The Effect of India's Election on Investors

Since the Congress party now dominates the Indian government, the risk for investors over the long term has declined sharply.

That said, we are still in a severe worldwide recession. Since the legal infrastructures of emerging markets (and some developed markets) are not as efficient in delivering information to the markets (e.g. European banks will have stress tests but not reveal the information), the full extent of the problems in emerging markets has not yet been revealed.

So my belief is that the BRICs have been over bought at this point, specifically India. All of these markets tend to be very volatile, so you have to be very careful. An almost doubling of the Sensex strikes me as more of a short play than a long.

Still, although the short term outlook might require some caution, I believe the long term outlook for India is one of the best, if not the best for the emerging market space.

What the elections in both India and the US proved to me is that democratic countries can change course and choose better economic policies. The disaster is the stimulus package in China. The Chinese stimulus package was based on forced loans from the banks and local government money. The bank money has gone to the large state owned industries (see my blog post on Venezuela) and the more efficient smaller firms are starved. The local governments have simply not paid up. It is difficult for China to change policies because it cannot change leadership.

Still many of the issues with the legal infrastructure that will slow or even kill economic growth in China are major issues for India and will be a challenge to the new government. The largest of these is the banking system.

Although the Indian banking system is not as bad as China, it is a major impediment. The Reserve Bank of India recently bragged about the stability of the state owned banking system which makes up as you know 70% of the system in India (vs. probably 98% in China, not including shadow banking systems in both countries).

The economic purpose of a banking system is to serve as an intermediary between investors/depositors and debtors. The banks hopefully should have sufficient economic incentives and legal disincentives to gather accurate information on the most efficient firms; make loans to those firms and then monitor those firms. The reasons why we are in the present mess is that the incentives changed. When you securitize loans the incentive is to get any debtor and then once you sell the loan, the incentives to monitor disappear as the risk shifts to the ultimate investor.

With state owned banking systems the incentives are to lend for political reasons. In China this has meant lending to large inefficient state owned industries. In India it has meant lending to the government to finance the deficit. Without decent independent banking system India’s growth is dependent on foreign capital, which will be slower in coming until the recession ends in the West. In China, despite some rather odd economics to the contrary, return of rapid growth will depend on Western consumers.

In India, it will depend on Western investors, unless the government privatizes the banking system, which given the view of the Reserve Bank, will be very hard.

The second main issue is the bankruptcy system. Bankruptcy systems are the plumbing of economics. They flush away the inefficient firms and reallocate capital to more efficient firms. A lot has been written about the problems of foreclosures in the US. This is not a problem. It is great! The foreclosures and bankruptcies help the market find new equilibriums.

Bankruptcy systems in emerging markets are either very weak or nonexistent. Ten years ago I wrote my first papers on the lack of bankruptcy systems in Asia. It is still a big problem although much bigger. The law in China is untested and does not apply to state owned industries (see recent problems with Asia Aluminum and Greentown).

In India it takes ten years. The Gulf States adopted the English law but are afraid of the uncertainty. The result is that nothing gets worked out. For example the bankruptcy of Asia Pulp and Paper (APP) which occurred in 1998 after the Asia crisis was finally resolved last fall, 10 years later.

So the new government of India has some work to do. This does not include stuff like the fact that “the Planning Commission and National Highways Authority of India (NHAI) confirming to FE that not a single road project was executed in the last calendar year—the first time since 2001”

As to other challenges Arvind Virmani, the prime minister’s chief economic adviser says it best (from Economist, December 2008):

Asked what reforms are most pressing, Mr Virmani tosses over a book in which he describes them. They include, in order of importance: fiscal reform, including of subsidies; privatization of public enterprises; opening state-controlled banks to more private ownership; reform of India’s throttling labor laws; and liberalizing certain industries, including coal and sugar. Mr Virmani’s book was published in April 1999. Hardly any of its prescriptions, he notes, have been followed: “We have to start acting faster.”

