Demographics and Capital

India is among the youngest population in the world with a median age below 30. While the net addition to the working population is the highest in the last decade (2000-2010) but the overall working age population will continue to rise until the early 2030s. Simultaneously, it is also adding significantly to its old (60+) population which will be more than its addition to the working age population.

The cycle of capital creation / consumption is the simply the following:

•  0- 20/25 years: Parents spend the child’s food, clothing, education, travel etc. This category is a net consumer of capital;
• 25-35/40 years: This is a category which has begun to work and is borrowing for its first car loan, to purchase a house and is a net consumer of capital again from the system. In India till the early 1990s this cycle never played out as young adults were less mobile living in joint family systems plus retails loan availability was extremely restricted. This is also the segment which is the primary consumption driver;
• 35/40 to 60 years: This is the saving class which is in essence providing capital to all other demographic categories;
• 60+ years: This category is essentially in retirement and drawing upon its savings over the last 20-30 years.

Simply put Indian economy will continue to import savings, despite its high savings rate, for a very long time as both the youth and the old continue to expand relative to its mature working population. Most of the German population is currently in their 40s and one can witness the savings bulge. Urbanization, infrastructure and consumption imports will all need foreign capital.

The Indian currency was Rs.8.4 in 1975, Rs. 17.5 in 1990, Rs.44.9 in 2000, Rs. 45.73 in 2010 and Rs.60 now per USD. Given this continues propensity to import savings and relative high inflation to the developed world, rupee will be in secular decline, except for unusual duration experienced in 2000-2010 when the external environment was extremely benign followed by easy money by the Fed.

As we look into the next 2 decades the Europeans, Russians, Japanese and Canadians will be experiencing a massive surge in the number of retirees. The Americans will continue to have reasonably good demographics as the baby boomers are replaced by the next generation in 8-10 years and by 2020 even the Chinese median age will cross the American median age. In this environment the global availability of capital will decline over the next few decades. This is the period when the need in India for global capital will continue to rise. Having said this, given the pension imbalance in the developed world the last 5 years of low interest policies have created, the need for higher currency adjusted return on capital will continue but this will be counter balanced to an extent by increasing Fed rates. The basic reason for economic slowdown in India over the last 3 years is its inability to keep the investment cycle going which is in turn dependent to a large extent on availability of foreign capital.

In this backdrop, political stability and policies that create a conducive investment environment is critical if we seek to achieve our national aspirations and benefiting from positive demographics. We are probably the country receiving the highest remittances (again savings) globally which means we export a lot of talent. Do we always want to keep exporting talent or use our people to enhance India’s productive capacities?

All across..

In the last few weeks, I have been thinking about the e-commerce space and the impact on the economy. India for instance has developed in the last half-decade a US$3+ bn e-commerce market (excluding travel). This has replaced the typical brick and mortar retailing which means retailing space worth an equivalent amount has been taken out of business (assuming 10% rental cost and 10% cap rate). This has spawned a another industry on the other side of warehousing and logistics which may be taking almost an equivalent proportion of e-commerce cost but delivering customer through an alternate, more convenient, channel. Whether this has made the economy more productive is an altogether different question but it has surely reduced cost to the consumer which at least yet seems to be been paid for by VC firms and the vendors.

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This gets me the next aspect of how the current expected recovery in savings (despite reduced cost of ecommerce purchase which is very small) and form of savings will impact the Indian economy. The economic identity to remember in these discussions in savings (imported or domestic) is equal to investments. In the past decade while we saved at 30%+ rates our capital formation levels have been 200-400bps higher which meant we needed to import savings, a large part of this came through portfolio investments and NRI deposits both susceptible to short term movements. The last year Indian savings has dropped to below 30% levels to ~27%. Savings levels have been severely impacted by the incessantly high inflation levels in the last few years. This should recover as inflation comes off with a decline in food inflation.

But the bigger question is as the new government comes in in May 2014 and tries to push the overall growth levels in the economy for which recovery of investments is critical, Indian savings is woefully short. This will require a massive concerted effort to attract and manage foreign capital as the gap between investments and savings will become much wider in the initial timeframe. And, channelling of foreign capital into the infrastructure sector will enhance the long-term trend growth of the economy. The other aspect is that a large part of the savings in the last few years has gone towards real estate. This should change as real interest rate recovers providing more productive usage of capital.

While household savings have declined, income inequality levels have also risen. The rich do not consume the same in proportion to their income is a fairly well-known fact which means continued pressure on overall demand.

We will continue to have bright sparks in the economy (even Spain has its Zara clothing brand) but the macro needs some able management. In a savings glut world with easy money, problem of under-investment is relatively easy to solve than over-investment in case of China.

