Paper tigers chinese and india capital markets

Global Financial Institute Your entry to in-depth knowledge in finance Paper tigers: Chinese and Indian capital markets S6 SPECIAL ISSUE... Deutsche Asset & Wealth Management’s Global F

Global Financial Institute Your entry to in-depth knowledge in finance

Paper tigers: Chinese and Indian capital markets

S6 SPECIAL ISSUE

Deutsche Asset & Wealth Management’s Global Financial Institute asked the Economist Intelli-gence Unit to produce a series of white papers, custom articles, and info-graphics focused spe-cifically on global capital market trends in 2030

While overall growth has resumed, and the value traded on capital markets is astoundingly large (the world’s financial stock grew to $212 trillion by the end of 2010, according to McKin-sey & Company) since the global financial crisis

of 2008, the new growth has been driven mainly

by expansion in developing economies, and

by a $4.4 trillion increase in sovereign debt in

2010 The trends are clear: Emerging markets, particularly in Asia, are driving capital-raising; in many places debt markets are fragile due to the large component of government debt; and stock

Introduction to “Global Capital Markets in 2030“

markets face weakening demand in many mature markets

In short, while the world’s stock of financial assets (e.g stocks, bonds, currency and commodity futures) is growing, the pattern of that growth sug-gests that major shifts lie ahead in the shape of capi-tal markets

This series of studies by Global Financial Institute and the Economist Intelligence Unit aims to offer deep insights into the long term future of capital markets It will employ both secondary and primary research, based on surveys and interviews with leading institutional investors, corporate executives, bankers, academics, regulators, and others who will influence the future of capital markets

About the Economist Intelligence Unit

The Economist Intelligence Unit (EIU) is the world’s leading resource for economic and busi-ness research, forecasting and analysis It provides accurate and impartial intelligence for companies, government agencies, financial institutions and academic organisations around the globe, inspir-ing business leaders to act with confidence since

1946 EIU products include its flagship Country Reports service, providing political and economic analysis for 195 countries, and a portfolio of sub-scription-based data and forecasting services The company also undertakes bespoke research and analysis projects on individual markets and busi-ness sectors The EIU is headquartered in London,

UK, with offices in more than 40 cities and a net-work of some 650 country experts and analysts worldwide It operates independently as the busi-ness-to-business arm of The Economist Group, the leading source of analysis on international business and world affairs

This article was written by Dr Paul Kielstra and edited by Brian Gardner

Dr Paul Kielstra is a Contributing Editor at the Economist Intelligence Unit He has written on

a wide range of topics, from the implications of political violence for business, through the eco-nomic costs of diabetes HIs work has included

a variety of pieces covering the financial services industry including the changing role relationship between the risk and finance function in banks, preparing for the future bank customer, sanctions compliance in the financial services industry, and the future of insurance A published historian, Dr Kielstra has degrees in history from the Universi-ties of Toronto and Oxford, and a graduate diploma

in Economics from the London School of Econom-ics He has worked in business, academia, and the charitable sector

Brian Gardner is a Senior Editor with the EIU’s Thought Leadership Team His work has covered a breadth of business strategy issues across indus-tries ranging from energy and information tech-nology to manufacturing and financial services In this role, he provides analysis as well as editing, project management and the occasional speaking role Prior work included leading investigations into energy systems, governance and regulatory regimes Before that he consulted for the Commit-tee on Global Thought and the Joint US-China Col-laboration on Clean Energy He holds a master’s degree from Columbia University in New York City and a bachelor’s degree from American University

in Washington, DC He also contributes to The Economist Group’s management thinking portal