Still with the new government there is room for hope. What prevents radical reform in India is what prevents it in all countries. There are powerful groups with large economic investments in the present system of laws, rules and regulations. At least India has a chance for change. China does not. All governments make mistakes; I believe that the new government will correct at least some, which will encourage growth in the long term and that will be good for investors.

Comments

[Chandragupta]

Good article. Your views are appreciated, except where you say "......India’s growth is dependent on foreign capital, which will be slower in coming until the recession ends in the West." In fact, the recession in the West may only help India, as avenues to deploy capital in the West diminish due to the recession. Global liquidity may have no option but to come to places like India, where there is still decent growth in the domestic market.

2009 May 22 11:47 AM

[William Gamble]

Could happen. My view is that the process of recession is the process of creative destruction. Capital get deployed away from less efficient firms to more efficient firms through the foreclosure and bankruptcy process. With less competition more competitive efficient firms have more room to grow. So in my view, a recession actually gives more avenues for higher growth until more competition develops later in the cycle.

The restrictive labor and other laws make going under difficult in India (and many other countries including some in Europe). So the process of creative destruction is not as efficient. Worse, like Europe, and other emerging markets the landscape will be littered with zombie companies who are probably not paying for capital since their defaulted loans go uncollected. These companies will not allow the more efficient companies the growth that would normally take place.

If the new government can reform these systems and laws, a big if, then there will be no question that India will have great opportunities. There is one and only one thing standing in the way of India's growth, the law (actually the legal infrastructure) the rules. It was meant to protect and has ended up creating harm.

2009 May 22 12:37 PM

[Chandragupta]

You are right. I was only talking about global liquidity flows. There is no doubt that legal infrastructure in India needs a complete overhaul. Thanks!


On May 22 12:37 PM William Gamble wrote:

> Could happen. My view is that the process of recession is the process
> of creative destruction. Capital get deployed away from less efficient
> firms to more efficient firms through the foreclosure and bankruptcy
> process. With less competition more competitive efficient firms have
> more room to grow. So in my view, a recession actually gives more
> avenues for higher growth until more competition develops later in
> the cycle.
>
> The restrictive labor and other laws make going under difficult in
> India (and many other countries including some in Europe). So the
> process of creative destruction is not as efficient. Worse, like
> Europe, and other emerging markets the landscape will be littered
> with zombie companies who are probably not paying for capital since
> their defaulted loans go uncollected. These companies will not allow
> the more efficient companies the growth that would normally take
> place.
>
> If the new government can reform these systems and laws, a big if,
> then there will be no question that India will have great opportunities.
> There is one and only one thing standing in the way of India's growth,
> the law (actually the legal infrastructure) the rules. It was meant
> to protect and has ended up creating harm.

2009 May 22 12:43 PM

[Subhankar]

The Congress party had been in power for most of the 62 years since independence from British rule in 1947. The growth in GDP has always been a pittance because of the ruling party's socialistic policies.

It's only since 1991 that the economy has gradually been opened up. But the biggest reforms actually happened in the 5 years (1999-2004) that the right-wing BJP was in power. It is doubtful that the Congress party will hasten financial and infrastructure reforms.

But one lives and hopes.

2009 May 22 12:57 PM

[William Gamble]

Yes they can. They may not want to, but at least they cannot blame their coalition partners.

2009 May 22 03:37 PM

[Russ124421]

This is a very myopic view and reflects a preconcieved notion that everything a democracy does is right and a commie does is wrong. I do appreciate all the freedom the US provides us but unlike the author, i do appreciate the inability of nations to make significant change. US policy did not change with Obama's win. From the wars and Gitmo to bailout nation, nothing has changed. Same applies to India. With changes in Government, economic policies have continued the same trends. Finally, all the talk about China's inefficient allocation of capital is not too different from the US giving money to loss making financial institutions and Car makers.

2009 May 23 08:46 PM

[omni]

to know more about the effects of election on stocks u just have to visit fullertonsecurities.co.in

2009 May 26 03:31 AM