Commentary: The India-China Link – Cross Border Opportunities

India and China’s continued economic development is leading to increasing international integration, including cross border capital flows, outbound FDI, and the emergence of an India-China axis for trade and commercial collaboration. The nature of the current and emerging future cross-border transactions between and from India and China are diverse and substantial. Each one bears a different set of challenges for companies and investors seeking to create value from them. As a rule, investors seeking to participate will require among other things a clear understanding of both countries’ challenges, history of confrontation, regional and geopolitical positioning and assumptions about each other as well as the ability to transcend these to build deep relationships across both countries and their links to their major trading and commercial potential partners. For both countries politicians, the well-trodden path of mutually beneficial trade and commerce has wider-ranging political benefits too.

CROSS BORDER TRADE AND INVESTMENTS

India-China Cross-Border Trade: In late 2004, we had the opportunity to take a small group of Chinese officials on a private tour of India and to see India “through China’s eyes”. It was an auspicious trip since shortly afterwards, in January 2005, Chinese Premier, Wen Jiabao, made his inaugural visit to India and the two nations announced far-reaching trading ambitions. At the time, Premier Wen predicted an increase in bilateral trade from the then current level of under US$14 billion to US$20 billion by 2008. In fact, bilateral trade surpassed US$39 billion in 2007 and reached US$60 billion in 2010, representing a 30-fold increase since 2000. The countries are currently committed to increase bilateral trade to US$100 billion a year by 2015. China has already surpassed the US to become India’s largest trading partner, and India is becoming an increasingly important source of raw materials for China.

The table below lays out the growth and breakdown of bilateral trade between India and China. Following a half-decade of extraordinary growth, albeit from a negligible base, bilateral trade growth stalled somewhat during the global financial crisis expanding only 8% and 10% in 2009 and 2010 respectively. Cross-border trade expanded by 20% again in 2011 to over US$70bn, making the current target of US$100bn within the next three years appear modest with its implied annual expansion of less than 8%. More important than the raw materials to bilateral trade is the potential changing nature of the goods being exchanged. Currently, raw materials, metals and capital goods constitute the majority of bilateral trade goods, with India sending raw materials and commodities in exchange for industrial products, mainly industrial machinery and power equipment. A key implication of this dynamic is the large deficit India runs in its bilateral trade with China, most recently at US$27bn or 36% of total trade. As the two countries continue to develop, diversify their economies, and strengthen trade links, the contribution of higher value products and services to the countries’ trade mix should increase significantly, particularly if India can successfully open the China market to its export driven knowledge industries like pharmaceuticals and software. This would not only provide an additional and substantial boost to trade overall but also significantly help address the growing trade imbalance. Longer term growing cross border trade can drive opportunities in a wide range of sectors, including healthcare, technology, business services and high end manufacturing.

India-China Cross-Border Investment and Partnerships. As companies in India and China continue to develop and build their competitive positioning domestically, entrepreneurs in both countries are increasingly looking to acquire skills and assets outside their domestic markets. In this regard, there is significant untapped potential for commercial collaboration between Indian and Chinese companies. India and China today enjoy a strong fit in skills and requirements across a range of strategic industries.

Corporate collaboration in these sectors could help companies develop domestic markets on the one hand and strengthen the value proposition of companies seeking to compete abroad. The potential shape of cross-border collaboration for these types of opportunities could range from technology and best practice transfers, service and product integration and potential corporate investments. For example, Chinese companies have emerged as global leaders across a range of scaled manufacturing industries, including electronics and certain capital goods, whereas Indian companies have built leading businesses in knowledge based and services industries, such as IT and healthcare services. As a second type of cross-border corporate partnership, companies from India and China within particular industries can work together to create integrated offerings. For these types of industries, collaboration could range from a preferred vendor relationship all the way to a cross-border merger creating an international industry leader. As business owners/managers in the India and China seek to transform their businesses for domestic leadership and international competition, the number of commercial partnerships between Indian and Chinese companies will likely increase significantly.

