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A New Bull Market in India

Economic reforms and changes to India's stock trading system add up to opportunity for foreign investors.

The statistical blip up in US inflation last week should prove a one-off. It is a testimony to the power of present bullish sentiment that stock markets in the US and Asia have not reacted more negatively to the news that the Fed has turned to a tightening bias.

Fears about overheating and rising interest rates in the US conflict with the new high made by the

Dow Jones Utility Average

. Strength in utility stocks is usually a lead indicator of a rally in bond prices. This has not been the case this time. Is the bond correction now over or are the American utility stocks just another resting point for feverish liquidity looking for a home?

Meanwhile, Greed & Fear is adjusting the

Far East Free ex-Japan

asset allocation primarily for changes in the


weightings announced this week which will be implemented at the end of May. Details can be found below.

India's Stock Market Surge

When a stock market rises as sharply as India's has in recent weeks, it is natural to expect a significant correction. The surprise this time may be how limited the pullback proves to be. The most interesting point Greed & Fear learned in Mumbai this week is that the so called "operators," who traditionally front-run foreign investors in this market, have totally missed out on the recent rally. They have been absent because this has been a classic asset-allocation surge driven by global emerging-market investors.

With global emerging markets as an asset class rallying on the global reflation theme, India proved hard to resist when the fall of the


coalition government led to a sharp pullback in share prices.


in telecoms and


in petrochemicals are examples of stocks which became extremely cheap by international standards, though in the former case the domestic stock, as opposed to the GDR, is extremely illiquid.

The buying by foreign institutional investors, or FIIs, has been, by Indian standards, huge in recent weeks. FIIs bought $345 million net in the first 17 days of May. The real foreign buying is even larger since many have been buying through derivative structures. This marks a complete reversal of the trend last year when FIIs turned net sellers for the first time since the stock market was opened to foreign investors in 1993.

The FII inflow has also been aided by the realization that the "dematerialized" trading system, introduced via the

National Stock Exchange's

depository, has now reached critical mass. More than 100 stocks currently trade in paperless form, and these stocks represent more than 75% of daily turnover. Liberated from the previous chaotic paper trail, this has made the stock market both more liquid and more user friendly for foreign investors.

Greed & Fear has banged on for the past three years about the significance of the depository in terms of its potential to transform the infrastructure of the equity market for the better. The trading system, not the investment case for India per se (or rather the lack of it), was the biggest turnoff for potential foreign investors. This qualitative improvement has now occurred. It means that, as has already happened in Korea, the stock market will increasingly move on-shore, lessening the importance of the GDR market. That must also mean a reduction in GDR premiums. It is also worth noting that the depository is not just popular with institutional investors. There are now 600,000 accounts in the depository.

The change in the stock market's character, and the resulting difference in the quality of the rally, is clear from the fact that a larger number of shares are now being delivered in the sense that more trades are actually settled. Delivered trade in March 1999 equals 20% of total traded value for

Bombay Stock Exchange

and National Stock Exchange.

Traditionally, most stocks are not settled with delivered trades only accounting for about 10% of total trading volumes, as the operators simply finance their positions via the so-called "carry forward" system. The fact that outstanding positions have not risen in this most recent rally therefore provides important technical support for the market.

With the depository having reached critical mass, India will now be open to a wider universe of foreign investors, especially from the US, as awareness grows that the trading system is no longer a reason not to invest. It is also positive that the national stock exchange is pushing for a compulsory rolling settlement system based on T plus five, thereby eliminating much of the incentive to front run. This goal should be achieved by early next year.

A Bullish Story, With Some Blips

Improvements in stock-market infrastructure are one thing. But is India a good investment story? Here, a confession is in order. Whenever Greed & Fear visits India, the reaction is to come away bullish. The last occasion was a year ago, just after the nuclear testing. The correct reaction then was that the blasts were not a big deal and that the then-new BJP-led coalition offered some hope for more sustained reform.

But the stock market subsequently succumbed in the second half of last year to the fallout from the problems at the

Unit Trust of India

, the dominant domestic player in the local stock market, when it was revealed that the real net asset value of the fund was below par. This was fundamentally a technical problem which has now been resolved, in part by a government bailout, in part by the subsequent surge in share prices. The important point is that the problem was exposed and sorted out.

