The differing responses of the Indian and Chinese economies to a common global event – the Fed’s announcement of the tapering of QE – is an example of the resilience of the Indian economy in comparison to its more vaunted Chinese counterpart. China’s systematic over-investment, pegged exchange rate, lack of free press and distorted macro data are in stark contrast to India’s performance on these fronts. Whilst India has a long way to go for stockmarket investors (as opposed to FDI investors), India continues to be a more reliable bet than China.
On 19 June, the Fed stated that it would gradual start reducing its purchases of US Government bonds and Mortgage Backed Securities so that by June next year, QE is brought to a halt altogether. In anticipation of and in response to such an announcement, bond prices have fallen across the world and Emerging Market currencies and stockmarkets have fallen in unison. Since 1 June, the INR has
depreciated by 5% versus the USD and the Nifty has fallen by 2.7%. The comparable figures for China are 0% (for the Reminibi) and 14.9% (for the Chinese stockmarket). The contrasting responses of the Indian and Chinese economies to a common global ’shock‘ – the Fed’s signal of tapering – gives us a window into how these two economies function and why, from this admittedly biased observer’s perspective, India is the market to bet on going forward.
The Chinese dragon wobbles
- Systematic overinvestment: In the years after the Lehman crisis, the Chinese Government went into overdrive to keep the economy stimulated as exports to the wounded Western economies sagged. Investment as a percentage of GDP surged from 39% in 2007 to 45% by 2009. The Government-owned Chinese banks were at the center of this stimulus, and now loans outstanding amount to 2x GDP. Furthermore, given the stories which abound of overcapacity in China in a host of capital-intensive sectors – from shipbuilding to steel to real estate – it is questionable as to how much of this investment has actually been put to productive use. That in turn raises the issue of how the Chinese financial system can now deal with this sort of quantum of bad debts without a statefunded recap. More fundamentally, it raises the question about whether the Chinese economy can actually provide the appropriate signals that a free market economy does to provide socially optimal levels of investment. Remember, capex in heavy industrial sectors depreciates rapidly. Hence, if not utilised, it is lost forever. For intelligent analysis of China’s over-investment it is worth reading Michael Pettis: How much investment is optimal?
- The inability to generate ’free market‘ signals: By systematically distorting free market signals, from interest rates to exchange rates, the Chinese Government is exacerbating the hot money outflows triggered by the Fed’s ’tapering‘ signal. Whilst other EMs, such as India and Brazil, have seen their currencies slide by about a fifth in response to tapering, because their exchange rates have depreciated, the quantum of hot money outflows has moderated (as the weaker exchange rate makes the economy more attractive). In contrast, because the Yuan is pegged to the USD, the quantum of outflows from China has been such that it has triggered a system-wide shortage of liquidity. Whilst the Chinese Government is claiming that this is a controlled crisis – see the next bullet point – it is not obvious as to how the Government can control the crisis. For example, if the Chinese Government, the world’s biggest non-American holder of US Government bonds, sells US Treasuries to reverse the hot money flows, the fall in the price of US Government bonds, coinciding as it does with the Fed’s tapering, will dramatically reduce the value coinciding as it does with the Fed’s tapering, will dramatically reduce the value of China’s US$3trn of FX reserves. If, on the other hand, the Chinese Government prints money to inject liquidity into the economy, it will further fuel China’s speculative real estate bubble. (For more on this issue and for clear headed analysis of China, Andy Xie is a ’must read‘: When the Tide Goes Out
- The muzzling of the press: If you were to believe the steady stream of op-ed pieces produced for newspapers around the world by card-carrying members of the Communist Party (including Economists working for brokerages and Chinese universities), the ongoing downturn/crisis is being monitored by the Chinese Premier who, when he deems fit, will step in to save the day and initiate structural reform. In that context, I find it hard to understand why foreign journalists who have worked in China have long complained that their phone calls are tapped and their movements followed. Even stranger is last week’s Financial Times report about how the Chinese Government wants the press – national and international – to say that the economic situation is currently under control. If the truth is so self-evident, why does it have to be dictated to the press?
- Deficient macroeconomic data: On 4 July, after six months of keeping its manufacturing PMI a whisker above the 50 mark which separates growth from contraction, China finally threw in the towel and suspended the publication of sector-specific manufacturing data. “We now have 3,000 samples in the survey, and from a technical point of view, time is very limited – there are many industries, you know,” stated Cai Jin, vice president of the China Federation of Logistics & Purchasing, which compiles the data along with the National Bureau of Statistics. Now, when a country stops publishing key macro data, this does not quite suggest that its leadership is in charge of the crisis. More usefully perhaps, investors can turn to data on electricity consumption in China to understand what is really happening – in May, power consumption in China increased by 1.9% YoY, the slowest growth since May 2009. For more on dodgy macro data from China and why the Chinese economy might already be growing at a very Indian 5.5% or less, please refer.