Introduction to Global Financial Institute

Global Financial Institute was launched in Novem-ber 2011 It is a new-concept think tank that seeks

to foster a unique category of thought leadership for professional and individual investors by effec-tively and tastefully combining the perspectives of two worlds: the world of investing and the world

of academia While primarily targeting an audi-ence within the international fund investor com-munity, Global Financial Institute’s publications are nonetheless highly relevant to anyone who is interested in independent, educated, long-term views on the economic, political, financial, and social issues facing the world To accomplish this mission, Global Financial Institute’s publications combine the views of Deutsche Asset & Wealth Management’s investment experts with those

of leading academic institutions in Europe, the United States, and Asia Many of these academic

institutions are hundreds of years old, the per-fect place to go to for long-term insight into the global economy Furthermore, in order to present

a well-balanced perspective, the publications span

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& Wealth Management invites you to check the Global Financial Institute website regularly for white papers, interviews, videos, podcasts, and more from Deutsche Asset & Wealth Manage-ment’s Co-Chief Investment Officer of Asset Man-agement Dr Asoka Wöhrmann, CIO Office Chief Economist Johannes Müller, and distinguished professors from institutions like the University of Cambridge, the University of California Berkeley, the University of Zurich and many more, all made relevant and reader-friendly for investment profes-sionals like you

In recent decades, the overarching economic story out of Asia has been the transformation of the continent’s demo-graphic giants into economic ones This has happened on any number of levels For example, in recent years in nomi-nal GDP terms China has surpassed Japan to become the world’s second largest economy, and India already is the world’s tenth largest GDP Only a decade ago, China and India were in 6th and 13th place, respectively

Dramatic growth can also be seen in the two countries’

capital markets Today, Shanghai and Shenzhen combined have a greater market capitalisation than that of any other country’s exchanges except those of the United States

India’s collective total, meanwhile, lags behind only those

of America, China, Japan, the United Kingdom and Hong Kong In terms of total securities, India has far more firms listed – over 5,100 on the Bombay Stock Exchange alone – than any other country; the NASDAQ and the NYSE col-lectively have a little over 4,100 domestic companies, although cross listing means the total number is somewhat lower The two Chinese exchanges have fewer listings, but

have seen faster growth in their number Between 2009 and

2011, according to Dealogic, they were both in the top five exchanges for initial public offerings by value, and in 2012 remained in the top 10 More broadly, Shanghai and Shen-zhen also saw the fourth and fifth highest levels of share trading by value globally last year

A number of indicators point to continued growth China currently has among the highest gross savings rates in the world (51% in 2012 according to the World Bank) which represents an increase on the roughly 40% of the 1990s The country is putting capital to work privately and pub-licly: the World Bank calculates China’s gross fixed capital formation at 47% of GDP in 2012, with absolute spending in this area more than a quarter higher than that of the United States that year India’s gross savings rate is a comparatively modest 34%, but it, too, has a substantial amount of money

in search of effective allocation And with a gross fixed capi-tal formation rate of 30%, India has plenty of opportunity for investment

Paper tigers: Chinese and Indian capi-tal markets

A Global Financial Institute research paper written by the Economist Intelligence Unit

June 2014

Written by

65 %

53 %

35 %

24 %

22 %

21 %

19 %

8 %

8 %

3 %

5 %

United States China India Japan United Kingdom Brazil Germany France Italy Other, please specify Capital will be so international that location will have little

relevance

Which of the following economies do you think will have the most important public equity markets for the global economy by 2030? Please select up to three

Source: The Economist Intelligence Unit (August 2013)

It is not surprising, then, that China and India’s capital markets seem poised to take on significant global importance According

to a 2013 Economist Intelligence Unit survey of over 350 compa-nies active in global capital markets, 53% say that China will be among the countries with the world’s leading equity markets by

2030, and 35% say the same of India That would make these two countries the second and third top equity markets in 2030, after the United States, in the estimation of global executives On bond markets, China came second (45%) while India was sixth (24%)

That said, China’s and India’s capital markets institutions are a long way from being global players Even in their domestic roles, these markets are often not efficiently allo-cating the substantial capital being saved A 2013 study by World Bank researchers found that “the expansion of finan-cial market activity since the 1990s has been more limited than…the aggregate figures suggest.” A handful of large companies have dominated activity on equity and bond markets, with the top 10 firms in India and China account-ing for 62% and 43% respectively of the capital raised between 2005 and 2010.1

