India facing a jagged transition

It is amazing how perceptions change with time. I was last here in 2007. The Indian economy then was defying gravity and morphing into a mass affluent society, with a 350m-strong middle class. Its attractiveness as a source of new funds as well their destination was not in doubt.

But the 2008 credit crunch ruined the party. It showed that, like other tiger economies, India was as susceptible to the contagion effects of globalisation as its trading partners in the West. The annual growth rate dived from an average of 10 per cent to 6.5 per cent.

The stockmarket started a rollercoaster ride. From a peak of around 22,000 in 2007, the Bombay Stock Exchange’s benchmark Sensex went into freefall, hitting 8,000 a year later. By late 2010, it had recovered lost ground, only to tumble again by 20 per cent in 2011 due to the sovereign debt crisis in Europe. Domestic and foreign investors lost a packet. But the worst may be over.

This year has started well. The rupee gained 7.5 per cent against the US dollar in January, its best monthly gain in 17 years. The net inflow of foreign funds was $2.1bn after a net outflow of $500m last year. The Sensex rose by 11.3 per cent in January, its highest gain in a January in 18 years. Inflation has dropped from 9.1 per cent to 7.5 per cent. Sales of durables goods have returned to their double digit growth rates.

As a snapshot, these numbers convey an image of shoppers thronging the malls and investors rushing to the races. But as the 19th century Irish playwright Oscar Wilde cautioned: “The truth is rarely pure and seldom simple.”

To start with, the markets have recovered but the bulls are not in sight. Quite simply, the recovery is a liquidity play. Most of the recent net inflow came from foreign professional traders engaged in ‘carry’ trades based on the low interest rates in the US and the weak rupee at home.

In contrast, Joe Public is staying on the sidelines. The memory of big losses in the recent past is one factor. The other is the unintended consequence of the abolition of front-end commissions on mutual funds and the introduction of advice-based fees. Upon discovering that anything up to 2.5 per cent of their assets are chewed up by fees, high net worth investors have flocked to banks that offer up to 10 per cent on term deposits (with an extra 0.5 per cent for senior citizens).

Before the crunch, wealth management resembled investment banking: a product machine pushed to the tipping point. It relied on the herd mentality that thrived on hype, greed and fear. Fund sellers sold what they had rather than what clients needed. The prevailing beat-the-market mentality ensured that investment had a strong gambling undertone.

Now, investors are wising up, as are their wealth managers. The latter have, on the whole, welcomed the abolition of commissions as a necessary step towards kick-starting investor education and a buy-and-hold culture. The long prevailing feast-and-famine mentality benefited neither them nor their clients.

On their part, the regulators are keen to ensure that distributors can no longer run tacit auctions that place clients’ money with managers who offered the highest front, trail or exit commissions – irrespective of clients’ need or managers’ track record. So rife were conflicts of interest that without regulation, investing faced the same epitaph as medieval medical procedures: “The operation was successful, but the patient died.” Private investors are now deeply suspicious of anything that looks funky.

While they are drawn into term deposits, their ultra-rich peers are coming back into the market – albeit cautiously – via two sets of products: asset allocation funds, blending equities and bonds; and high conviction strategies. However, in both cases, they show zero tolerance toward mediocrity, such that the shelf life of a typical product is unlikely to exceed its long-term average of two and a half years.

Periodic forecasts from global consultancies paint emerging markets as a source of untold bonanza for the wealth managers. They ignore one stumbling block: the magnetism of the time-honoured savings culture. It has long delivered capital preservation and income upside that the risk-return calculus of the investment culture has yet to match.

This transition from savings to investment needs tailwinds from four sources: a long bull market that inspires confidence, compulsory retirement planning that puts the onus on the individual, a high investment literacy that minimises herd behaviour, and an advice overlay that permits sensible asset choices.

In India, the first one is unlikely for a while, the second one is not being contemplated, but there are distinct baby steps towards the third and the fourth. However, their impact will be diluted from time to time by market volatility.

The trajectory between the two cultures will be anything but a straight line. India may well be the next gold rush for wealth managers – but later rather than sooner.

Yet, the medium-term omens are favourable. As the decade progresses, Asia will increasingly shape global economic dynamics. Its governments are keen to promote an indigenous industry for top-down and bottom-up strategies to promote cross-border trade in funds across the emerging markets.

In the process, they are keen to involve wealth managers from the West provided they create manufacturing capability on the ground, instead of distribution alliances, as happened in the last wave of globalisation. Client visibility will become ever more important, as India promotes financial literacy directly and investment culture indirectly. That necessarily means digging in for the long haul.

Thus, as a source of new funds, India will not be an easy roll-over; nor will it be, for that matter, as a destination of funds.

The Achilles’ heel

Most of India’s quoted companies are part family-owned. Transparency in business conduct and financial performance required by investors in the West are conspicuous by their absence on the ground. Investors have bought into the overall India story, not its business practices.

Before 2007, many companies traded at stratospheric multiples: as did their counterparts in Japan some 40 years ago when Japan was expected to overtake the US by the 1990s - only to crash and burn when Nikkei spectacularly lost its bloom in 1989.

India’s recent successes are amazing. But we live in a world where the past is an imperfect guide to the future. Anyone hoping to make a quick buck is living in a fool's paradise.

Investors in the India story fall into two camps: opportunistic and buy-and-hold. Those good at market timing are attracted by the former; those prepared to ride out regular volatility by the latter. At present, the weight of the money is in the former. Knowing that the investment graveyard is full of CIOs who tried to time the markets in the past, the omens are not good. Only professional traders are likely to be the main winners in the short term.

In any event, transparency and governance have yet to reach levels conducive for deep liquid markets. Like other nations, India will have its share of financial scandals and social upheavals. Governance may prove its Achilles’ heel.

The regular well publicised lapses extend beyond the boardrooms and engulf the body politic, as shown by the recent ruling from the nation’s Supreme Court cancelling the so-called 2G licences to mobile phone companies and ordering open auctions for the airwaves. The scale of corruption – that short changed the exchequer by some $39bn – reveals a grossly indecent love affair between politics and business.

The media regularly carry stories of people in the inside lane thriving on ill-gotten wealth typical of crony capitalism. When asked recently why the state of Karnataka was finding it hard to recruit the head of lokayukta – the anti corruption ombudsman organisation – its chief minister Sadananda Gowda said: “I’m helpless. What can I do? Everybody has some allegations.”

To reduce the abuse of power, India needs systemic reforms more than just a change of government or the crucifixion of individuals from the ruling party or corporate boardrooms. Until then, the majority of portfolio investors from the West are unlikely to adopt India as a buy-and-hold story.

The good news is that both the free press and the burgeoning middle class are demanding reforms relentlessly. The earnest of intention is there. The 2G scandal has forced serious introspection. But it may take a new generation of leaders to make a difference.

Amin Rajan is the founder CEO of Create-Research

Amin Rajan