India is now in a new bull market which should allow the

Sensex Index

finally to break through the long-established trading range of 2,800 to 4,200. There are several features to the bull story. First, after several years of sluggishness, the industrial sector finally seems to be recovering.

This is most apparent in a pick-up in cement and diesel consumption. These are two key indicators in India; cement is a proxy for housing and diesel for commercial vehicle movement. But it is also apparent from meetings this week that business confidence is improving and that banks are beginning to entertain the proposition of lending to people other than the government.

The anticipated industrial recovery complements the view if the earnings cycle bottomed out in the fiscal year which has just ended.


forecasts a rise in earnings growth this fiscal year of 20%, well up from last year's meager 6.5% increase.

An earnings kicker will be provided by sectors such as cement and petrochemicals operating at nearer full capacity. It is also positive that a market heavyweight like Reliance has completed its capex expansion with no new spending planned on the horizon. This makes the stock more attractive in a world where, post-Asian crisis, fund managers have become suspicious of growth stories driven by capacity expansion.

The rally in Reliance and other cyclicals also points to India participating, belatedly, in the global reflation investment theme. But there is another point worth noting, discrete to the Indian market: India is one of the very few emerging markets which has in the recent past been bottom-up driven.

With the index stuck in a trading range, investors had increasingly focused their portfolios during the past three years on the growth stories of software and consumer goods. Both sectors have seen huge gains. The most recent rally has been a long overdue rebalancing of what had become an extremely lop-sided market. The move back into cyclicals and other index heavyweights, such as



State Bank of India

, reflects FIIs refocusing their portfolios on some of the old names they had sold down. By contrast, software has underperformed of late.

If there is growing hope of a cyclical recovery in India, it is natural to ask if the current political uncertainty will delay the economic rebound, since the new government will not be in place until October following the elections due to be held in September.

The trend again appears to be positive. The fun and games in India's insanely loquacious political culture appear increasingly to have less to do with the underlying trend in the economy with both of the two dominant parties,


and the BJP, essentially pro-reform.

In this respect India is likely to be compared increasingly to the likes of Italy and Brazil, two other countries with strong private sectors but where coalition-prone politics has caused a history of governmental instability and, as in India, seemingly chronic fiscal problems.

It is clearly unfortunate that the BJP-led coalition government has fallen, by just one vote, since it had begun to generate positive momentum in terms of both budgetary and legislative policy initiatives. This momentum began with the pro-investor budget in April and has been followed by some important legislation, most of which is still before parliament.

There has been enough going on to justify talk of a "second generation" of reform to follow on from the spurt in response to the 1991 economic crisis which saw the Indian economy start to be opened up for the first time since independence. Like the first burst of reform, its successor should also take place in the context of the bull market. By contrast, initiatives on the policy front have been extremely limited during the past four years.

The best result for the stock market would be the return of another BJP-led coalition. The chance of such an outcome has improved this week with the growing likelihood of a split in Congress over the issue of whether a foreigner in the shape of

Sonia Ghandi

should lead the party.

The evidence of a willingness to reform is clear. There are laws before parliament to do such good things as open up the insurance sector, abolish rent controls and introduce financial derivatives, including stock index futures. Meanwhile, "priority lending" in the banking sector is becoming more and more of a formality and therefore more and more of an irrelevance.

Even if the BJP does not return to power, it is unlikely that Congress will stand in the way of the direction of reform. For there is now a growing political consensus among establishment politicians which can be described as a retreat from populism. This reflects a conscious decision to shed India's pro-planning interventionst past, the unfortunate legacy of British socialism, as the reality has dawned that reforms are politically popular.

To cite just one example, it has become clear that Indians are prepared to pay for the provision of electric power if it means they do not have to suffer the curse of interminable power cuts. Mumbai is the only city in India where power is provided on a 24-hour basis because the utility is privately owned.

This, and the fiscal burden, is why privatization will now occur in India. There is likely to be substantial divestment of government holdings in public-sector corporations in the next two years in areas as diverse as petrochemicals, aluminium, hotels and airlines.

The need to privatize will be accelerated by the fiscal problem. India has an endemic fiscal problem with 35% of bank deposits deployed with the government or central bank to fund the deficit. But the fiscal problem is not bad enough to undermine the stock market and/or the currency either this year or next.

