There has been much discussion about the “India Story” and the key drivers of the world’s second most populous nation’s gradually accelerating growth path. The conventional wisdom is that India’s growth is being driven by its burgeoning young working age population (the “demographic dividend”) which is creating a growing middle class with increasing purchasing power driving India’s rise. This in turn gives rise to a number of investment themes which point policy and investors to focus on backing incumbents in the domestic market: domestic consumption including organised retail, healthcare, education and financial services, the creation of infrastructure among others. However, despite the rapid growth at a macro level, many of these themes have failed to deliver scaled and rapid change over many decades and consequently have failed to deliver consistent returns leaving many investors in India disappointed. While there are a variety of reasons for the inconsistent returns on domestic themes including significant regional economic differences, substantial currency depreciation and poor governance standards which make it challenging for the same consumption theme to be applied nationwide. The most important factor is that India, despite its rapid growth especially over the last two to three decades is still a very large and fundamentally poor country. Its per capita income is only US$1,720 and the vast majority of its population is poor, rural and working in the ‘unorganised’ sector, with their consumption still focused on essentials (food, energy and basic health). Until the vast majority of Indians are employed in the organized sector in higher value jobs, their incomes will not reach levels where consumption evolves towards more discretionary items (such as their homes, vehicles, higher education, branded retail goods and other consumer durables) the Indian domestic consumer cannot be the key driver of the country’s economic development and value creation. A far more important driver of growth in the near-to-medium term is India’s growing links to the rest of the world and this is already playing an increasingly important role in the country’s development. These links include not only India’s inbound investments and trade, but also Indian businesses which are leveraging the country’s core advantages to sell their products and services globally and bringing back global intellectual property, brands and know-how to help build leadership positions in the domestic market. Fully leveraging this ‘India-International’ opportunity will help drive a more balanced and sustainable growth model for India, and one that can draw on the lessons of trade and investment-led growth strategies that have been successfully deployed by other rapidly industrializing nations in the past. This month’s Sign examines the key drivers of the India-International opportunity along with implications and considerations for policymakers to support this important driver of India’s position in the world.
A Disconnect Between Economic Growth and Value Creation
If India cannot deliver returns to global capital, it will not attract investment and given the fundamental lack of domestic capital formation, it will struggle to break from its current trap of employing the majority of the population in low value activities. For many investors, the country’s macro growth has not to date translated into attractive risk-adjusted returns. Over the last decade the benchmark Sensex index has delivered annualised returns of only 6.8% in Rupee terms and only 2.7% in US dollar terms despite India’s impressive nominal GDP growing at a CAGR of 13% in Rupees and 9% in US dollars over the same period. "Until Indians are employed in higher value activities, they will not be rich enough for consumption to evolve towards more discretionary items, and the Indian domestic consumer will not be the key driver of the country’s economic development and value creation." This dissonance between growth and market returns is reminiscent of China’s equity markets during its economic miracle which saw the Shanghai Stock Exchange deliver annualised returns of 6% from 1992-2016 or a 4x absolute increase even while China’s nominal GDP grew at an average rate of 15% over the same period, or a 27x absolute increase. Nevertheless, despite the poor performance of China’s public markets, private equity investors eventually learned how to capitalise on China’s growth and its increasing links with the world economy, and succeeded in generating average annualised returns of 24% over a ten year period . In contrast, Indian private equity returns during the same period have been significantly weaker averaging 6% for deals invested between 2004 and 2013. This was lower than private equity returns in less risky markets in the region including Japan, South Korea and Australia, and lower than returns in the mature US and European markets. Given this reality, the value creation potential of the ‘demographic dividend’ and the related domestic consumption narrative tends to ring hollow for most institutional investors.
