I stepped out of the airplane to an immediate assault on the senses. As the jet’s engines wound down a steady racket of car horns arose from the chaos of Jaipur’s streets. It smelled like a dirty garage on a stuffy summer day—a mixture of oil, dirt and car exhaust, combined with a whiff of the chemical scent of air freshener. The car ride to our hotel took us past shanties with people cooking dinner over open fires, wedding celebrations complete with music and dancing not more than 10 feet from the highway, stray dogs scrounging through garbage, hundreds of small shops offering everything from cement to smartphones, and, at the midpoint, a man on an elephant going about his evening’s business.
This was my first lesson in India. When you arrive in the country, you don’t just land at the airport, India lands on you.
India is on many investors’ minds these days as it is one of the few markets in the world in which investor optimism is upbeat. With a population of one billion people, we can no more ignore India as an investment destination as we can shut out the sights and sounds when visiting. Thus, my trip was a good opportunity to further my understanding of this immense and complicated country.
The Potential of a Nation
There is reason behind investor excitement for India. Compared to many regions in the world, India is blessed with several long-term trends that should be positive for economic growth. The country’s population is relatively young, with over 200 million people projected to be added to the workforce over the next twenty years. It is also urbanizing. In the next twenty years, over 350 million people are projected to move to its cities. By 2050, the equivalent of the population of two United States is projected to urbanize within India.
The country is also poised to reap huge productivity gains through the adoption of better technologies and processes. Just how much potential growth is possible through even basic improvements is plainly visible. As an example, I saw three construction workers at the airport as I was leaving to come home. The three men were squatting down with hand-held hammers, their tools each weighing no more than a kilogram, slowly whittling away at the concrete. It was shocking to see. Where this method would surely take all day to finish the task, one jackhammer could probably do the job in fifteen minutes. And this kind of labour-intense activity is prevalent throughout the country.
The process of adding capital to labour, moving people from the countryside to cities and shifting from agriculture to manufacturing has been a well-worn path for many countries to lift economic growth. Sometimes, as in the case of Japan, South Korea and China, the results have been spectacular. Adding to its potential, India remains under-banked and under-levered. Unlike countries like China or Thailand, India is in the early stages of a credit cycle and has a lot of room to borrow, expand investment and finance consumption.
In short, there is a great deal of upside to economic development in India. So the question is why hasn’t more of this potential already been unlocked? If India’s natural rate of growth is purportedly around 9%, why has the country recently been growing closer to 4.5-5%?
The answers to these questions are numerous. For starters, India’s political system is notoriously ineffective, with political gridlock and corruption undermining progress. Poverty, pollution and poor infrastructure also challenge development, along with historical social norms that segregate people into strict socioeconomic classes. Moreover, the banking system remains log-jammed. Indian banks hold significant amounts of non-performing loans on their balance sheets, limiting their lending ability until the bad loans are dealt with. An estimated $200 billion worth of projects are stalled because of these bad loans.
All of this prevents progress, yet none of it is really new information to investors. India’s potential and its challenges have been understood for some time now. So what are the factors that now elicit hope?
The Game Changer
The reason for optimism seems to come from a genuine belief that things are changing for the better. Much of this is due to the Narendra Modi government which was elected last year with a mandate to reform the country.
While it is too early to call, there are some short-term indicators that change is indeed afoot. Already, we have seen an important bill passed regarding foreign ownership of insurance companies. Progress has also been made in coal mine auctions—a key to expanding India’s woefully inadequate power sector. In terms of social programs, the government has implemented a nationwide biometric identification program that allows a population with high levels of illiteracy to be identified and brought into the modern economy.
Monetary and fiscal policies have also been improving. The new governor of the Reserve Bank of India, Raghuram Rajan, has earned the confidence of international markets through swift interest rate action, which has helped to stabilize the rupee. Cheap oil prices have also supported growth and government finances, given that India is a significant net importer of energy. As Jayant Sinha, the Indian Minister of State for Finance, put it in one meeting I attended, “the decline in the price of oil has been a $50B gift.”
These are some of the positive signs that seem to be underlying investor enthusiasm. The question for our team has been, just how reasonable are these expectations and is it still possible for us to find good investments in the country?
What we see so far
One of the great benefits in traveling to a region is getting to spend time with local business leaders and experts. It is informative to compare the stories heard from analysts in New York and London versus what is happening on the ground.
So, were the locals as enthusiastic as investors?
While locals acknowledged some of the positive changes occurring, the mood among the group of leaders with whom I spoke was fairly muted. Even though many individuals believed that India is on the right track, few believed that victory has been won. They pointed out that there are still powerful interest groups that are fundamentally opposed to many of the proposed reforms. Moreover, the long-term challenges such as corruption, poverty, pollution, weak infrastructure and bureaucracy still exist. These are not battles won overnight.
The stock market, however, appears to be acting like victory is at hand. India’s Sensex index now trades at the upper end of its historical range and more expensively than many of its emerging market peers. It is now up 32% over last year and 49% over the last two years. The valuations of many of the stocks we examine appear to be pricing in high probabilities of successful reforms and faster growth.
In our view these valuations leave very little cushion for anything to go wrong, yet many risks still clearly exist. As an example, inflation continues to be a worry. The weather in India has been on the dry side this year and without a return of normal monsoon rains, crops may be weak and food prices could become elevated. Should inflation exceed the Reserve Bank of India’s targets, we should expect the central bank to tighten monetary policy, potentially weakening growth. In addition, India may yet be impacted by U.S. dollar strength. Should we see a “Taper Tantrum II” when the Federal Reserve gets on with tightening, we could see credit outflows, higher interest rates and higher financial costs for businesses and consumers alike.
So, at least among our team, we have yet to see opportunities that get us very excited.
What we are doing
This puts us in a waiting game. There are many good businesses in the region. The benefit of being long-term investors is that we can be patient with them—buying only when presented with attractive opportunities.
Meanwhile, we are also waiting for some macroeconomic signals. How the rupee and the Indian economy react to eventual Fed tightening is still to be seen. Similarly, we are looking for signs of improving trends in non-performing loans in banks and for continual progress with respect to economic reform. The passing of the upcoming Land Acquisition Bill and the re-start of major infrastructure spending projects will be good tests of the momentum behind Modi’s agenda. All these things will take time, however, so we’re not compelled to dive in headfirst at the moment.
Getting the hang of it
By the time we drove to the airport for my flight home, I had acclimatized to India’s sights and sounds. The sound of car horns still filled the air, but I no longer noticed them. Signs of poverty were still everywhere but this time it didn’t depress me; it gave me hope. I left India believing in the promise of the country. Modi seems to be the real deal. India is on the threshold. We’re buying in—albeit slowly and deliberately.