Monday, December 18, 2006

Will the bull run continue?

The Sensex has recovered somewhat after the fall of nearly 7% last week. It has had a dream run since 1999 producing an annualised return of 23.7%. Will this continue? Many think it will. Swaminathan Aiyar, writing in the Times of India, argues that nominal GDP will grow at around 12.5%. Profits of the better companies will grow at at least 1.5 times nominal GDP. So the Sensex can be expected to grow at 18% in the next years and touch 30,000 whatever the intervening ups and downs.

Is this plausible? I see several problems in Aiyar's formulation. First, sales of top companies may grow faster than GDP but not necessarily profits.

Secondly, earnings growth in recent years are, to some extent, the result of savings in costs, including interest costs. These savings are not entirely sustainable. Besides, there will be earnings dilution arising from funds raised for capital expenditure.

Thirdly, in projecting a Sensex level of 30,000, Aiyar assumes that the current level is right. The P/E for the Sensex is around 24, way above its historical level.

In short, projecting an 18% annual rise in the Sensex from today's level appears unrealistic.

There is also the issue of what sort of returns we can expect from the equity market in the long run. The long-run premium in the US is 5.8%. For the world as a whole, it is 4.9% (based on an index of 16 developed country markets). That is the historical premium. An academic study (which I cite in my recent ET column) projects the future premium at 3%.

If we assume that returns in India over a long period of 20 years (the past seven years plus another 13 years)will approximate returns to a global index, we can most likely expect an annual return of 10% (assuming a 3% risk premium on a risk-free return of 7%). This return, according to the study I cite, has a probability of 50%

There is, of course, a chance that the coming decade will be a unique period of exceptionally high returns in the Indian market. But, going by a study on world-wide stock market returns, the probability that the annual return of 23.7% seen in the past seven years will be sustained is just 10%. There are no miracles in the stock market, you see.

I explore this theme in greater detail in my latest ET column.

Thursday, December 07, 2006

Reforms and growth

There is a fairy tale version of India's economic reforms that has seized the popular imagination. It goes like this. The Indian economy was comatose until 1991. Then, a brave band led by Narasimha Rao (or Manmohan Singh,if you like) strode in and waved a magic wand called 'reforms'. Private entrepreneurs then stepped in where the state had dominated the economy. ZOOM.... the Indian economy took off, never to look back again.

That, as I said, is the popular perception. The academic viewpoint tends to be rather different. It would highlight three key facts:

1. The 'structural break' in India's economic growth, occcured, not in 1991, but in 1980, a full decade before 'reforms' were said to be have been ushered in.

2. Growth accelerated from 6% to 8% in 2003-04 just when people had begun to give up on 'reforms' and were wringing their hands in despair over the opportunities being squandered by the Left-supported UPA government.

3. The state sector and public sector enterprises are very much part of the turnaround story.

Start with the first point. Enough studies have documented the acceleration in growth rate in the eighties to around 6% from the 'Hindu' rate of 3.5% in the preceding decades. In the nineties, the growth rate did not change significantly.

What caused the acceleration in the eighties? Well, there was a definite pro-business orientation and a loosening of controls in the eighties itself- so certain policy initiatives had occurred in the eighties itself, whether you want to call these 'reforms' or not.

What we saw in the nineties was a continuation and extension of policies that had already been initiated in the eighties. While the overall economic growth remained at around 6%, the driver of growth in the nineties was not industry, which had been the primary target of 'reforms', but the services sector. The services sector is much larger than IT- it comprises things such as real estate, finance, tourism, etc, areas that were largely untouched by the nineties' 'reforms'. This is one big puzzle that needs to be cracked by those who believe that it was the nineties' 'reforms' ushered in more rapid growth.

The next big puzzle for the 'reforms' brigade is the performance since 2003-04. The 'reforms' brigade argued that the momentum created by the first round of reforms had been spent and that growth could be accelerated or even sustained only if the 'second generation' reforms were pushed through- labour market reforms, cuts in subsidies, privatisation, downsizing of government, greater FDI, etc.

The UPA government showed itself averse to these. But the rebound in growth in 2003-04, just before the UPA government took over, has been sustained since. How come? The big difference certainly is the increase in savings rate of 5.5 percentage points from 23.5% to 29% of GDP. Of this, nearly 4 percentage points is accounted for by the turnaround in public savings. Increases in savings made higher investment possible and this has caused growth to accelerate. This bears out point (3) above, namely, that the state sector has contributed towards higher growth.

An important aspect of India's growth story is the performance of the IT sector. This contributed to the improvement in the balance of payments in the initial years after reforms. Nobody can deny that the state contributed in a big way to the IT story-through the huge investments in technical education and also through tax breaks.

I believe that lower interest rates are the key element in the India story. There has been a huge surge in foreign inflows- whether through remittances, FII or FDI- and this has caused interest rates to decline. Lower interest rates have caused public savings to rise, they have made exports more competitive and they have fuelled a huge increase in consumption as the demand for retail credit exploded. The surge in foreign inflows, in turn, reflects growing overseas (including NRI) confidence in the Indian economy, confidence created by two decades of sustained growth, not just growth in the nineties.

