’s for the first time since 1989, and growth is expected to slow to 5% or less over the next five years as the government moves to tighten the property market and rein in local government debt. Politically, China appears to be stable with Xi Jinping appearing to exercise much tighter control over the government and the party than his predecessors have done. This has been accompanied however by a series of crackdowns on the media, private conglomerates, civil society and any other potential power blocs that could shape or mobilise domestic opinion. Given the worldwide populist backlash against stable governments, this increased government control over the near term may well increase the risk of a disruptive backlash and therefore creates uncertainty for the future.
- Europe – Significant Uncertainty Ahead. Europe too faces significant uncertainty over the near to medium term. With the UK and the EU struggling to develop a clear plan for the Brexit and increasing voices in the UK arguing to stop the process altogether, it remains unclear what the EU will look like without Britain. Traditional political parties and institutions across the region are losing support, as they appear to be ill-prepared to address the economic and security concerns of large swathes of the population. Nearly two thirds of Europeans believe that their children will grow up to be worse off financially than they are, and a steady increase in terrorist attacks has an overwhelming majority of Europeans thinking that ISIS is a major threat to their own country, an issue that has become closely entangled with the millions of refugees currently in the EU. While there are bright spots of economic activity, particularly in Germany, the general uncertainty about the future direction and shape of the EU and Europe as a whole will likely see investors exercising increased caution when deploying capital across the region for the foreseeable future.
- Japan - Abenomics Near the End of its Tether. Japan has performed strongly economically under the economic policies of Prime Minister Shinzo Abe. A combination of negative interest rates weakening the Yen and increasing competitiveness, and fiscal stimulus through government spending has seen the country recover from the decades long stagnation following the burst of its asset bubble in the 1990s. However, wage levels have remained stagnant, meaning that real incomes are actually declining, putting pressure on consumer spending, one of the core pillars of self-sustaining growth. Further, a wide range of planned and needed structural reforms remain politically difficult and unlikely. The now defunct Trans-Pacific Partnership (TTP), on which Mr. Abe had spent significant political capital, was expected to provide a significant boost to reforms, both by way of its obligations on its members and by way of linking Japanese industry more closely to its trading partners. In the TTP’s absence, further reforms will likely face significant headwinds that risk undermining the gains of the previous years. Prime Minister Abe has decided to take on the mantle of TPP without the US and that seems necessary. However, the risk of Japan returning to stagnation remains a real one.
The major nations that drive global growth and have been the agents of lower risk seem to have placed themselves in a position of damaging their own growth while increasing their risk. With the scale and scope of global changes underway, investors will need to carefully assess the changing risk profiles offered by different developed and emerging markets. Forming an objective view of these profiles requires a framework that captures both the comparative levels of risk as well as their trend-lines. The table below attempts to capture how major investing destinations are faring with regards to seven key components of risk. Recognising that traditional measures of risk may not cope well with the magnitude and frequency of event risk, a more qualitative approach is merited alongside some key risk indicators. For another time, the narrow measures of risk that have been used in traditional risk analysis seem to be failing to capture the dynamic and inter-related nature of risk that is now materialising; it is undoubtedly more in line with chaos theory than linear in nature.
Analysis of the above suggests that there is a meaningful global rebalancing of risk underway which is working in India’s favour. The stability of the current BJP government and the momentum building that is now evident in the pace of structural reforms that are being introduced, alongside strengthening macro-economic and financial fundamentals, are effectively reducing risk for investors, and increasing the relative attractiveness of India as a destination for capital. In the meantime, the major global players are mostly either standing still or increasing in risk. Adding the dimension of growth changes the analysis quite dramatically. The reduction in risk coupled with the leap in growth creates the conditions for a material change in potential value. In the last decade, such a growth shift drove China to emerge as the world’s second largest economy. It is this type of phenomenon that would be transformational for India and if it plays out can be expected to see India rise to join the US and China as one of the major economies in the world. History shows that this is a virtuous cycle with investment driving returns and returns attracting investment.
