Don’t Forget India

  1. When comparing China and India as investment choices, India often loses out. To give just two oft-repeated points of comparison, India’s infrastructure lags far behind China’s, while the ability of the Indian government to push through many necessary changes is hindered by the country’s chaotic democracy.

    Still, when lined up alongside the peculiarities of China’s financial system, India’s looks remarkably conventional and successful. It certainly has plenty of limitations and idiosyncrasies of its own. But when it comes to progress in developing modern, market-driven private sector finance, India is far ahead of China.

    To begin with, the two stock markets are very different. As previously discussed, the Chinese “A” share market is largely closed to foreigners, with just US$17 billion in investment currently permitted under the qualified foreign institutional investor (“QFII”) scheme. There are also tight limits on Chinese citizens investing abroad. As a result of these and other factors, the A share market frequently seems irrational, trading at ridiculous valuations or showing little relationship to what’s going on in the wider economy.

    India doesn’t yet permit free access to its market. There are capital controls on the rupee and on foreign investment. But they’re considerably less restrictive than those in China. Foreign firms that register with the Securities and Exchange Board of India (SEBI) can invest directly in Indian equities. There are no overall quotas, unlike the Chinese QFII scheme, although there are limits on the maximum shareholding that foreign investors can take in a stock, which vary by firm and industry. And, again unlike China, foreigners can hold rupee-denominated debt.

    Institutions who don’t want to register – typically hedge funds – can invest through offshore derivative instruments, of which the most common are participatory notes or p-notes. These are derivatives linked to India-listed shares that are issued by foreign institutional investors (“FIIs”) who have the ability to buy the underlying share.

    Indian regulators were never entirely comfortable with the p-note market, especially when p-note holdings grew to represent half the total shareholdings of FIIs. Three years ago there was discussion about banning them altogether, something that seemed quite likely when p-note holders were blamed for mass outflows of foreign investment during the global crisis.

    Instead, SEBI settled for regulating them more closely, introducing a system that required FIIs to verify and report the identities of p-note investors. This is likely to be enforced fairly strongly – earlier this year, Barclays and Société Générale were banned from trading p-notes for reporting incorrect details of transactions – but ensures that Indian markets remain relatively accessible.

    Most foreign retail investors can’t invest within India, but non-resident Indians and those with Indian ancestry can. Meanwhile, Indian residents can invest up to US$50,000 a year directly overseas; again, this compares favourably with China, where locals can only invest through funds that operate under the qualified domestic institutional investor scheme. So even at an individual level, there’s more freedom of investment in India.

    Like most emerging markets, India has structural issues. In many firms, there’s a controlling stake held by the founders or by one of India’s long-established business families; these interests are known as ‘promoters’. Obviously, this can give rise to corporate governance problems.

    The government also has a substantial stake in some of the largest firms that in the past were wholly or partly nationalised. Once you add other long-term investment interests into this mix, including stakes held by foreign multinationals in their local listed subsidiaries, the overall cap-weighted free float of the market is around 45%, based on Bloomberg data.

    Part of the problem is that companies that originally took in more than Rs1 billion (US$21 million) in new funds from their IPO are allowed to have a free float as low as 10%. The government recently proposed increasing the minimum free float for all firms to 25%, but this would require a huge amount of new issuance: over 500 firms would need to raise a combined US$50 billion in the next three years according to Bloomberg, against an annual average of US$12 billion over the last four years. And some major firms that are part of the benchmark indices would currently fall foul of the new limit, including Reliance Power, property developer DLF, and IT services firm Wipro, as well as a number of government-controlled businesses such as power firm NTPC and steelmaker SAIL. Consequently, the proposal is running into heavy criticism and may well be watered down.

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