Taken together, points (1) to (3) make it clear that the Indian growth story is not just about private entrepreneurship having come of age. The story is rather more complex than that and it embraces the state sector as well. So, it is simplistic to suggest that we can now get to 10% simply by rolling back the state even further.

Read my ET column on this subject.

Sunday, December 03, 2006

Microfinance - a trifle hyped up?

The award of the Nobel peace prize for this year to Grameen Bank founder Mohammed Younus has evoked a barrage of peans in praise of microfinance. Here at last, it seems, there is a trusty cure for poverty. Don't give the poor handouts or jobs, let them help themselves by gaining access to credit. Give the poor a loan and you have the makings of an entrepreneur.

I have been rather sceptical of the claims made on behalf of microfinance and found my scepticism reinforced by a recent exchange between two redoubtable economist-bloggers, Richard Posner and Gary Becker, the latter a Nobel laureate himself.

Posner notes that microfinance fills a gap left unfilled by commercial banks who may be averse to taking the risks involved or may be constrained by interest rates they can charge. Microfinance takes over from informal loans made by relatives and clan members. It thus marks a transition from an economy based on trust to one to a normal commercial society.

Having placed microfinance in a conceptual framework, Posner goes to underline its shortcomings:

As a substitute for trust, microfinance has obvious drawbacks. Extremely high interest rates, though justified not only by the risk of default(and the opportunity cost of money, that is, the riskless interest rate) but also by the very high transaction costs of a tiny loan (since those costs are largely fixed,
rather than varying with the size of the loan), burdens the borrower with very heavy fixed costs, since he must repay the loan regardless of the success of his enterprise.....Borrowing at astronomical interest rates seems an unlikely formula for commercial success--and the more unlikely the poorer the borrower......

The evidence for the efficacy of microfinance in stimulating production and alleviating poverty is so far anecdotal rather than systematic. The idea of borrowing one's way out of poverty is passing strange. And I am unaware of any historical examples of nations that climbed out of poverty on the backs of small entrepreneurs financed by credit. Also, recall that Grameen Bank has lent almost $6 billion to some 6 million persons. This implies an average loan of almost $1,000, which in a country like Bangladesh is not chicken feed and makes one wonder how much of the Grameen Bank's loan portfolio is actually microfinance.....

I suggest, albeit tentatively, that there may be a good less to microfinance than its boosters claim.

In his response, Becker says that he does not believe that micro-finance loans are at market rates, that, is they price risk correctly. There is an element of subsidy in microfinance.It is the subsidy element in microfinance that explains why commercial banks have not ventured into micro-loans.

The Grameen Bank and other groups active in making micro loans have had some financing from NGO's that do not seek to make commercial returns on their spending. So my belief is that despite the seemingly "high" interest rates on these loans, they have earned returns, adjusted for servicing, risk, and other costs, that are below market interest rates in their respective countries

On the positive side, Becker notes that a big chunk of microfinance goes to women. To the extent that this enhances empowerment of women, it is welcome. So microfinance should be seen as a more effective way for private groups to make gifts to women that the customary handouts.

Microfinance will begin to make a big impact only when it becomes viable as a for-profit operation. That alone will make it a sustainable business model. It remains to be seen whether this challenge is addressed.

In India, microfinance is still very small in size with an estimated Rs 40 bn of total loans and mostly concentrated in four states in the south. The big impact on poverty will still come through job creation and through financial deepening, that is, commercial banks enlarging their reach and covering the under-served segments of society.

The danger with all the hype about microfinance is that it becomes an excuse for government and bankers to not do their bit- hey, we have microfinance, so why should the government or commercial banks bother about poverty alleviation?

Friday, December 01, 2006

Much ado about outward FDI

The Tata group's bid for Corus hangs in the balance. When Corus management indicated its acceptance of the Tata offer, the response in India was euphoric. Corporate India, the pundits said, had come of age. Indian companies would now sally forth and conquer. We should soon expect outward FDI to exceed inward FDI.

Calm down, folks. Yes, there will be overseas acquisitions, more so as the rupee appreciates. But not many companies are in a position to bring off deals of this size- they do not have the financial muscle or the stature to put together deals of this order. Others, such as software companies, have chosen to go in for small acquisitions ($50 million or so) because their problem is managing high rates of organic growth.

Not just software companies but those in pharmaceuticals, automotives and bio-tech find they are able to compete in the international marketplace from out of India. Knowing the hassles that go with large acquisitions- the majority of cross-border acquisitions fail to enhance shareholder value- they will play it safe and make relatively small acquisitions.

As for the impact of balance of payments, we need to factor in the following:

i. The bigger deals will be funded overseas, so will not entirely involve outward FDI.

ii. Most acquisitions, as stated above, will be small.

iii. Inward FDI is today very low in relation to the potential of the Indian economy and is bound to rise sharply.

For these reasons, net FDI (inward minus outward) will remain positive.

Read my ET column on the subject.