India is buzzing. Its $1000bn economy is expected to double in size in the next five to six years and its order books are positively bulging. In the first 10 months of 2007, companies received orders worth Rs1281bn ($32.6bn), up by 68% on the same period last year. In its fifth year of strong gross domestic product (GDP) growth, India has a real GDP growth of more than 8% per year. It has 190 companies with a market capitalisation exceeding $1bn and 30 valued at more than $10bn.
Foreign direct investment (FDI) has more than doubled in the last 12 months: as 2007 drew to a close it had reached $19.4bn, versus $7.7bn in 2006. But India’s growing confidence and global ambitions have also led to increasing flows of outward FDI, which had risen to almost $10bn by the end of 2006, up from $2.5bn in 2005.
India is also among the least exposed economies in Asia to a global economic downturn. Exports may have risen to 23% of GDP, but they are still less than half the ratio for Asia (excluding Japan). And while India’s banks are not immune to global risk aversion, the country’s credit risk remains low: the credit-to-GDP ratio is only about 45% and the Reserve Bank of India has been strict in tightening provisioning standards and increasing risk weights.
Plenty in the tank
At the same time, India is not as vulnerable to short-term capital flight as its policy-makers may fear. Even if exports fell by 20% and non-FDI capital flows (currently 83% of total net capital inflows, according to data from Lehman Brothers) fell by 50%, the number of months covered by India’s FX reserves would fall only from 13.6 to 10, which is more than adequate.
The financial sector has been a major beneficiary of the country’s dynamic growth trends, and Hemendra Kothari, chairman of DSP Merrill, believes there is little chance that India’s growth story will be derailed in the foreseeable future.
“India will be a growth story over the next 25 years,” he says. “The scope is huge: it touches one billion people. Many financial services sectors are growing at about three times [the pace of GDP]. The economy may be slowed by a few factors, but I can’t see it hurt to the level that [growth will] stop. We are very confident of the growth rate continuing.”
Such confidence is borne out by buoyant M&A volumes. According to data from Thomson Financial, in the first six months of 2007 alone, deals worth $46bn were announced, almost a 50% jump over the figure for the same period in the previous year (earning investment banks in India about $538.4m in fees). This, too, looks set to continue, says Prahlad Shantigram, head of corporate finance and advisory for South Asia at Standard Chartered.
“Indian companies are still active; seeking [to acquire] commodity suppliers, as well as companies that offer overseas distribution, strong brands with good client relationships to which they can add value through cost-effective Indian operations,” he says. “The inbound story is also positive, driven by companies seeking to cater to the growing Indian consumer market or to cut costs through establishing India-based operations.”
India’s equity markets are also rocketing. According to the Bombay Stock Exchange (BSE), total market capitalisation is $1600bn, which is on a par with South Korean and Italian markets. As a proportion of GDP, the Indian market, at 89% in 2006, is high relative to other countries at a similar stage of economic development, and is much higher than most other large emerging markets such as China (43%), Brazil (68%) and Poland (44%).
The sheer number and diversity of listed companies is a vivid example of the country’s well-developed equity culture. The BSE lists nearly 4800 companies and the National Stock Exchange lists 1283, compared with 2280 on the New York Stock Exchange and 3256 on the London Stock Exchange. In terms of the number of transactions per year, the National Stock Exchange is the world’s third largest, after Nasdaq and NYSE. The primary market is active too, with $48bn of new issues over the past three years.
Spanners in the works
But India’s financial story is not all positive. Without the vibrant equity market and the large government bond market, India’s financial sector looks more threadbare. Despite a thriving corporate community operating on an increasingly global scale, gaping holes remain in the range of financial products such clients require for efficient capital raising and risk management.
Most notable, perhaps, is the immature domestic corporate bond market. Lehman Brothers’ data reveals that debt outstanding equals just 2.3% of GDP, compared with 26.2% in the rest of Asia (excluding Japan), and to 46% in France and 121.4% in the US. There is virtually no market in bonds below investment grade.
“The lack of a well-developed bond market is a problem,” says Falguni Nayar, head of investment banking at Kotak Mahindra Capital. “The demand is there but it has not taken off, mainly due to structural issues. A government committee identified the issues that need to be addressed, but so far little progress has been made because of the multiplicity of agencies that need to agree to move the market forward.”