If anything, debt markets in India are even less developed than equity ones The Indian government, in its 2012-2013

budget economic survey admits, “Though, the develop-ment of the corporate bond market, has been an impor-tant area and has received greater policy attention in recent times, it is yet to take off in a significant manner.” The country’s Economic Times newspaper goes further, citing low trading levels, poor liquidity in the secondary market, and a lack of interest by banks in corporate debt, it calls the country’s corporate bond market “a mirage”.2

In contrast, China’s bond markets have seen substantial growth in the recent years and are the fourth largest in the world in absolute size They are still dominated by govern-ment debt rather than funding more diverse private sector endeavours According to the Asian Development Bank,

at the end of 2013 the total of all corporate bonds repre-sented 15% of national GDP This is more than double the

2008 figure, but still well below the equivalent number for the United State (around 60% in 2013) Moreover, the vast majority of Chinese corporate bonds are “enterprise bonds” issued by government affiliated companies Traditional corporate bonds can be issued by smaller, private firms but that market is thinly traded and highly illiquid The ability

of organisations without strong state connections to tap bond markets remains an open question

1 Tatiana Didier, Sergio Schmukler, “The Financing and Growth of Firms in China and India: Evidence from Capital Markets,” World Bank Policy Research Working Paper 6401, April 2013

2 “Indian corporate bond market still remains a mirage”, 28 November 2012

68 %

45 %

30 %

28 %

26 %

24 %

12 %

10 %

9 %

3 %

4 %

United States China Japan United Kingdom Germany India Brazil France Italy Other, please specify Capital will be so international that location will have little

relevance

Which of the following countries do you think will have the most important bond markets for the global economy

by 2030? Please select up to three

Source: The Economist Intelligence Unit (August 2013)

Moreover, the transparency of the Chinese bond markets is

a significant worry Not a single bond has seen a default, in part because the government and other interested parties have stepped in on occasion to make good insolvent par-ties This makes pricing risk a fraught endeavour In Octo-ber 2012, the IMF highlighted that “the apparent pattern

of ‘higher returns and suppressed default risk’”, already a worry amongst trust companies and alternative lenders, has extended to the bond market.3

Overall, then, capital markets in these countries are deliv-ering less than they appear to on the surface Professor Venkatesh Panchapagesan of the Indian Institute of Man-agement says, “India has had 10 to 15 years of phenomenal growth, but capital markets have not been the primary driver The exchanges, institutions and intermediaries have not been able to do a good job.” In China, especially for smaller, private entrepreneurs without political connec-tions, the situation is very much the same

Common weaknesses

A number of issues present in both countries greatly dimin-ish the attractiveness of their capital markets to investors and companies alike In recent years especially, one such problem has been that capital markets are unlikely des-tination for investors looking to profit from Chinese or Indian growth Markets around the world all saw substan-tial drops in 2008 and some recovery in 2009 Since then,

however, despite steady, robust economic growth in each country, India’s volatile equities have failed to keep pace with economic growth in the country and China’s stock indices have even seen substantial overall declines [See Table] Looking more closely over the last decade, a rapid expansion of the number of listed companies helped drive the increase in market capitalisation for Shenzhen and the NSE rather than this arising from rising share price alone

Economic growth and market indices are only loosely related in most circumstances Nevertheless, the weak showing of these markets, especially in China, brings con-cerns for those potential investors otherwise willing to overlook institutional deficiencies

One such deficiency is the poor level of investor legal pro-tections and legal enforcement Stock scandals have been all too common Chinese authorities have pursued a well-publicised crackdown in this area, which has included a freeze on initial public offerings (IPOs) between October

2012 and January 2014 Meanwhile, in April 2013, three arrests were made in a high-profile bond market scandal The March 2013 comments of Zong Qinghou, China’s rich-est man, to the Wall Street Journal sum up the attitude such activity has created in the country “When the ordi-nary people invest in it, the market should reward them with some benefits But it does not,” he says “Speculation has totally cheated ordinary investors of any benefits.”4

3 Global Financial Stability Report, October 2012

4 “China’s Richest Man Says Capital Markets ‘Suck’”, China Real Time Report, Wall Street Journal, 5 March 2013, http://blogs.wsj.com/ chinarealtime/2013/03/05/capital-markets-suck-says-chinas-richest-man/