Why India is not China and why that is good for India?
- Rational levels of investment: Other than the FY04-09 period, India has never seen a sustained surge in capital investment. That is but natural given that India has the highest cost of capital outside sub-Saharan Africa and given that neither India’s labour market nor its democratic institutions (including, thankfully, checks and balances created by the courts and regulators) are developed enough to cope with higher levels of capital investment. Furthermore, it is not as if India’s levels of capital investment are low – even in the last three years, India’s investment/GDP ratio has been at 32% in FY11, 31% in FY12 and 30% in FY13. To put these figures into context, Japan in its heyday of investment – i.e. in the 1960s – clocked up figures in the region of 30-35%.
- A functioning free market for the most part: Other than the Government bond market (which is distorted by the Government forcing banks and insurers to buy Government bonds) and public food distribution system (where prices are set by the Government), most other prices in the Indian economy now float based on demand-supply levels. This helps because free-market-driven competition helps the Indian consumer get a good deal; for example, competitively-priced, high-quality cars available at US$10K, return air fares to Singapore well below US$300, and a range of FMCG consumables at prices well below US$1. The fact that the average Indian avails of these bargains and pumps up consumption (as opposed to investment) in the economy is NOT a sign of economic malaise – it is a sign of a functioning economy.
- The benefits of a free press: India’s free press combined with the Right to Information Act has given further teeth to its democracy. Gone are the days where, Chinese style, the people who rule Delhi could hand over large arms and infra contracts to their friends and family. Whilst this has slowed down capital formation, it has also meant that resource allocation and infra construction has become more efficient in India. To give a pertinent example –when I visited Uttarakhand (a state which has grown at a staggering 10.6% per annum of FY09-13) two months ago, I heard numerous entrepreneurs complaining about how due to obstruction from the Ministry of Environment in Delhi, the state was not utilising its potential for hydro-electric power generation. To belatedly give this much-abused Ministry some credit, had it signed off on more hydro-electric projects, the devastation caused by the recent cloudburst in the state would have been even more pronounced. Thankfully, the Indian press cottoned on to this, and after the floods, launched into the nexus of infra companies and state Government officials who have connived to undermine the state’s environmental ecosystem.
- The fracturing of political power and the slide of the ’connected company‘: India’s real triumph over the past five years has been to push back corporates whose core competitive advantage is political connectivity. Our P75 Index (of the 75 most-connected companies) has now underperformed the BSE500 by over 50% over the past two years. In contrast, our ‘Good & Clean’ portfolios (which are the opposite of the P75) have outperformed the BSE500 by 20% over the same period. As political power fractures in India – away from the Cabinet in Delhi and towards the state capitals, powerful economic regulators and courts – corporates can no longer depend on their political sponsors to work the system in their favour. Whilst this lowers economic growth in the short run (as the dominant ’connected companies‘ slide, and other less connected but more efficient corporate groups push to the front), in the long run, this leads to higher growth and better economic outcomes. Given how the Communist and military elite controls China, the Middle Kingdom is likely to struggle to create anything akin to what India has achieved on these fronts.
To be sure, India has a long way to go to catch up with China – any country where over 300mn people struggle to get food to survive and where 40% of the populace is illiterate cannot claim otherwise. But when it comes to the India vs China economic comparison, in a turbulent global economy, the Indian economy is likely to be more flexible and hence more capable of progressing in the face of change.
None of what we have said here is really new to seasoned global stockmarket investors. Their unwillingness to commit capital to China and their eagerness to invest in India are now well known – over 1 year, 3 years, 5 years and 10 years, the Sensex has outperformed its Chinese counterpart by 6.5%, 1.8%, 4.6%, and 2.6% respectively.
(All of these are annualised figures. We have taken the Hang Seng China Enterprises Index, i.e. the HSCEI, which represents H Shares listed in Hong Kong as the Chinese equity benchmark; performance of the Shanghai Composite is even worse. Further returns are currency adjusted, i.e. in USD terms.)
This outperformance is likely to be sustained going forward as India’s economy recovers and China’s falters in a difficult global economy where capital will become expensive and where EMs will no longer be the darlings that they once were.
(Saurabh Mukherjea is the Head of Equities at Ambit Capital. The views expressed here are his own and not Ambit Capital’s.)
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