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The India investment story

Invest in Indian equities, but given the near-term risks, it may be more prudent to wait before jumping in

“Should I be investing in India?"

The frequency with which this question was asked earlier has gone down noticeably since the heady days of 2009-10. Then, central banks had just rescued the global economy, and a “reformist" UPA-II, promising permanent prosperity, had been sworn in. Unfortunately for investors, the India story became a tragedy while politics descended into farce. The stock market (as measured by CNX NIFTY index) is up a mere 25% (as of 14 March 2014) since end-2009 (equivalent to roughly a 6% annual return), which hasn’t even protected against inflation. The plight of foreign investors is even worse. The rupee having depreciated 30%, they have earned negative returns on investment. Moreover, Indian bonds have provided no safety either with 10-year yields more than a percentage point (7.6% on 1 January 2010 to 8.7% on 14 March) higher in the given period (i.e. prices are down). Real estate may be the one bright spot, but that too has been moribund of late. Also, given the prohibition on foreign nationals buying immovable property, real estate is usually not in focus for most people asking the question above.

However, there seems to have been a small recovery (or at least the slide has been arrested) since the last quarter of 2013. Stocks have hit an all-time high, the rupee has rallied, and even bonds are marginally higher despite a rate hike. It is all the more impressive given the greater political uncertainty and the looming national election. So, is the market indicating a return to the original script of the India story?

The trouble with stories is that they make us oblivious to risks. We confuse a possible outcome with being the only outcome. To be sure, India can grow at a rapid rate to become a middle-income or even a highincome economy, but there is nothing inevitable about it. Development requires good policies and a favourable external environment. Without these, India can easily remain stuck in poverty or even regress. Argentina is a good example. At the turn of the 20th century, it was considered a certain bet and investors were rushing to take advantage of the opportunity (The Economist has a great cover story with parallels for India). External challenges coupled with poor policy choices meant that it went from being one of the 10 richest countries in the world to its current state.

Therefore, to evaluate the India investment case, we need to first assign a subjective probability to the realization of the India story. Investors need to answer two broad questions: is the external environment going to be conducive to Indian growth, and are policies going to favour growth over populism?

Unfortunately, external developments are becoming more unfavourable. Not only is the great liquidity tide ebbing due to US Federal Reserve’s (Fed) tapering, but heightened geopolitical risks due to Crimea may impact oil prices. These may be managed if policymakers were on the ball, but the current government has been in shambles and the chances of a better one are not very high. The internal political situation seems more chaotic, with chances of a hung Parliament higher than what they were six months ago. Therefore, the probability of resurgent India growth seems slim at this time. However, this can change significantly after the general election. The over 17% rally on the day of the last general election result in 2009 shows how quickly expectations change and the strength of their impact.

Even if the probability of a happy outcome is slim, the investment may be justified if the downside risks are small and the upside large enough. At least on a valuation perspective, downside risks are relatively low. Indian equity valuations (as of end-February) are below their 10-year average (Graph 1), with the price-to-earnings ratio marginally lower at 15.8 (16.3 is the 10-year average) and price-to-book ratio 23% lower at 2.4 (3.1 being the 10-year average).

Moreover, with the stock market essentially flat since its peak in 2007 and inflation running in double digits (IMF consumer price inflation for India), real prices are back to 2006 levels (Graph 2).

Since equities should protect against inflation in the long run (as corporates have pricing power), the fall in real terms indicates that much of the pre-crisis euphoria has unwound, thus limiting further downside.

The second is ignoring the bigger picture. As 2008 proved, financial markets are interconnected and stress in one part is usually transferred to other parts. Emerging markets are especially at risk given the Fed tapering and the recent wobbles in the Chinese market. A flight out of the emerging markets will impact India irrespective of its fundamentals. This is more so given that the Indian equity market has been primarily driven by foreign money. FIIs have been net buyers while domestic mutual funds (MFs) have been sellers all through 2013 (Graph 3).

So the answer to the question is, yes, invest in Indian equities, but given the near-term risks, it may be more prudent to wait before jumping in. If the India story is validated, then missing a 17% post-election rally is not going to make much difference in the longer run.

Shashank Khare is an investment professional and writer. After studying engineering at IIT-D and business administration at IIM-A, he entered the world of credit derivatives before CDS became a four-letter word. Having successfully batted through the crises, he now indulges his passion for economics, finance and policy through writing and trading.

Read all of Shashank’s earlier columns

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