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It is almost that the centre part of Eurasian landmass has come to political life all at once…

Russia has annexed Crimea whether the west likes it or not and little it can do about it. NATO is a non-functional organization which leaves US alone to respond. US given its weariness of the last 15 years is finding it difficult to get its bearings but it has no choice but to build a new containment strategy for Russia before we see further capitulations across eastern Europe or Balkans.

Turkey continues to convulse under the factionalism in the Erdogan’s grand coalition with the Gulen movement turning away and multiple scandals breaking out. In the end, Turkey’s elections are about finally controlling the key city of Istanbul which is the economic life-blood (40-45% of Turkish economy).

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Finally, the BJP in continues to be among the favourite to win the election with >220 seats but not by itself (or its pre-election alliance) have enough seats to govern India. While this trend has held for the last few months parties which have been in power with the Congress in the last 2 governments are finding this prospect increasingly difficult and given their support base they will be unable to participate in the next government. This is resulting in the Congress and these parties making more and more acidic attacks (i.e. chop Modi etc). Second, UP and TN seems like the most likely states which will make the difference between a 220 and 240 BJP position. And, politics at the center can be very different based on the distance from the 272 mark. If the BJP misses the 220 mark by a margin then be prepared for a massive dent in investment sentiment.

This one said by Lincoln may sound familiar to Modi governance style, “I do the very best I know how, the very best I can, and I mean to keep doing so until the end. If the end brings me out all right, what is said against me won’t amount to nothing. If the end brings me out wrong, ten angels swearing I was right would make no difference.” So be prepared for the new style..no remorse no recourse..

Cycles are reality

The Indian economy has gone through a full cycle – the bust of the late 1990s, the benign period of early 2000s, the roaring period from 2005-2008, the near bust of 2008 which was rescued by global and local counter-cyclical measures and now the demand destruction of led by inflation of 2012 – 2014. This demand destruction has been led by the inflation bitten urban markets which resulted in high interest rates and slowdown in government tax buoyancy which in turn has resulted in government reducing the rural spends – MSP, volume of purchase and M-NAREGA. With urban demand already down and rural demand slowing in the next couple of years but is the counter balancers in place to address this situation.

There are potentially 4 areas due to which India is likely to see a revival in the economic cycle:

•  Inflation, interest rates and investments – The lower MSP hikes (5.5% in FY14 vs CAGR of ~16% in 2008 – 2013) and rural spend will bring down the food component of inflation, which has the largest share in the CPI basket of ~40%, within a year or so. This reduction in inflation should result in a less than proportionate reduction in interest rates (given RBI’s clear stance on achieving positive interest rates) but a reduction nonetheless. The likely clearance of many delayed projects, replacement capex cycle and lower interest rates should revive the investment cycle within 15-18 months. Further, we have an unprecedented situation of almost no new project announcements in the last 6 months which is unlikely to sustain.
• Recovery in financial saving – The financial saving in the economy have declined to an all-time low with real assets like gold / real estate accounting for at least 70%. With the re-emergence of real interest rates, we will see an increase in investments in equity, bonds and bank deposits. This will allow for greater credit creation and risk capital to corporates.
• Reduction in external vulnerability – Current Account Deficit has come off massively over the last year. For the April-December period it was 2.3% of the GDP, down from 5.2% the same period earlier. This has significantly reduced the pressure on interest rates and the exchange rate. A large part of the reduction has been achieved by duties on gold loans. However, our significant dependence of FII flows, ~$40bn NRI deposits mobilized over the last year at very high interest rates and potential depreciation of the Chinese yuan will continue to maintain pressure on rupee and interest rates.
• Oil prices – Oil prices have been fairly stable over the last couple of years. It is surprising that they have not declined but given the likely reduction in the Chinese GDP growth and also the fuel propensity (better technology and environment consciousness) over the next few years we should expect to see oil prices continuing to remain benign.

While these factors would positively influence the Indian economic cycle, this will also coincide with the initial period of the new government. Unless we have a broken mandate, we should see decisions which would further aid this revival.

As we see the revival of the economy, the heady past and excessive leverage built both at the government and the corporate level needs to be unwound. The Reserve Bank needs to nudge the public sector banks to adopt an aggressive posture towards the NPA’s in the system – this capital needs to be released for productive usage – otherwise we will have a zombie banking system unable to support growth (PSU banks have ~75% market share).

The key economic risk remains a Chinese devaluation. The Chinese economy has grown since the financial crises through a massive expansion in leverage to its infrastructure and real estate markets. This engine no longer has wings and has the potential of triggering banking sector crises if pushed further, maybe already. The likely fall-back massive purging of excessive capacity and reduction in state government leverage through central government recaps or devaluation. The former is deflationary and can potential create political risks. We have seen a trailer recently of the devaluation possibility which caught all market participants off-guard. A Chinese devaluation will trigger an Indian currency devaluation and potential capital flight.