The currency is now supported by strong capital flows to the extent that foreign-exchange reserves now cover seven months of imports while the current account deficit is only a moderate 2.2% of GDP. Finally, the total national debt burden is not a systemic problem, amounting to only 55% of GDP. Short-term debt amounts to only 4% of the total debt burden.

It is also a long-term positive that the government is now paying a hefty 12% rate for its funding on its bond issues, as opposed to the subsidized 6%-7% rates of the past. This is forcing a more disciplined approach to the fiscal issue at both the federal and state level. Monetization of the deficit has also declined, with the phasing out of the appropriately named "ad hoc" treasury bills.

All of the above are positives. Still, India remains bedevilled as ever by infrastructure bottlenecks in core areas such as power, roads and ports. This is preventing the economy from achieving higher long-term sustainable growth which reformers in government reckon should be at a minimum of 7% plus.

Progress on infrastructure remains limited thus far in terms of evidence of new projects completed. Still, Greed & Fear is of the view that things will finally get moving during the next two years since everybody, including ultra-skeptical local journalists, seems to agree that the infrastructure issue will finally be addressed if only because it has to be.

Meanwhile, fulfilment of the huge potential in the telecom sector must await clarification of the overall policy framework. India now wants to move to a revenue-sharing model from the old scheme of selling off licenses. This is widely recognized. The issue is making it happen.

The ongoing deregulation of the property market should also not be neglected. A major achievement of the last government was the repeal of the obnoxious Urban Land Ceiling Act. This, like much other legislation, now has to be ratified by individual states. That process has now begun. State governments have been offered a carrot in that they are being offered access to cheaper housing loans if they repeal the Act.

The potential for property development to act as a catalyst both for economic growth and development of the banking system remains hard to exaggerate. The combination of the repeal of Urban Land Ceiling Act, rent controls and unhelpful planning laws has meant there has been almost no development since independence, as is clear to anyone struck by the Dickensian character of downtown Mumbai. The potential for a property boom, once the market clears, is huge since total credit to GDP is only 28%.

These macro facts, when combined with India's better appreciated micro story in terms of the breadth and quality of companies quoted compared to some other Asian markets, will again excite fund managers looking at India for the first time.

Newcomers are needed to make the bull market run, because Indian specialist investors have become understandably cynical as a result of the past four years' trading range and associated numerous false dawns.

Greed & Fear advises global emerging market investors to go at least to a neutral weighting in India, which is 6.9% at the end of April based on the


, with a view to going overweight on any correction of 10% or greater. India is not in the MSCI Far East Free Ex-Japan Index used for ABN AMRO's Asian asset allocation.

An out-of-the-index bet at present levels is not warranted given the dramatic nature of the stock market's recent surge. But Greed & Fear will again be looking to place such a bet on any significant correction to the 3,800 level.

The top five favored stocks among liquid names are: consumer goods company,

Hindustan Lever

; capital goods maker




, the leading software marketer;


, the major tobacco company and; cement producer



Some Changes to Country Indices

MSCI has announced this week some significant changes in the constituent stocks in its country indices due to be implemented from June 1. For example, 15 stocks have been taken out of the Taiwan index and 14 added. Accordingly, Greed & Fear, in an anticipatory consequence of these changes, is raising weightings in Taiwan from 15% to 17% to maintain an effective neutral stance on that market based on the MSCI Far East Free Ex-Japan Index.

The weightings in Thailand and Indonesia are also raised to 7% and 5% respectively. The Philippines is reduced to 6% and Hong Kong to 32%. Hong Kong's neutral weighting has fallen to an estimated 36.7% following these changes from 39.4% at the end of April.

The reason to remain underweight in Hong Kong is that it is most vulnerable to the concerns on US dollar rates. Also, as the only Asian economy apart from China not to enjoy an exchange-rate adjustment, its economy is likely to take the longest to recover since the deflationary pressures will be most intense.. The overall bullish view on the region is maintained with 4% borrowed money.

Christopher Wood is the global emerging market strategist for ABN Amro and the author of The End of Japan Inc. (Simon & Schuster, 1994). Under no circumstances is this to be used or considered as an offer to sell, or a solicitation or recommendation of any offer to buy. While Wood cannot provide investment advice or recommendations, he welcomes your feedback at