India and China: Dissonance Between Economic Growth and Equity Market Returns
Of course, there are a number of investors who have managed to earn attractive returns in India over this period, focusing on specific sectors and themes where the country’s growth has been strong. However, two factors in particular stand out in defining both the current problem and the opportunity. The first is the lack of sufficient well paying jobs. As pointed out above, India today has still a relatively minor national domestic consumption story from a scale perspective. While India has 1.3bn people, only 30m people have jobs in the ‘organised’ sector, of which only 14m are private sector jobs, with the balance comprised of generally less well paid central and state government jobs . Furthermore, the total number of Indian adult consumers with wealth over US$10,000 is only 31m compared to 1.3bn such consumers globally implying that India’s potential share of higher value global discretionary consumption for the time being remains negligible. This means that the bulk of the domestic opportunity in India lies largely at the bottom of the income and wealth pyramid, where the consumer wallet share is dominated by food, energy, health and spending on basic essentials. There is a minor opportunity at the high end too, given India’s share of millionaires and billionaires. Investors who have focused on the bottom of the pyramid sectors, particularly on low cost and scaled value propositions, have generally fared better than those targeting the mid-upper middle class during the past decade. The second factor is the presence of a limited number of prosperous geographies. India’s economic growth and value development today remains very concentrated in these geographies. For example, India has five states which contain only 23% of the country’s population but today generate 40% of India’s GDP and are home to 57% of its companies , with the remaining 24 states trailing far behind in terms of development. The large differences between geographies imply that domestic consumption themes need to be analysed in the context of the addressable markets within specific target geographies rather than assuming a uniform opportunity across India. The limited size and scope of the consumer market gives rise to a number of structural issues that further limit the attractiveness of the domestic opportunity from an investors’ perspective. The issues include hyper-competitiveness due to the mass of players and ever-rising new entrants in most areas of the domestic market, sub-par governance standards as the fight for survival leads to taking shortcuts, low returns as entrepreneurs are prepared to forego profits just to earn the equivalent of a wage rather than a return on risk capital, leading to poor provision of finance in general and poorly developed capital markets.
However, from the mass of striving humanity that is Indian enterprise some clear gems have emerged. Indian companies are highly resourceful and today can produce almost every level of quality of products and services. Cash starvation has led to very low cost structures and highly frugal financial management in Indian business. The difficulty of rising through a generally low literacy-poor opportunity nation with historically onerous business regulations has produced a group of highly resilient, resourceful individuals who with the right nurturing can become great entrepreneurs and business leaders internationally and given the hyper-competitiveness of the domestic market they are used to innovating to be able to do more with less. For a growing small number of these businesses, low margins at home lead them to turn to better markets where their low cost structures provide a more meaningful advantage. This presents these businesses with the opportunity to leverage the best of India’s assets and advantages to compete successfully in foreign markets. “The transfer of global IP, brands and know-how into India, is not only a critical source of shareholder value, it is also a significant driver of economic development for the country as a whole, as international capital, talent, technology and IP are put to work domestically.”As an example, smart Indian entrepreneurs are leveraging India’s large, well-educated, English-speaking pool of knowledge workers and its low cost structure to sell overseas. Indian IT workers and data scientists now help power the world’s largest businesses, while people of Indian origin run three of the world’s technology companies and many of Silicon Valley’s most promising startups. Taking the best and deploying it in attractive markets creates a virtuous circle which allows companies to bring back to India foreign intellectual property (IP) and best practices to become leaders in the domestic market. The transfer of international capital, talent, technology, global IP, brands and know-how into India is not only a critical source of shareholder value, it is also a significant driver of raising the quality of jobs and therefore of economic development for the country as a whole. In this manner India-International, both inbound and outbound, helps to address the disconnect between economic growth and value creation created by the country’s historical poor growth model and thereby positions the country for sustainable development.
Therefore, not unlike China at the beginning of its economic miracle, businesses and industries that leverage India’s core advantages to build global enterprises are important engines for India’s development as whole. Much like China’s consumption is today, India’s too will grow and move beyond subsistence level items with a genuine global-scale middle class emerging, at which stage the consumer story will also drive economic development and create a wide range of investment opportunities across product and service categories in the process. “Businesses and industries that leverage India’s core advantages to build global enterprises are important engines for India’s development as a whole.”However, for now, as far as the consumer story goes, the most attractive domestic opportunities for the time being remain centered around companies and sectors that compete on delivering massive scale at low cost to serve India’s population. Over the next decade or so, increasing development and wealth creation should open up opportunities for a much wider range of sectors and companies just as the past decade in China has given rise to companies such as Alibaba and Tencent which have built innovative and scaled platforms to capture the growth of the Chinese consumer. For the time being however, India-International appears to be a fundamentally more attractive risk-reward proposition than a purely domestic strategy.