As yet, the pool of domestic institutional investors is shallow, which is not helped by the tight controls governing portfolio allocation, and there is little if any retail investor participation. Moreover, public offerings are expensive and involve onerous regulatory requirements, and this discourages issuers. Disclosure demands are burdensome compared with other markets, yet little data is easily available (although transactions have begun to be reported on the stock exchanges). This hampers secondary market development; as does the fact that repos are not allowed in corporate bonds, which hinders market making.
The government-sponsored committee, chaired by Dr R H Patil, identified these structural problems and its report, released in December 2005, proffered a series of recommendations to develop the market. But little obvious action has been taken to implement them.
“This could hamper future growth,” adds Ms Nayar. “It is critical that we build up a domestic market that is sustainable alongside international flows. Our demand for infrastructure funding, for example, is huge [the estimated required spend in the next five years is $490bn, or 50% of the economy]. So far this has been fed by equity, but we need to offer a debt market alternative and banks cannot carry the weight of that on their books.”
Other missing markets include interest rate and currency derivatives, and these, too, seem stymied by too much discussion and too little action.
The delays surrounding currency futures – seen as critical to help exporters manage the growing currency risk represented by the rupee’s almost 12% rise against the dollar last year – is typical of the Indian policy maker’s wary approach to market development.
Dubai caution
In June 2007, when trading of rupee futures began on the Dubai Gold and Commodities Exchange (DGCE, set up in Dubai by Indian entrepreneur Jignesh Shah because, he says, the environment is more welcoming), India responded by setting up a committee to look at the matter.
What is there to look at, ask critics? The need is obvious and the market rules and technology are already out there. Such delays mean that markets are simply moving offshore, where the country’s policy-makers will have no hand in their regulation, and market participants gain no benefit from their growth.
“India is not designing a new market; simply adopting one already used successfully the world over,” says one Indian investment banker. “Instead, the market is taking off in Dubai, with all the attendant benefits accruing to participants there. In India, fear over what could go wrong – whether the market could be manipulated or whether unsophisticated institutions may get themselves into hot water – leads policy makers and regulators to slow market development, or to mire it in rules that limit or prevent innovation.”
The chief executive of the National Stock Exchange, Ravi Narain, has stated that talks are under way to introduce currency futures, “possibly” by early 2008.
The IFC debate
The vexed question of how these markets should be developed (or even whether they should), threads into another hot Indian debate. The question of if and when Mumbai should become an international financial centre (IFC) has become a proxy for discussion about deregulating, liberalising and globalising all parts of the Indian financial system.
In April 2007, another government-sponsored committee, the 15-member High Powered Expert Committee (HPEC) chaired by former World Bank economist Percy Mistry (who resigned from the Committee before its report was officially released), published its roadmap for Mumbai as an IFC. In response to the question given by the government – what steps would need to be taken to achieve IFC status? – the HPEC’s bold report encompassed 48 deliverables, as well as a clear statement of why it was the correct goal.
The central tenet of the report is that India’s exploding financial needs cannot be met by its current financial system. By 2025, it is estimated that India will be the fourth largest economy in the world. It is rapidly gaining in global significance and needs enormous infrastructure investment. In 2005 (the latest for which figures were available as The Banker went to press), India purchased international financial services (to fund overseas acquisitions) worth more than $13bn. A working assumption of a 2% fee on such cross-border flows reveals the amount of fee revenue being lost to centres like London, New York and Singapore.
Some of HPEC’s recommendations make uncomfortable reading for policy-makers and incumbent institutions. Key recommendations are that the Reserve Bank of India’s role be restricted to managing inflation alone; that India move to full capital account convertibility by December 2008; that the state divest ownership in financial sector companies; that there is deep and wide financial sector reforms; and that regulation shifts from a rules-based, to a principles-based approach similar to the UK’s Financial Services Authority.
Some, such as the sale of state-owned banks (SOBs) will meet stiff political resistance; others, such as financial reforms and a change in regulatory approach, will require a complete change in mindset.
If the overall aim of the report was generally well received, it quickly became apparent that the political will is not there to make it happen. As with the Tarapore Committee, which advocated in June 2006 the move towards fuller capital account convertibility by 2011 (the first Tarapore Committee in 1997, recommended the same goal by 2000), little has been done to implement the recommendations, but much has been said to justify inactivity.
