Now that the unassailable rise of Indian markets has been rudely interrupted, some have expressed the worry that the India growth story has somehow become suspect. How did economists and investors get so excited even as the value of local shares climbed an amazing 40% over the course of the last year and then suddenly lost one third of gains based on external events like changes in global interest rates, commodity prices and emerging market risk spreads?

The reality is that even after the recent reduction in market value due to these external shocks and a changed investor risk-appetite that brought a liquidity-driven and globally-integrated market back to its fair value, India continues to be a leading destination for investment and a success story among economists and businessmen. This is because of its strong macro as well as micro economic performance over the last four-five years which is expected to continue into the future.

The India Advantage

Having a large base and a high growth rate make the country unique and significant in a global context, much like its neighbor China. But what makes India special is the more productive nature of its economy. A simple calculation can help illustrate this point: Consider that China has a growth rate of 9% driven by a savings and investment rate of close to 40% while India has achieved a lower average growth rate of 7% with a savings rate of 25%. In other words, if you consider return on investment for a country as for a company, China has an ROI of 22% (9% growth divided by 40% savings) while India has a higher ROI of 28%, which means its firms are more efficient in generating returns from a limited amount of investment. This is also borne out by evidence that while India has received less investment than China, it boasts a greater number of world class companies that generate higher returns on invested capital, the most relevant metric for business productivity.

India is the fourth largest economy in the world on a purchasing-power basis witnessing consistently high GDP growth averaging over 6% from 1995 to 2005. The sheer size of the economy means that India is the world’s largest producer of items as diverse as sugar, cement, two-wheelers and movies. The Indian economy is unique compared to other developing countries because over half of GDP comes from services, and it is in this sector that India has made the maximum progress. India’s size is also backed by financial stability. Foreign exchange reserves have tripled from $40 billion in 2001 to $140 billion in 2005 while the rupee has appreciated from 49 to 42 with respect to the dollar in the same period of time. One of the most important drivers of growth has been the successful deregulation of financial markets and a decrease in interest rates from 12% in 2000 to about half that level in a span of five years. Inflation has been kept in check and, though they remain important risks, the fiscal and current account deficits have not deteriorated substantially despite increased government spending on poverty and oil prices being stuck at historically high levels.

What makes the India story more compelling is that in addition to the stable macro environment, the country displays strong micro fundamentals in the many quality Indian companies that generate superior revenue intensity and margin expansion, which translates into higher returns on investment. Indian firms have an average return on equity of 25%, much higher than the ROE for regional or global comparables. Considering that the cost of capital has come down by half from 12% in 1999, Indian firms have performed extremely well in delivering returns on invested capital in excess of the cost of such capital, the fundamental measure of shareholder value creation.

The spectacular rise of asset values in India is a result of this heady mix of positive macro and micro factors, the strong operational and financial performance of Indian companies combined with an upward “re-rating” of India or “the India story” to create an excess demand for Indian assets. This helps to explain the 40% appreciation in the prices of Indian companies that comprise the Bombay Stock Exchange sensitive index in 2005, an increase more than 5 times faster than the 7.5% GDP growth rate and one and half times as fast as the 25% increase in underlying earnings during the same period.

Turbulent Markets

The tailspin that the public markets have gone into since early May was initiated by external events including an interest rate increase in the US, a sudden fall in commodity prices and an increase in the perceived risk of emerging markets in general. The magnitude of the reaction in the Indian market to such international developments shows how India has become more globally integrated and sensitive to changes in foreign capital flows. Once global markets began to fall, many foreign investors in India with large holdings (especially ‘in the money’ capital held through the spectacular gains of the last two years) became net sellers for the first time because they understandably wanted to book long-term profits at the peak of the market cycle.

An ambiguous and ill-advised statement from the government created confusion about whether foreign profits from capital appreciation might be taxed and this contributed to the downward selling pressure. The worst outcome was panic selling by retail investors and brokers forced to cover positions taken on margin, often with the underlying security which was now reduced in value as the only collateral. Institutional investors were also stung badly by the sudden loss in market value and its effect on business confidence, but some will find a silver lining in the return to reasonable valuations that will drive consolidation and the opportunity for returns in M&A, private equity and control transactions.

Fundmental Strength

Despite the significant correction in asset prices and the ongoing volatility being experienced in the capital markets, the key economic variables that drive India’s growth continue to remain stable. Growth will be higher than initially forecast for 2005-06 and GDP is forecasted to grow at above 7% for the next two years. Both services and manufacturing sectors are healthy while, as always, agriculture remains the key risk. Inflation is a concern because of rising oil prices and the increased pricing power of manufacturing firms and could go up to as much as 7% next year. The current account deficit, currently at about 2.5% of GDP, is expected to narrow over the next two years to below 2%, again assuming oil prices come down from the current levels of over $70 a barrel. The Indian currency is expected to strengthen with rising capital inflows and rising domestic interest rates and the next 2 years could see the rupee appreciate by 10%. Finally, the fiscal deficit, among the biggest macroeconomic risks, has been somewhat reined in by the current government which reported a lower than budged figure in 2006 and expresses confidence at achieving the target fiscal gap of 3.8% of GDP in financial year 2007.

While the rate of earnings and ROIC growth will slow from 25% to 15%, the macro enablers and favourable investment themes of the India growth story remain unchanged. With the crash of the SENSEX, the focus of the Institutional Investor will shift from pure growth to value plays and consolidation strategies, and from the capital markets to M&A and private equity. The markets may be range-bound or even drop further, but a bullish long term view makes this a buying opportunity.

(The Institutional Investor is a corporate finance and strategy specialist who hopes to catalyze anonymous yet informed debate on specific opportunities and risks in India’s economy. Next week the Institutional Investor will examine the growth of corporate consolidation and private equity and highlight three investment themes to compare the different growth opportunities that make up the India story.)

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