Ten Reasons Why India-International Creates Superior Value
India-international strategies have been critical in driving many of India’s major corporate and industry-wide success stories to date. International strategies have been successfully executed to create not just companies such as Infosys or TCS, IT services giants with market capitalisations greater than HP’s, but also to reshape scaled industrial conglomerates such as Tata Sons, which has made some of India’s most significant overseas investments and as a group generates US$70bn, or 67% of its revenues, abroad. There are a number of factors that allow outward facing Indian multinationals to create disproportionate value:
International focused industries and companies clearly outperform domestic focused comparables on quantitative financial metrics, as laid out above. However, international focused companies also compare favourably across a series of equally important qualitative metrics. These companies’ ability to access international markets for talent provides them with more diversified workforces and access to specialised skill-sets that remain scarce in India today. The product and service quality demands are also higher in foreign markets given a richer and more sophisticated customer and higher norms in terms of product and service specifications. Also, importantly, participation in many foreign markets and engagement with foreign investors helps drive improved corporate governance, transparency and adherence to international business standards. And while corporate social responsibility is not a new concept in a country where large conglomerates such as the Tata Group have provided many of the social services to its employees and the community that the state has been unable to, the emergence of contemporary environmental, social and governance standards is being driven by a newer generation of companies with exposure to international best practices, as well as by international entrants themselves, applying their standards globally across their businesses.
Implications for Policymakers and Investors
International expansion and domestic economic growth are fundamentally linked in a virtuous development cycle. All of the ‘economic miracles’ of rapidly growing nations in the past 50 years have been driven by international trade and particularly exports. Japan and later the Asian Tigers reconfigured their economies to produce goods and services for international markets, first as low cost providers and increasingly as innovators and market leaders, requiring only limited direct foreign participation and creating international corporate champions as a result. “International expansion and domestic economic growth are fundamentally linked in a virtuous development cycle. All of the ‘economic miracles’ of rapidly growing nations in the past 50 years have been driven by international trade” In China, on the other hand, the absence of a functioning domestic market economy and of home grown private corporations required significant foreign participation in terms of expertise and capital to establish domestic industries and drive development, unlocking a globally unprecedented growth phase based on investment and exports. India today enjoys a growing base of highly cost competitive companies with the appropriate quality of business, that are scaling their businesses internationally and are also well placed to leverage their international based advantages to drive domestic development. The evidence is clear that businesses that sell abroad create higher quality jobs (and sometimes entire industries), raise standards of living, drive innovation and better governance standards and thereby drive higher national growth. Therefore for policymakers, the key question is how they can proactively encourage Indian businesses to venture outside India. There are three key policy areas which India’s policymakers need to focus on:
- Simplifying Regulations for Investing Abroad. India still has strict exchange-control restrictions on allowing Indian businesses to invest abroad, which can pose artificial barriers for Indian businesses trying to venture abroad, and also discourage Indian multinationals from repatriating overseas profits. The impact of these regulations needs to be evaluated at a sector level and the regulations need to be streamlined to make the process easier for Indian entrepreneurs.
- Aligning Domestic Regulations with International Standards. Part of the challenge Indian businesses face in venturing abroad into new markets are the often stricter compliance and governance standards required to operate in mature economies. Aligning India’s regulatory, governance and reporting standards to gradually become in line with mature markets will not only help prepare more Indian entrepreneurs for venturing abroad, but also lift the general standard of governance in India domestically and make the country more attractive foreign investors and corporations.
- Making ‘India Wide Open’ to the World. Finally, international trade and investment has to be a fundamentally reciprocal relationship with mutual benefits in order to be sustainable over the longer term. This is visible in some of the recent protectionist backlash in mature markets due to China’s imposing position in world trade. Therefore, making India open to foreign capital, goods and services, and securing reciprocal openness from key end markets, is critical not only to attract the IP and capital India needs to develop domestically, but also to ensure that Indian businesses are able to operate freely abroad over the long-term.
