Commentary: India and China’s Growing Equity Markets

Given the strong long-term GDP growth outlook for India and China which consensus estimates place between 7% and 8.5%, both countries equity markets have the potential to grow significantly over the coming decade(s) to emerge as among the world’s leading capital markets. However, this transformation implies a fundamental deepening, maturing and restructuring of the countries’ equity markets, requiring among other things continuing financial and corporate reform; continuing transformation of industries, corporate scale and profits; and the on-going development of a strong and substantial private sector. The global allocation of funds would alter dramatically if the conditions for success were to be met. In this note we provide an indication of the significance of the impact on the flow of funds and the requirements that both countries would need to meet for the global funds to be allocated in significant volume.

Nearly Half the Global Allocation of Capital Flows to India and China by 2040
Over the long run, listed corporate profits correlate well with underlying economic growth, and profits remain the main drivers of long-term equity market returns. This implies that macro-economic growth is a reasonable indicator for potential equity market expansion.

The analysis above calculates the expansion of countries’ capital markets and the resulting flow of value as measured by total market capitalisation assuming constant market cap/GDP ratios in each country (based on Dec 31st 2011 levels). Changes in relative market capitalisation are driven by different GDP growth rates in the countries. From the perspective of an investor’s portfolio allocation, this significant market expansion implies a practical flow of funds from more mature markets to India and China, as both countries continue to receive an increasing share of investors’ assets. The headline numbers suggest this shift could be as substantial as nearly 50% of global capital allocation. A failure to shift significantly from today’s 20% would be politically significant for both countries. Even if the answer fell somewhat short of this, the economic and political implications would be profound for political leaders, corporations and financial investors worldwide.

The Ten Conditions for Attracting the Funds

Indian and Chinese equity markets today remain underdeveloped as compared to the US in particular. While the total market cap/GDP ratio in the US as of Dec 31st 2011 was 98%, India’s and China’s trailed significantly at 55.8% and 74.1%. Since 2008, the Chinese and Indian capital markets have significantly underperformed ((15.1%)% BSE Sensex and (58.5)% SSE returns) the US ((9.1%)% S&P returns) despite GDP growth of between 7.5% and 9.5% in both countries versus the US GDP growth of only 0.5% over the same period. There are clear systemic issues with both markets, unsurprisingly, given their capital markets have not kept in tandem with their economic development.

The underlying growth of the countries’ economies has the potential to drive the expansion of local capital markets in absolute terms, and both countries at current growth projections will have the world’s largest and third largest equity markets by 2040. This analysis does not assume an expansion of India or China’s market cap to GDP ratio to US levels, indicative of a sophisticated and well developed equity market. We assume that this ratio will continue to at the current levels stated above, which represents an approximately 25% discount (in China’s case) or even 50% discount (in India’s) to the current US GDP/market cap ratio. However, given the strong projected macro-economic growth of India and China, even an expansion at the countries’ lower market cap to GDP ratios implies a fundamental transformation of their equity markets. This growth and transformation will require significant conditions to be met. We highlight ten key conditions to be fulfilled that require top-down government and regulatory management in both countries as well as a transformation of the private sector:

1. Focus on Achieving High Corporate Profitability Not Just GDP Growth. GDP growth in India and China to date has driven the development of the private sector and translated into rising corporate profits as the main driver of equity value. While the scaling of industry has been an enormous success story of Chinese policies, corporate profitability has not necessarily followed. The culture of a state-driven economy favours large public sector economic participation, state controlled wages and exchange rates. India has traditionally done better at driving its growth through the private sector but this has stalled in 2012 in the face of policy impasses that are failing to incentivise private sector investment to scale its businesses.
2. Favourable Policy Environment for Inward Investment in Creating Businesses, FDI flows. Further, continued economic development requires the conditions for continued FDI flows to be met. This includes on-going favourable conditions with regards to tax, employment law, a large pool of competitive labour, comparative cost advantages or IP development advantages and other structural factors that will continue to help the countries attractive foreign capital for development. Both India and China have challenges in this area evidenced by both policy-driven FDI restrictions (limited foreign investment in a wide range of sectors) and structural limitations including high inflation and poor infrastructure (in India) rising wages and an unclear legal regime (in China) and corruption and bureaucracy (in both).
3. Transparency of Regulations and Tax Necessary. Tied to the generation of corporate profits above is its translation into value for investors, particularly the ability to realise value. This includes favourable tax treatment and the ability for foreign investors to repatriate profits. India’s recent general anti-avoidance rules (GARR) which could potentially lead to increased capital gains for investors are clearly recognized domestically and internationally as a step in the wrong direction in this regard. China’s VIE “reforms” last year proposed placing foreign listed Chinese companies using VIEs under CSRC supervision. These proposed regulations were interpreted to indicate that China was seeking to restrict the use of one of the most popular investment structures used by foreigners and thereby effectively shutting out foreign participation in key industry sectors. Although not implemented to date, these regulations are and were widely seen as a step in the wrong direction.
4. Ease of the Flow of Domestic Savings into Investments. Equity market growth and increased flow of value implies the allocation of significant new capital from domestic and international sources. For the former to be tapped, India and China will need to reallocate growing pools of domestic savings into equity markets. In China, which has one of the world’s highest savings rates, this implies attracting domestic investment into a broad range of sectors. Current domestic investment options are limited, partially explaining China’s real estate bubble. Equity investing will need to be made more attractive through tax breaks in order to attract the required capital to grow markets domestically. In India today, only 8% of India’s US$800bn of household wealth in held in equity markets, compared to 14% in China and 42% in the US. At current levels of GDP/market cap ratio, by some estimates Indian firms will require an additional US$2.9 trillion in funding between 2010 and 2020, creating a potentially significant funding gap that will require increased household participation to fill, both by way of increasing household wealth overall as well as significantly higher allocations to equity markets.
5. Liquidity of the Capital Markets to Attract FII. Further, a growing flow of value to India and China will require large net inflows from foreign investors. This will only happen if the Indian and Chinese capital markets have the liquidity to enable efficient exits. The liquidity of the Indian and Chinese markets are incredibly low as compared to the US and UK. The daily trading volume of the average stock on the Sensex index is under US$3m as compared to over US$44m for the average company on the SSE and over US$164m for the average company on the DJIA. Today over 53% of the top ten companies in India by market cap are held by founders, against less than 10% in the US (with Wal-Mart and Berkshire Hathaway being outliers and most companies having little or no founder stakes). For the future flow of funds to India and China to equal that of the US in the past decade, investing in either market will need to be as easy to enter and exit as it is in the US for global investors today.
6. Connectivity to Major Trading Markets. Tied to the previous point, Indian and Chinese capital markets will need to be linked seamlessly into global markets, allowing domestic companies and both domestic and international investors in and out of the markets without restrictions with broad based investor market participation. This implies among other things an easing of institutional investor qualification requirements currently in place in both India and China to bring them in line with more mature markets. For example, in China today there are only approximately 100 qualified foreign institutional investors allowed to participate in the domestic equity market, with a combined investment quota that was raised from US$30bn to US$80bn in April of this year.
7. Freely Traded Currency. The value of the RMB has been in the past decade or so a political issue between the US and China. However, it will be requirement for China’s sustained growth that at some point the currency is set by the needs of a sophisticated capital market. China seems to understand this well and argues it is a matter of timing. Today, in China there is virtually no possibility for domestic investors to convert Yuan in foreign currencies and international investors ability to invest domestically is also severely restricted. In India, where it is significantly easier for foreign investors to participate in domestic equity markets, there are still severe restrictions in place on debt inflows from foreigners. However, in order for the flow of funds into Indian and Chinese markets to reach their full potential, domestic and international investors will require free access to large amounts of local currencies with fully liberalised capital accounts.
8. Depth of capital markets. As they grow, Indian and Chinese equity markets will also require increasing levels of depth, defined here as the ability to quickly deploy and transfer large amounts of value in and out of markets. Despite average daily trading volumes on the DJIA being over 50x higher than on the SENSEX and nearly four times higher than on the Shanghai Stock Exchange, the average volatility in the US during 2011 was nearly the same as the other markets, with average 90 day volatility during 2011 for the three indexes all between 18.7% and 19.7%. Increasing market depth requires the development of a sufficient number of broadly held and heavily traded large cap companies. India today has less than 50 companies with average daily trading volumes above US$10m. For the flow of value to the Indian equity market to increase to the projected levels, a new generation of diversified large cap companies will need to develop.
9. Breadth of capital markets. Further, capital markets in India and China will need to increase significantly in breadth to continue to attract value, offering investors a wide range of investing options across industries, company sizes and business models. Broad capital markets imply significant diversification for investors. Equity value in China today is highly concentrated across a few sectors, with financial services alone representing over 30% of total market capitalisation, compared to just over half this ratio in the more diversified US capital markets. In India, value is highly concentrated in large companies, with the top 50 companies representing 61.4% of the total market capitalisation, vs. 39.3% in the US.
10. Capital structure maturity. Growing capital markets and the flow of value to India and China also requires increasing capital structure maturity and sophistication for corporates, including equity and debt and capital market access as well as other financing methods. Debt capital markets and alternative financing in India and China today is even more nascent that its equity markets – continued growth of the latter will require a concurrent development of the former two as corporates mature to employ a balanced range of financing options. Private equity, venture capital and more traditional financing will need to mature.

The Politicians’ Dilemma: Wanting Progress and Not Wanting to Let Go

It is clear that short term international investor sentiment will certainly have a significant impact on the shape of global equity markets, too, with significant shorter term swings in equity markets being driven by US and European investor appetite for international equity exposure, particularly in India and China, where relatively small capital in- and outflows have the potential to significantly move markets. Although such shifts are likely to be cyclical and reactive to relative market performance, interest rate levels and other short term factors, there are additional structural factors like the continued ageing of the Baby Boomers and their potential transfer of assets from equities to fixed income securities which could affect the shape of future equity markets more fundamentally. Looking at the sheer size of absolute economic growth in India and China over the next 30 years though, structural factors in the US are more likely to only influence rather than shape the future flow of funds.

Given the underlying shift in the macro-economics of both countries, it is clear that Indian and Chinese equity markets have the potential to emerge as among the world’s largest, most dynamic and most important in the coming decades attracting the lion’s share of global fund flows. The market and policy reforms required to make this potential become a reality are not insignificant and will require tough decisions on liberalisation with short term political and potential economic costs. However, the overall wealth creation and development potential of mature capital markets far outweighs these short term costs. India and China’s leaders will need to let go for their countries to participate in this potential.

These changes need to be seen in the light of the on-going transformation of the story of capitalism, free markets and globalisation. The Global Financial Crisis has not resolved itself to a stage where it is clear what the transformed or reformed investment model looks like. The end of capitalism is a pithy catch phrase which leads nowhere. China, in particular, given how well it has embraced US style capitalism as the model to strive towards, albeit in a Chinese way and pace, has the most soul searching to do to find the new road map. India had always embraced this model and suffered more from policy and political figure’s mishaps. Securing nearly 50% of the world’s capital allocation is a prize worth rethinking one’s assumptions for.

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