‘Stars are aligned, but India must overcome execution risk’

(This interaction with JP Morgan’s chief Asian and emerging market equity strategist Adrian Mowat was published in DNA edition dated November 20, 2010.)

Venky Vembu

The global credit environment is very propitious for economies like India, which run a current account deficit, to borrow and invest in infrastructure, according to JP Morgan’s chief Asian and emerging market equity strategist Adrian Mowat. “But the biggest risk is that India fails to take advantage of the current environment.” Responding to questions from DNA Money’s Venky Vembu in Hong Kong on Friday, Mowat explains why he’s overweight on the Indian equity market for 2011, what worries him about the Chinese stock market in the short term, and why, in his estimation, the debt crisis in peripheral Europe won’t lead to another “shock to the system”. Excerpts:

What’s your outlook on the Indian stock market for 2011?

We’re overweight India, and have been for more than a year now. We see India as probably offering the fastest GDP growth in 2011, potentially even overtaking China. The dynamics in India are different from those in China: India, for instance, runs a current account deficit rather than a surplus. And if you run a current account deficit, you care about borrowing conditions. At the moment you’re much better off being a borrower than a saver, given the rally in credit markets. We think India is going to be able to fund a very significant increase in fixed asset investments next year because the external borrowing environment is so attractive. We’ve seen about 18 per cent nominal GDP growth in India, whereas international bond yields for corporates are at 5.7 per cent. Also, the rupee is appreciating.

The perceived borrowing costs are very low. Onshore bond yields are 8 per cent. You can find a lot of investments that will give you substantial returns in excess of the borrowing cost.  That’s the dynamic we need to focus on: India is a very powerful growth story; it trades at a growth multiple, but that is acceptable.

What are the policy risks you see in India?


To me, the biggest risk is that India fails to take advantage of the current environment, which is one in which it can borrow a lot of money to invest in infrastructure. All the stars are aligned. It’s now about execution risk – and the Commonwealth Games was an inauspicious story when it came to that. We haven’t seen the pick-up in fixed asset investments that we were expecting. We think that’s delayed because it just gets longer to get things done with the bureaucracy. The Reserve Bank of India governor was talking earlier this week about how disappointed he was in the capex story and how we need to see that accelerated. That, to me, is the biggest risk, and I think it’s a much bigger risk than inflation, which is what people tend to focus on.

As a general story, ‘execution risk’ is a big issue. It’s a very favourable environment, where you want governments around the region to go into an investment phase, renew infrastructure, and improve the capability of their economies to grow faster. So, all the stars are aligned. The question is: can governments execute on it?

What are the risks of a reversal of capital flow in the event of a crisis in Europe or elsewhere, and how badly might it affect emerging markets?

Part of our strategy is driven by the expectation that capitals flows continue. If capital flows reverse, it will be very negative for the Indian story. But let’s explore this. What are the conditions that cause capital flows to reverse? We expect to see no change in G3 interest rates for the foreseeable future. Capital flows could reverse if, in fact, US growth was very strong and you began to see a change in interest rate expectations.

I don’t believe that the current situation in Europe will cause a reversal. The European financial system is operating quite well in core Europe, and the European Central Bank has given European banks a long period of time to adjust their portfolios and reduce their exposure to peripheral Europe. There’s no evidence of stress in the inter-bank market in Europe…  So I think it very unlikely we’ll see the conditions for a reversal of flows. But if we did, it would be negative.

So you don’t see a ‘shock to the system’ coming from Europe?


I don’t really see any reason why it should. We’re talking about relatively small economies that are having problems at the moment, and there are facilities in place. Ireland doesn’t need to borrow money, and in any case the ECB has had plenty of time to prepare for this.

I’d also make a big distinction between what happened in the sub-prime crisis and what’s happening now. In the sub-prime crisis, we had these securitised products and we didn’t know what we owned. But if I own a Greek government bond or an Irish government bond, I understand what that is: it doesn’t come with the lack of information that we saw during the sub-prime crisis. These are relatively small economies. In fact, the big economic surprise of this year has been how strong the Germany economy – and to an extent the French economy – has been. So, I’m not concerned about that.

What’s the upside – and the downside – in China?

I’m very excited about the changes that are going on in China. The Chinese government’s policy advisers have spent a lot of time looking at the development models in Asia and other emerging markets. Asia’s experience was of investment-driven economies with high growth rates, but it happened in one of two ways. If they used external funding, they ended up having the problems that Thailand, Indonesia and Korea had in the late 1990s: eventually if the returns on investment fell enough that creditors were no longer willing to give them more money and you had a current account crisis. The other model is what’s happened in Japan and Taiwan, where, although they used their own savings, overinvestment led to very low rates of growth in the domestic economy.

China’s fixed asset investment as a share of GDP is now 50 per cent. Of the 9.1 per cent GDP growth last year, 8.6 per cent came from fixed-asset investment. Chinese authorities clearly understand they cannot continue this growth model. What they need to do is engineer up consumption and reduce fixed asset investment as a share of GDP.

During the last decade, house hold income as a share of GDP fell in China, whereas profits expanded sharply. This is the class Asian growth model: you fund your investment story with households cross-subsidising industry through low wages, low returns on savings, and an undervalued currency. The big news story out of China now is about wage negotiations and wage growth – and that’s part of a policy to encourage consumption.

We’ve seen measures designed to slow down slow down growth in China, but they’ve been focussed on the property market; there’s no evidence that Chinese authorities are trying to slow down consumption. In China, consumption is the theme you must focus your investment ideas on for the next decade.

In the short run, though, there are some policy risks. This week, the markets have been quite concerned about price controls. Also, China’s housing market will facing an inventory issue in 2011. For now, sales is keeping up with construction starts, but as the government continues to control property prices, there’s a risk that sales volumes will fall, as happened in 2007.

We also have to be very careful about commodity markets. They tend to extrapolate very high growth rates from China. But China’s economic model is changing, and there are some inventory cycles to think about. The expectation for Chinese commodity demand growth is too high, in my view. But if we were to get a correction in commodity prices, it would be good news for most emerging markets, which are at the moment worried about inflation.

Related reading
The opportunity in India is too extraordinary‘:
Interview with Edward Pulling of JF Asset Management.


About Venky

Journalist, blogger, amused observer of worldly goings-on... More about me here.
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One Response to ‘Stars are aligned, but India must overcome execution risk’

  1. Pingback: ‘The opportunity in India is too extraordinary’ | It's only words…

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