2010 – 2013 January 2010 – December 2013 Selected Stock Market Indices

Shenzhen Component Index -11

BSE Sensex +19%

Economic growth and market indices are only loosely related in most circumstances

Nevertheless, the weak showing of these markets, especially in China, brings concerns for those potential investors otherwise willing to overlook institutional deficiencies

Source: The Economist Intelligence Unit (February 2014)

India has also had its share of business corruption, as Mr Panchapagesan puts it, “regulators have not been able

to provide confidence to investors as scandals come up

on a periodic basis.” Even the CEO of the National Stock Exchange agreed in an interview last year that insider trad-ing is “rampant,”5 and in August 2012, a government minis-ter revealed that three regulatory officials from the Securi-ties and Exchange Board of India (SEBI) itself were being investigated for corruption

Such problems are not unique to these two countries, and the authorities are at least taking some steps to address them Nevertheless, cleaning up the markets is absolutely essential for them to grow, as investors in both countries are already accustomed to seeking profits elsewhere

In this case, though, the particular vehicles vary by coun-try Traditionally, savers in China had little option but low-paying accounts in state-owned banks In the last decade the products available have diversified rapidly but, Simon Gleave – regional head of financial services, KPMG Asia-Pacific – notes, bank deposits remain popular “Investment sophistication is pretty low,” he adds This is exacerbated by government restrictions on interest rates and capital flows

Those looking for other choices have tended to put money into real estate – a property bubble is another issue facing the country – or into trust companies

The latter are private companies that promise high returns often attained via lending to companies where state-owned banks will not As the government has tried to reduce lending in recent years by political fiat, such institu-tions have filled the gap In January 2014, meanwhile, the People’s Bank of China reported that the shadow bank sec-tor provided more than 30% of aggregate financing for the whole economy, up from 23% a year earlier Worse still, the country has seen worrying growth in completely unregu-lated informal lenders The IMF estimated in October 2012 that collectively such loans totalled the equivalent of 6% to 8% of GDP, with interest rates often upwards of 20%

A majority of household savings in India also goes into banks, which have traditionally paid little real interest

According to SEBI, out of a population of over 1bn, just

18 million Indians own equities, and only a small percent-age of household savings are held in shares, mutual funds, and government debt Nor is this spread across the coun-try: most of the money comes from a single city, Mumbai Indians looking for better returns than found in banks or life insurance choose gold Although this partly reflects the cultural importance of the metal in the country, it is also very much an investment choice A report by Morgan Stan-ley in June 2012 found that between 2008 and 2011 the value of gold purchases totalled eleven times the money going into equities and by the latter year it accounted for 10% of household savings In June 2013, the finance min-ister publicly encouraged Indians to stop buying so much gold, for good reason: in the fiscal year ending March 2013 half of the country’s current account deficit came from the import of $54 bn worth of the metal Since the summer, Indian gold imports have dropped due to increased gov-ernment restrictions and duties, although purchases of silver have risen Now the Chinese may have caught the gold bug as well: lower purchases by Indians and a rapidly growing interest in the metal among Chinese made the lat-ter the world’s largest imporlat-ters of gold in 2013

If savers are looking to invest outside of capital markets, companies also often prefer to look elsewhere for fund-ing Bank loans have a number of advantages over other financing Mr Panchapagesan explains, “The Indian bank-ing system is highly relationship driven Firms can get all kinds of sweet deals In India creditors don’t force firms into bankruptcy If a business gets in trouble, they call the bank and restructure loan If I am a CEO, why would I go to the capital markets where I have to be transparent? I go to my bank, where I am not penalised even if I don’t pay.” Further-more, large corporate groups often tap into retained earn-ings as such activity arouses little shareholder opposition

in India

Similarly in China, large companies often find exchanges an unappealing place to seek capital Corporate savings rates

in China are already high – for much of the last decade they have been around the same proportion of GDP as house-hold savings Financing from retained earnings can be an easy option, especially for bigger firms As for those which need cash, says Mr Gleave, “bank loans are much cheaper

5 “Insider trading: Large corporates should come together to decide on disclosure code, says Ravi Narain, NSE”, Economic Times, 11 March 2013

and easier They don’t see any point in raising capital Why bother with all the costs?”