INTERNATIONAL TRADE AND INVESTMENTS

Wave One, China: Inbound Investment. China first opened to FDI investment in 1978 under Deng Xiaoping, creating a number of “special economic zones”, eventually comprising 14 coastal cities, which became the initial recipients of foreign capital. These initially modest first investments were largely made in Southern China by Taiwanese and Hong Kong investors seeking to tap into China’s low cost labour pool for light manufacturing and assembly work on commodity products. Until 1991, realised FDI inflows totalled less than US$2bn annually on average. Following Deng Xiaoping’s Southern Tour in 1992 and the opening up of additional sectors to foreign investors, including wholesaling and retailing, banking and insurance, FDI across a range of sectors skyrocketed, attracting a wider range of international investors. The realised annual value of FDI in the 1990s increased ten-fold, growing to over US$40bn in 2000. Following China’s accession to the WTO in 2001, its export market became larger and more stable, focusing FDI on export related sectors, in addition to sectors with large domestic market potential, like telecoms, banks and insurance. The third and on-going phase of FDI in China has been driven by multi-national corporates seeking to exploit these markets with FDI crossing US$100bn in 2010.

Wave Two: India Inbound Investment. FDI in India was negligible from independence in 1947 until the launch of market reforms in 1991, due to the inward-looking socialist tendencies of its leaders, and an unpredictable policy regime. Following the balance of payments crisis and the ensuing reforms FDI grew exponentially, increasing 15-fold to ~US$1.5bn p.a. during the decade and reaching c. US$3.6bn (or 0.8% of GDP) by 2000. FDI in manufacturing was limited due to India’s poor infrastructure and restrictive policies with the majority of investment going to services sectors. With the ongoing gradual deregulation of key sectors over the past decade, including banking, telecom, infrastructure and others, FDI has continued to expand rapidly, peaking at US$42.5bn (or 3.3% of GDP) in 2008 and levelling off after the financial crisis to reach US$35bn in 2011 (or 1.6% of GDP).

Should India succeed in attracting FDI at a similar rate to what China achieved in the last decade, then total FDI inflows could increase from 1.6% of GDP in 2011 to [2.5-3.0%] (the average for China between 2001 and 2011), FDI growth at substantially faster levels than nominal GDP. As the chart on the left shows, if India’s FDI-to-GDP ratio stays at current level, assuming c. 7% average annual real GDP growth, total FDI will scale its previous peak within the next 4-5 years. However, if India can increase this share to Chinese levels, total annual FDI inflows would start approaching the US$100bn level (which China is currently at) by 2016 (See the dotted line in the chart on the right). While such growth (27% CAGR from current levels) seems difficult to conceive, it is important to note that countries which have been a major source of FDI for China have thus far been fairly limited investors in India. Major economies such as the US, UK, Japan, Germany, and France contributed less than 25% of the total FDI into India over the last decade. However, in order to attract exponentially higher FDI from these countries, India would need both its manufacturing and service sectors to become at least as competitive as China has been (and in some cases superior to China) in terms of ease of doing business, quality of infrastructure, light touch regulation, low labour costs and favourable tax rates.

Wave Three: India-China Outbound Trade and Investment. Exports from both India and China have grown at a c. 20% CAGR between 2001 and 2011 – further accelerating to 30% and 26% over the last two years (2010-2011), respectively. Despite China’s traditional trade surplus turning to a record deficit in February, the country continues to be the world’s largest exporter with US$1.9 trillion of exports (or 26% of GDP) in 2011. Given its large manufacturing base, infrastructure and other resources, China should continue to lead the world in exports in the foreseeable future. The Indian economy, by contrast, continues to run a large trade deficit, focusing exports on the services rather than manufacturing sector. Despite their rapid growth total exports from India were only US$298bn (or c. 16% of GDP) in 2011 – with exports of primary commodities (including food, fuels, ores etc.) accounting for a just under 50% of exports (as compared to 6% for China). As the chart on the below shows, there is substantial scope for India to continue to grow exports at a rapid pace (i.e. 25-35% pa) provided it can continue to deepen its bilateral and multilateral trade relations with OECD countries, as well as with China and other developing nations. Beyond growing exports, overseas direct investment (“ODI”) from India and China has been accelerating rapidly. As companies build dominant domestic positions in India and China, the acquisition of international footprints and the capabilities required to service them become a natural next step in the progression from domestic to international leaders and recent ODI growth is a reflection of the increasing size and maturity of domestic companies in India and China. The table on the right outlines the historical and projected growth of ODI from India and China from 2007 to 2015. Currently the US and Europe are the preferred destinations for both the acquisition of capabilities and the establishment of market reach for companies from the Target Regions. However, to date, few companies in either country have demonstrated a track record of successfully executing large acquisitions of established companies in the West. Inexperience with intermediated auction processes, the lack of top-tier advisors and cultural and language issues have all hindered companies from completing potentially transforming acquisitions in the past. Companies seeking to pursue these types of transactions in the future will need to work with experienced partners with both local and international experience and track record of executing complex and cross-border transactions. Few investors have to date managed to do this well.