The third policy area is perhaps the one on which India’s government has focused most to date, e.g. with its ‘Make in India’ campaign and Prime Minister Modi’s trips abroad to secure foreign direct investment. The former two on the other hand remain to be fully explored and executed. From an investor perspective, it is important to recognise the key role that India’s growing international links play in generating shareholder value and in mitigating key risks. Many investors in India have followed the conventional macro narrative and placed bets on ‘macro stories’ around domestic consumption without considering the micro level data that challenges these stories. That is of course not to say that domestic consumption themes cannot generate strong investor returns. Sectors such as financial services, healthcare, education and consumer technology are all at inflection points and will likely see rapid growth (in specific sub-segments) as India moves from c.US$1700 per capita income towards lower-middle-income levels (US$3000-5000). However, discretionary consumption related themes (such as branded goods, apparel, organised food and beverage) are still likely to remain sub-scale and challenging over many years to come. In contrast, the India-International opportunity is already driving rapid value creation today, and is likely to continue to do so over the next few cycles as outlined above. Therefore, rather than focusing on macro-level narratives, investors should concentrate on India’s core competitive advantages and how they can be leveraged internationally, and also on highly selective inbound opportunities that enable them to be differentiated in the domestic market. This will inevitably help to close the country’s huge development gap.
Conclusion: India-International in the India Growth Story
Global trade, although recently much maligned by the alt-right and populist movements of the West, is exactly what India needs. It provides the most chance for India to learn how to raise its standards and to help the nation grow out of an environment of stifling competitiveness. “Indian companies can justifiably claim that India over the past 50 years has represented one of the most challenging environments for businesses to succeed in, and one that has delivered a huge batch of enterprises now ready to take on the world. “ From India’s perspective, the timing is right for this. All the reasons that have previously made it difficult for enterprises and its people to survive and prosper have left India with assets that it can to leverage internationally: high competitiveness, low cost structures, cash frugality, and a labour market where qualified individuals significantly outnumber available positions. Indians born in this testing environment have long prospered in less economically extreme and more meritocratic environments – whether that be in the US, UK or Africa. In some sense, this makes the mission of India’s government simple: creates a meritocratic environment in India that allows the deep pool of talent to prosper. Clearly, this is no easy task, but it is the one that Modi has been elected for and failure here would stifle the country.
Indian companies can justifiably claim that India over the past 50 years has represented one of the most challenging environments for businesses to succeed in, and one that has delivered a huge batch of enterprises now ready to take on the world. It is these companies and entrepreneurs who will lead the charge in India-International, leveraging their experience and assets to compete effectively around the world. In doing so they will gain access to global technology, know-how, talent, assets and capital that they will bring back home and will further fuel India’s growth story and accelerate the creation of wealth and prosperity for the country.
Note: ‘India-international’ is the core strategy of Greater Pacific Capital’s India focused PE fund, Greater Pacific Capital Partners, L.P. Greater Pacific Capital is an investing institution designed to identify and develop investing opportunities in and between the high growth market of India and other international economies. Greater Pacific Capital believes that the Indian market can and will continue to provide significant opportunities for investors with sufficient market experience, expertise and a fit for purpose strategy that allows them to manage the risks of operating in rapidly developing and dynamic markets. The firm’s in-depth macro-economic and sector research informs its investment strategy, driven by many of the factors outlined above.
1 Source: IMF World Economic Outlook Database (Oct-2016); CY2016 estimate
2 From 31-Dec-2006 to 31-Dec-2016
3 Nominal GDP has been used instead of Real GDP in order to make it comparable to the public market index returns which are not adjusted for inflation
4 Source: Centre for Asia Private Equity Research, average returns for deals invested in the 10 year period from 2004 to 2013
5 Source: Directorate General Employment and Training, Ministry of Labour and Employment of India; Data for fiscal year ending 31-March-2012 (latest available); “organised” sector refers to formal, documented employment in the private and public sector; the balance c.90% of India’s workforce is employed in “unorganised” activities which includes self-employment, casual and contract labour
6 Source: Credit Suisse, Global Wealth Report Databook 2016
7 Ministry of Corporate Affairs; India National Accounts; Indian Census
8 See the February 2012 Sign of the Times: India Wide Open – Transforming India Now for 2040