In both China and India, then, poor capital market results

in recent years and ongoing corruption issues are likely to continue underpinning business preferences for raising capital via bank loans, and investor preferences for other investment vehicles

Differing paths Each country also has specific issues that will inhibit the ability of their capital markets to take on a global role

For China, this begins with the extent of restriction on exchange activity The shares available in Shanghai and Shenzhen are, for the most part, minority listings of state-owned companies or their subsidiaries Mr Gleave notes that this “is something that needs to change before you can build bigger equity capital markets The government

is determined not to sell majority stakes.” Meanwhile, growth-oriented small and mid-sized enterprises face regulatory hurdles to listing and accessing capital through these markets

Another core problem is the restrictions facing inves-tors wishing to directly access Chinese markets China has a highly regulated financial sector, a non-convertible

currency, and allows little access by foreigner investors

to its capital markets except through a number of limited schemes The government mulls reform, but as Mr Gleave explains, the “question is what steps to take to achieve [open markets] and in which order Do you deregulate the exchange rate or interest rate first? Do you reform equity markets first? Do you open the currency or float it first? These are fundamental question marks over how you go from quasi state controlled financial markets to free ones.” Real progress will have to await officials deciding on a more comprehensive roadmap Mr Gleave says that government officials are currently debating these matters intensely, but

he does not expect any detailed decision on them for a year or two Even then, the result will inevitably be experi-mental, as no country has ever taken this path before

The problem for Indian companies is not related so much

to market access; the country has more equity market list-ings than any other Rather, Indian markets’ suffer from a marked lack of liquidity despite high national savings rates

Of the roughly 5,100 firms listed on the BSE, over 2,000 are described by the exchange as “illiquid” The more active National Stock Exchange of India formally labels about a quarter of its approximately 1,600 listings the same way These, though, are the most extreme cases, with many other shares seeing scant activity India’s newest stock

Relative movement of NSE Nifty and BSE Sensex Indices and Rupee-Dollar Exchange rate

(All indexed with 1 May 2013=100)

110

100

90

80

70

Source: The Economist Intelligence Unit (October 2013)

exchange, the MCX-SX, opened for business in February

2013, and in its initial month saw trading in only 71 of the 1,118 listed shares

In practice, most estimates say that only a few hundred

of the largest Indian companies can be described as truly liquid Mr Panchagesan notes, “These are the household names The others are not going to grow.” Incidents of stock fraud among thinly traded shares do little to enhance their attractiveness As for secondary debt and deriva-tive markets, liquidity is even tighter The country’s major exchanges even offer incentives to derivative traders to use their facilities in a bid to improve liquidity

Perhaps as a result of this need for capital, foreign invest-ment restrictions in India have for some years been far less than those in China Registered Foreign Institutional Inves-tors (FIIs) can in aggregate buy up to 24% of the equity in almost every Indian company In practice, the restrictions are even looser, with some 300 companies having special exemptions allowing FIIs to purchase anywhere from 30%

to 100% of capital According to the Reserve Bank of India, only five companies currently cannot receive further FII investment and 15 have reached their limit of investment from non-resident Indians or persons of Indian origin

Easy access for foreign funds can bring dangers as well

as benefits, in particular because low domestic invest-ment gives this money outsized influence in Indian capi-tal markets: roughly a third of the daily turnover on the National Stock Exchange is driven by FII activity Events from the summer of 2013 are a notable example of what can happen Starting in late May, India’s equity markets and currency saw marked instability [see chart] This has had little to do with the country’s economic fundamentals, although a growing current account deficit was already affecting confidence in May and continued throughout the period Instead, the announcement late in that month by the United States’ Federal Open Market Committee that it planned to taper quantitative easing led nervous foreign investors to repatriate money in anticipation of possible turmoil on American and world markets