India’s central bank remains wedded to a more cautious approach to the development and regulation of financial markets, as well as to its role to controlling inflation and exchange rates, and maintaining growth. The Reserve Bank of India (RBI) governor, Dr YV Reddy, maintains that the economy is not yet ready for some of the HPEC’s recommendations, particularly capital account convertibility (CAC).
Instead, he advocates continued capital management using mechanisms such as mandatory cash reserve ratios for banks, and limiting the inflow of capital through tighter restrictions on external commercial borrowings and foreign investment.
Critics point to a recent International Monetary Fund (IMF) study which stated that capital controls have little impact on the volume of inflows or currency appreciation, and a paper from the Bank of Thailand which admitted that such controls had had limited efficacy when implemented in Thailand.
Mr Reddy defends the RBI’s approach. He argues that while the bank has left the way open to change when circumstances permit, different countries must approach capital account management in a way most appropriate to their situation. And ultimately, the RBI should be judged on results, he says.
“We believe in placing relative policy emphasis on sources and types of investment that we want to encourage, which is consistent with the principle of hierarchy of capital flows. Empirical evidence speaks for itself. In terms of growth and stability, China and India, who both actively manage their capital accounts, have performed exceedingly well in recent years.”
The cost of no action
But Mr Mistry maintains that ignoring the reforms is not an option.
“It is simple. If India’s economy keeps to much the same growth rate, by 2015 the country will be purchasing financial services worth about $70bn. It is absurd to believe that India can control entirely within her borders her own financial and corporate destiny,” he says. “We cannot meet the needs of the economy with the system as it stands; it is ill structured, market-deficient, institutionally weak, overly state-owned and micro-managed by regulators.”
He argues that if India does not move quickly, it will miss the boat – as evidenced by the launch of rupee currency futures in Dubai. What is to stop the much-needed corporate bond market also getting started there if entrepreneurial Indians such as the DGCE’s Mr Shah are welcomed with open arms?
And if more progress is not made to address Mumbai’s infrastructure ills (one of the central pillars underpinning the HPECs recommendations is the urgent need to improve transport, sanitation, roads and water supply, as well as housing and schools) then DSP Merrill’s Mr Kothari believes it will become increasingly difficult to attract the international financiers required to keep the financial sector running, let alone growing.
“Providing a comfortable and attractive living environment is as important as providing the regulatory and business backbone to attract international bankers,” he says.
The genie is out of the bottle and it is impossible to force it back in, says Mr Mistry. “You only have to look at India’s economic growth; its exports; its imports; its FDI. India needs free-flowing international capital, and new products and services, now. There is a great deal to play for here; and a great deal to lose.”
But caution seems also to be the watchword of many bankers, who seem caught between a market approach and the desire to insulate the economy. Even while they recognise that change is essential and lack of it may be losing India Inc. business, most are largely sympathetic to the RBI’s approach.
Arvind Agrawal, CEO of Atherstone Group, a boutique investment bank based in Mumbai, acknowledges that “it is sometimes easier to do business in Dubai than here”, and that the Indian regulatory environment can be both “tedious and painful”. But at the same time, he believes that the RBI’s approach – to capital controls, for example – should be maintained.
“The RBI approach is right; it must try to control currency appreciation to some degree. [The rising rupee] is already hurting quite a lot of exporters and there have been lay-offs in several affected industries,” he says.
Gradual approach
R Sridharan, CEO of SBI Capital Markets, argues that a gradual approach is best. “Regulators are slowly opening up the markets but the worry is that if they bring in CAC, inflows would be an even bigger headache and render money supply management a greater problem.”
Others argue that, for practical purposes, the current account is convertible. “[The current rules] do not put the brakes on business; money can flow in an out as long as it comes through the right windows,” says Standard Chartered’s Mr Shantigram.
The HPEC report maintains that state ownership of the financial sector is one of the greatest blocks to India’s financial sector development. SOBs dominate the banking system – accounting for nearly 75% of assets and deposits – but are increasingly struggling to grow their equity in line with lending requirements or other opportunities for growth.
“Can the government fund them at the level they need? That’s a big job,” says DSP Merrill’s Mr Kothari.
Moreover, the way they are run is inconsistent with sound management, says Amit Tandon, managing director, Fitch Ratings India. “The government appoints the CEOs but gives them limited functional autonomy,” he says. “CEOs cannot decide on key business drivers, the promotion policy or the compensation structure. The government appoints directors based on whom they represent – such as industry, unions or states – rather than on their ability to run the institution efficiently. The government, as owner, needs to push these banks to merge, cut costs and create scale.”