IMPLICATIONS FOR INVESTORS, TRADING HOUSES AND CORPORATIONS

There are a number of different models available to companies, trading houses and investors seeking to leverage the growth of India-China-International, with investors generally being able to participate indirectly in India-China and directly in domestic and broader India-China-International opportunities. Investors seeking to create value from the India-China link will find that overcoming the significant barriers to success can lead to substantial opportunities that are difficult for others to overcome. The opportunity framework has five major components, namely:

1. Restructuring the West. Invest in companies at depressed valuations focused on benefiting from an active restructuring of their business leveraging India and China’s cost advantages.
2. India-China Trade. Invest in the intermediation of the trade between India and China of minerals, cotton yarn, textiles, chemical products, heavy machinery, iron and steel. In previous eras, trading giants have been built in Japan, Hong Kong and South Korea based on such cross-border trade between the West and the East.
3. Outsourcing. Invest in those companies positioned to provide a wide-range of outsourced services offshore from India and China and that will drive the improvement in the performance of US companies.
4. Into India-China. Intermediate, finance and partner in inorganic growth strategies where US companies enter India and China to tap new markets or access cheap labour capabilities.
5. India-China Into International. Intermediate, finance and partner with Indian and Chinese companies looking to leverage their low cost advantages to acquire companies in the US.

The barriers to success are many. The main overall issue is trust, along multiple dimensions. Between India and China, the single largest barrier is also trust. A litany of missteps and suspicions including a historic breakdown of talks and the Sino-Indian War in 1962, China’s backing of Pakistan and India’s backing of the Dalai Lama have all filtered into public and corporate folklore to establish a background of suspicion and hesitation. Growing commercial interests and imperatives are most likely to bridge these barriers and to establish the ground for trust and ground-up working relationships to be re-built. However, the time to this trust becoming the new reality will be long. In the meantime, intermediation and the ability to transact cross-border and create cross-border value will be at a premium. Trust is also a barrier for international players entering both countries. The key barriers to the scaled inflow from international groups – its continuation into China and its commencement for India – include China’s currency and exchange controls including issues related to investment structure (see October 2011’s Sign of the Times) and repatriation of profits; both countries enforcement of intellectual property rules and norms, particularly China’s willingness to engage with foreign entities in a manner that reassures them of China’s willingness to protect their IP; both countries’ willingness to liberalise key sectors, given recent set-backs in China’s internet and media sector and India’s retail sector; the increasing Western media expectations of a “hard landing” for China’s economy; the on-going lack of political and economic clarity in India; the doubts about the quality of foreign listings of Chinese corporations; India’s willingness to embrace radical openness (see February 2012 Sign of the Times), and; America’s implementation of its Greater Pacific strategic plan.

Having said all of that, the two economies are still growing GDP at 7% to 8% per annum and our analysis shows they each have eight industries that have grown at over 20% per annum during the past five years. The rest of the world can be expected to struggle to match the value that is being generated in the two. The challenge is about determining how to contribute and profit not if. The opportunity is clearly immense along the dimensions of the framework we have briefly outlined and as we all know, greatest when the outcome is unclear and the trend is not established.

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