The majority of such activity was in June, with FIIs taking

selling off $5.6bn worth of debt and $1.8bn worth of equi-ties Stock market indices dropped as did the value of the rupee in the face of substantial capital repatriation The sell-off continued at a slower pace in July but in the first half of August FIIs, although continuing to be net sellers

of Indian debt, were putting money back into the coun-try’s equities Then, on 16 August, the government, wor-ried about continued pressure on the rupee, announced limited controls on Indian companies investing abroad This sparked rumours that broader currency controls on foreign investors in India were under consideration, lead-ing to another round of selllead-ing: $1.1bn in FII money left equity markets by the month’s end while FII debt divest-ment continued apace

Government assurances that no such controls were in the offing; the appointment of Raghuram Rajan – known to be

in favour of further foreign investment – as governor of the reserve bank on 4 September; and the latter’s rolling back

of controls on Indian companies as well as bringing in fur-ther liberalisation of certain foreign investment rules has changed perceptions From Rajan’s appointment to mid-September, net FII debt divestment has slowed to a trickle, and FIIs put $1.1bn back into Indian equities

Broad lessons from these events should be drawn with caution They certainly show the potential influence of foreign money – and therefore foreign crises – on Indian capital markets, but last summer may not be represen-tative An IMF study of FII investment in Indian markets between 2000 and 2011 found little evidence that changes

in foreign investment as a result of long tail events abroad affected Indian equity values.6 Moreover, the summer FII sell off has to be seen in perspective: from January to mid-September 2013, FIIs were responsible for a net inflow of

$12.6bn in equities and the outflow on the debt side has been $1.6bn In other words, even where outside condi-tions were worrying, foreign investors seem to have been prudentially reducing their holdings rather than abandon-ing the country

Similarly, the speedy imposition of currency controls on Indian companies abroad might suggest that, if highly pressed Indian policy makers may restrict investor freedom

6 Ila Patnaik, Ajay Shah, Nirvikar Singh, “Foreign Investors Under Stress: Evidence from India,” IMF Working Paper WP/13/122, May 2013

just when foreigner might need their capital most On the other hand, the damage caused by rumours, the rapid reversals of these measures and disowning of controls on foreigners, and the attendant recovery in equity values and the rupee might equally suggest that the government has shown a strong commitment to free markets even while under stress and seen the rewards

At the very least, though, events of last summer’s events show that the large proportion of foreign capital in Indian capital markets adds to the risks which potential investors need to consider

The different problems and investor preferences in the two countries each lead to their own kind of inefficiency

China’s large pool of capital is finding ways to fund eco-nomic development outside of traditional capital markets

This is positive in some ways: a low cost of capital for gov-ernment has enabled extensive infrastructure develop-ment that might not otherwise have been possible On the other hand, whether capital is being allocated efficiently

is far less clear In India, on the other hand, savings are not translating into substantial liquidity, despite an openness

to foreign investment Money is more likely to go into gold than into shares

Conclusion Asia’s emerging giants clearly have the potential to estab-lish capital markets of global importance Change is occur-ring at the margins and both countries have taken steps

to curb corruption India recently appointed a Standing Council of Experts on the international competitiveness

of the Indian financial sector, tasked with, among other things, looking at capital market reform In July 2013, the Chinese government nearly doubled the aggregate allow-able quota under the Qualified Foreign Institutional Inves-tor (QFII) scheme – the main vehicle for allowing foreign money to enter Chinese markets – though the new total

of $150bn is still relatively small and by early 2014 only roughly a third of that amout had been issued in actual QFII licenses Furthermore the government has relaxed restrictions that required at least 80% of foreign assets be held in fixed income assets

However for the capital markets of these countries to become global actors more change will be needed Both countries need institutional strengthening so that inves-tors are able to trust companies seeking money on equity and debt exchanges Doing so holds out the possibility of much more efficient capital allocation, and therefore more sustainable growth Nevertheless the agenda is long and daunting, if Dalal Street is to join Wall Street, or Lujiazui the City, as leading global capital markets by 2030