Mr Mistry goes further. Aside from the debate about the capital that would be freed up if the government sold its holdings, he believes that these institutions retard the development of other institutions and markets. For example, SOBs command the lion’s share of the domestic savings market, which the government has traditionally directed into government bonds. Mr Mistry maintains that this has impeded the emergence of a broader fixed income market for more than three decades.
He also contends that over-protection of the SOBs by regulation at the expense of the private sector has prevented the Indian banking sector and the wider financial system from growing and diversifying in the same way that it has in most developed economies. The Indian system remains fragmented and rigidly compartmentalised. In turn, this has prevented the emergence of large complex financial institutions (LCFIs). The total market capitalisation of all Indian banks, private and public, is about $150bn. This compares to about $200bn for just the top three Chinese banks.
“Is if fair that institutions such as ICICI and HDFC are prevented from developing into LCFIs merely by regulatory strangulation and the protection of SOBs,” asks Mr Mistry. “In the real economy, this would be the same as preventing Tata Cars from developing so that auto production remained in government hands.”
Bad time for reform
The timing could hardly have been worse to call for radical reform. Just as the first Tarapore Report was lost in the aftermath of the Asian crisis of 1997, so the HPEC’s recommendations have become tainted by the subprime crisis and the credit crunch in US and European markets.
As global capital escapes turmoil elsewhere to seek a safe haven in India, it has increased pressure on the currency and inflation; this in turn adds credence to the RBI’s argument for tighter capital controls and reaffirms the belief that caution regarding capital convertibility and market innovation is justified.
“As a market participant, we might sometimes have asked for more of a free hand, but if you look at inflation, securitisation or opening up the country to dollar inflows, for example, then on each of these areas the call [by Indian regulators] has been right,” says K V Kamath, CEO of ICICI Bank. “And if you look at the crisis happening elsewhere, we can feel happy that they didn’t rush in.”
If Mr Kamath is right, the impact of the subprime crisis may be to make Indian policy makers more cautious still in some areas. “Given Asia’s experience in 1997 and what is happening now in other parts of the world – unless [India] can demonstrate the strength to withstand that sort of shock – with higher per capita income and greater foreign exchange reserves – I don’t think we will be moving to CAC too soon,” he says.
But the need to learn from a crisis should not stop market development, argues Bobby Parikh, managing partner in charge of financial services and private equity at professional services firm BMR and Associates. Sadly, he fears that this may be exactly what happens.
“There has to be an analysis to figure out what went wrong and then plugging those areas through improved regulations and oversight. But refraining from implementing policy change as a response to market failures comes at the cost of the considerable value that market innovations may otherwise contribute. [In India] market failures, whether international or domestic, have invariably resulted in slowing down the pace of reform.”
The wrong lessons
Mr Mistry fears that all the wrong lessons will be learned from 2007’s market turmoil and that it will be used as an excuse to to slow down the reforms laid out in the HPEC report.
“The subprime problems and the credit crunch will be used to justify micro-managing the regulatory environment and hinder market innovation,” says Mr Mistry. “In 1997, Indian policy-makers and regulators used the Asian crisis as an excuse not to implement the first Tarapore Report and to draw in India’s horns; we lost a decade as a result. They are doing the same thing now.”
Mr Reddy denies the very concept of a lost decade, stating that the 10 years to 2007 has easily been the best decade for India.
He avoids the question about whether the subprime crisis will be used to slow reform. Instead, he argues that reforms are a means to an end, and that imposing timetables and deadlines for reform steps in a fast-moving world is a dangerous pre-commitment for policy-makers.
“Policies [should] be judged in terms of their outcomes, not on the basis of assumed correlations between outcomes and the level of implementation of various reports submitted in the past. The recommendations made in these reports should not be seen as a mandate, but in the context of pre-conditions [for change] specified in the report. Progress in implementation must be seen in its entirety, against the backdrop of broader policy changes that may be required and in the context of all the [agencies] concerned.”
Most importantly, he maintains that much progress has been achieved. “The financial and external sectors have proved to be efficient and resilient – withstanding several domestic and global shocks.”
India’s growth path looks well set and much reform has been achieved. But the debate about the scope and pace of financial sector reform looks set to run and run.
YV Reddy: central bank governor says economy is not ready for some of the HPEC’s recommendations