Having said this, India today looks almost like a ‘saint’ in the face of events in Turkey, Argentina, Russia and the commodity intensive nature of Brazil and South Africa.

Indian Prime Minister with a ‘Russian’ Cerebrum

The Russians control 11.5% of global landmass with the ninth largest population in the world. It has borders with over 16 independent countries including US, Japan and China. It has limited natural boundaries protecting the Russian core (Moscow region) except buffer states like Ukraine  or ‘caucus’ countries like Georgia or buffer regions like Siberia. Given the diverse population in such far flung areas, it manages to keep relative calm. It is fundamentally an ‘unstable’ kept in some form of stability by strategy including coercive force of energy or military. It would take great skill and heft to manage such a situation. It is a country prone to expansion as it seeks ‘geopolitical stability’ and then recoils in itself.

Viswanathan Anand was quoted saying, “The Soviets included a chessboard along with the bride's wedding trousseau to ensure that the children knew the rules of the game. For the Soviets, chess was in their DNA” and he was so intimidated by the chess prowess in the country that that he thought he could be “checkmated by every cab driver.” This is a result of nothing but their national psyche.

As I have written in my earlier articles, India’s abundance of agrarian produce, benign weather conditions, protection of the subcontinent by the mountain ranges in the north and the sea in the south have all given the country a sense of ‘protective camouflage’ until it is pried open as by the Mughals and then by the British. It is not my contention that a similar thing will happen but more to give a sense of history.

The last decade has seen a significant shift in status quo in our neighbourhood:

• Chinese economic growth, infrastructure and defence build-up;
• Disruption of the Afghan-Pakistan theatre and the convulsion likely post the American exit in 2014;
• Decline in relationships with Nepal, Bangladesh, Sri Lanka and Maldives;
• Then, the changes in the Middle-East driven by the underlying conflict between the Saudis and the Persians (manifesting in Syria, Iraq).

We have not only failed to manage this change, we have also let down our guard both in terms of economic strength and defense management. Our economic growth rate is now running sub-5% with a very weak banking system. Recent news reports of our defense preparedness, hardware procurement and border infra-management also point in the southerly direction.

The political capital of the state has been spent on managing the internal dynamics which broke down as the schisms with the state and regional parties increased and with it expanded the cost of political management. Unlike Russia which gives rise to dictators, managing India’s diversity requires a democratic set-up with credible institutions but what it dearly needs is the art of strategic management.

India's geography creates the sense of 'self-containment' leads it to exist with itself but we are no longer in 1,000 BC, we are part of the global economic system and technological advances have reduced the physical space in both the economic and militarily dimension..

One day everything will be well, that is our hope. Everything's fine today, that is our illusion” ― Voltaire

Unmistakeable trends

Unless one has discovered faith or purpose in something, it is likely that there is permanent feeling of being adrift. But we have a situation today where the entire nation seems adrift and has lost faith in its leaders. Unfortunately, a nation state does not have the luxury of drifting; it will result in political catharsis. However, it is not my intention to discuss the potential outcomes but the underlying trends which have caused this:

• Regionalism unconstrained: Political democracy has become a struggle for maintaining regional empires across the spectrum, where old geographical and other divisive fissures (caste, religion etc) have come to the fore. Old divided India governed by many regional kings which was constrained by the Mughal and British empires is re-emerging over the last 2 decades in the form of the regional political ‘kings’. The inability of the centre to enforce itself due to divided and factitious polity is creating this situation.
• Unemployment: Inability of the political class to find mass employment is resulting in ‘restless’ youth. The political class is unable to create consensus to open areas of the economy which can result in mass employment (i.e. retail) or change labour laws. Manufacturing technologies is evolving rapidly (e.g. 3D printers, robotics) to cope with the western world population pressures. This inability is finding manifestation in the form of programs like MNAREGA which are in turn creating their own negative dynamics of fiscal pressure, increasing wage cost disproportionately.
• Changing communication: The massive increase in telecom penetration and new communication mediums like twitter, facebook, sms etc are creating an explosion of awareness. Government and governance has been unable to keep pace with this sharp curve disrupting old models of decision-making.
• Rise of aspirational India: With rising awareness and high income growth of the past decade has come the rise of an aspirational class across the country where consumption patterns and views differ from the old India. This is a class which compares itself to people in other nations, has travelled, likes different cuisines, is connected online and shops on the web. Their political views range from apathy to changing the country to bring it in the league of developed nations. It is this aspirational India which has not only led to the rise of Arvind Kejriwal but also the one which finds great appeal in Narendra Modi.
• Pressure on water resources: Water will continue to be a point of stress especially in North / central India reinforcing poverty, creating migration & sparking differences regional differences.
• Destruction in values: Growth and greed of the past 2 decade multiplied by the democratization of corruption across the political class and created a cynical public view.
• Exceptional Indians: There will be Indians who will continue to do well globally. It a function of 2 things: we are 1/6^th of humanity and two the pressure and chaos of our youth breeds a mind-set which can deal with a rapidly changing world.
• Movies: India will never tire with movies and their offshoots - movies at the theatre, movies at home, film based programs, movie stars in advertisements, movie stars for marriage dances, as owners of cricket clubs….