Risk-Reward Shifting in India’s Favour
Conventional wisdom has long held that emerging markets hold the greater risk and should therefore yield a greater return. In this model, investors accept lower returns from developed markets in exchange for lower risk. While the model holds true, we now find ourselves in a phase where the risk of developed and developing markets are converging to some extent. This would indicate that the nation-centric lens to risk-reward is losing relevance and investors will need to apply more asset specific approaches to assessing risk in the future. In the meantime, the fundamental attractiveness of any region as an investment destination going forward is of course a function of the risk weighted returns that are on offer. The question is not whether India will de-risk sufficiently to be comparable to other major mature economies (such as the US or the EU) on an absolute basis, it is whether investors can achieve superior returns given India is now on a trend-line of declining levels of risk. The chart below captures the changing positions of major investment destinations in terms of both risk and reward over the past five years, indicating the growing attractiveness of India relative to other major regions.
Shifting Attractiveness: Changing Risk-Reward Index for Major Regions 2010-2017
The chart clearly indicates that while the returns profile of each major economy has improved over the previous half-decade, India stands out as the only country that has simultaneously reduced risk.
Key Conclusions for Investors and Policymakers
Only a short time ago it would have been far-fetched to imagine the US embroiled in internal battles and withdrawing from its major ideological and power positions of globalisation, free trade, the support of liberal economies and its allies and control over major international institutions. And it would also have seemed unlikely that the China growth juggernaut would slow and appear to stall amid an internal drive to weed out corruption. The withdrawal of the UK from the EU regardless of the consequences to itself or to the European post-war peace project might also have seemed highly improbable. Among this series of concurrent unlikely events, the rise of India to become a stable and rapidly growing nation would have seemed equally doubtful. This, however, is the world we now live in.
What are the implications for investors and how should capital be (re)allocated as a result? In times of change and uncertainty, many long-term investors choose to wait and see, watching from the side-lines until markets settle and (at least appear to) become ‘predictable’ again. The fundamental wisdom of this approach aside, it does not offer long-term solutions in a world where increased uncertainty is becoming the norm and investors cannot delay capital allocations indefinitely. So, looking ahead, even in these times of uncertainty, there seem to be some “certainties” for investors to consider, namely, America, is and will continue to be, for a considerable time, the world’s largest economy with the largest corporations, the most liquid markets, the most innovation and the provider of the global reserve currency. China is an industrial powerhouse and as the world’s second largest economy, will create tremendous value even at 5% GDP growth. And India, at growth rates in the order of 8% is scaling rapidly and will become one of the world’s five largest economies within the next few years. It is clear that, the US, China and India should be part of any global asset allocation strategy. And with India delivering the highest growth of any major economy, and given it is growing rapidly from a low base, the time to allocate to India is clearly now.
It is worth noting that, any of the recent changes in the risk-reward profile of the major developed markets could easily reverse themselves. For example, the successful execution of Trump’s tax plan would loosen the political gridlock and provide the administration with room to manoeuvre, eliminating much of the political risk being observed in the US today. However, how long should investors wait for that and even if they should, how much should they allocate to that strategy?
Risk has followed a random walk through the world order and left investors in a land without a simple map. Disruptive event risk is shaping the world, and the investment landscape in turn, evidenced in events from the Arab Spring to the Brexit vote to the collapse of the UK government’s mandate for a hard exit from the EU to the election of an outsider to win the US election. The predicable flow of long-term capital to the safety of developed markets with a minority allocation to “risky” developing markets can no longer be safe. The risk profile of the world has made the safe unsafe. Investors can of course choose to move with the developed market investing crowd and risk missing the lower risk-higher returns that are now emerging in countries such as India or cities and asset classes across other rapidly developing markets.
For India’s government this is a time of great opportunity. Clearly, it cannot afford to be complacent. In addition to the reform agenda to drive growth, Mr. Modi has a new area to focus on, measures which reduce risk. Of the many ways to do that the highest impact might be felt from reducing the risk in the financial system (by reforming the financial system to increase the quality and quantity of participation), reducing the risk of stalling growth (by pushing consumer and small business credit into the market), reducing the risk of equity markets stalling (by driving equity market liquidity) and reducing the risk of corruption stifling returns (by continuing the battle to improve corporate governance, reduce bureaucracy and tackle corruption). While Mr. Modi focuses on the politics of winning the next election, it is true that the path to victory can only be surer if India offers the highest growth in the world at developing market levels of risk. Economics makes for good politics.
Creating Prosperity for a Billion People: Re-architecting the System of Wealth Creation