In economic markets, there is a concept of equilibrium such that the amount of goods or services sought by buyers is equal to the amount of goods or services produced by sellers. Markets rarely find equilibrium but conversely markets rarely trade at 4 standard deviations. Similarly, a country is rarely in perfect state but like the markets massive dislocations (e.g. global crises of 2008 or 2nd world war created a new world leader in US) can create new reality. The political ‘stretch & vision’ of the country is being tested by some of these trends.

India Anti-Competition

If one looks at the political discourse, there is no discussion whatsoever over the last almost decade on what it would take to create and maintain India’s competitiveness in the long-run. First half of the decade we were basking in the glory of the global run and then in the second half dealing with the political drift of the government.

During this period the world has changed immensely, where while demand is local and can be altered by government (fiscal stimulus) and central bank (low interest rates) policies but the supply chains have become global. Steel plants compete with their counterparts in China, Textiles with Vietnam and Bangladesh, Paper from Malaysia and Indonesia and so on. Consequently, there are 4 key aspects which will determine long-term competitiveness of an economy:

• Infrastructure (e.g. container ships turnaround time at Indian ports can be 3-6x Singapore ports);
• Land & housing (e.g. land cost impact project costs, rentals, people cost);
• Healthcare (e.g. while in the US the high healthcare costs are a drag, in India the quality of impacts productivity);
• Education.

These are large costs (implicit or explicit) where international supply chains cannot replace Indian cost and efficiency. We have seen very limited government focus all these aspects with politicians (as globally) celebrating massive increase in land & house pricing as indication of Indian prosperity little realizing they are massive proportion of the cost (capex & opex) structure and sub-component of wages. While India has seen growth in educational institutions, industry continues to complain about quality of entry manpower.

In addition, we continue to shy away from opening variety of markets except consumption markets (cars, water, chewing gums, coffee etc) like:

• Agricultural markets;
• Education;
• Retailing;
• Power distribution;
• Coal mining;
• Defence production.

Each of the above examples imposes significant costs and holds back economic efficiency. While certain markets may require support from the government but support cannot be perpetual and to prepare industry it is best done with a clear roadmap. Then, we have reversals recently like power sector tariffs being subsidized in Delhi then in Maharashtra.

A good thing that has transpired in recent years is that some states have begun competing with one another for improving governance; however, there is no bench-marking one to international standards. It is India’s myriad of regulatory arbitrages that keeps a large part of the elite and the current power structure going and they play their role in keeping things in status quo.

A focus on the 4 key long-term competitive factors coupled with graded opening of markets will substantially boost employment and raise the long-term trend growth of the economy. Question, of course, will the self-interested political class act? This is in some ways a manifestation of the way Indian political party’s work where the political class seeks to avoid competition, running their parties like fiefdoms. Further, India needs to increasingly use its large market like the US (NAFTA) to create mutual self-interest with its neighbours.

Edward Luke in an interesting article written in 1990 titled, From Geopolitics to Geo-economics: Logic of Conflict, Grammer of Commerce, wrote,”…World Politics is still not about to give way to World Business….Instead, what is going to happen - and what we are already witnessing - is a much less transformation of state action represented by emergence of “Geo-economics”.”

We as a country wait for each economic crisis to act and seem to be happy with the given moment as long as it is going well with no desire or willingness to act for the future.

Musings on 2014

As the New Year has come in so have new hopes and anxieties been kindled. 2014 is likely to be the turning point for the world in more than one way. We will have two key events play out, one political and the other economic:

• America and Iran are on course for a rapprochement, which will change the geopolitics of Asia. Israel, Saudi Arabia and Turkey are likely to feel the pressure from the coming settlement in the short and long-run. This will also create pressure points for large oil producers for the next decade like Saudi Arabia and Russia and will be beneficial for large oil importers like India and China. Geopolitically, this and Afghan draw-down will release US energy in central Asia to focus on the Russian front. India will bear the brunt of Afghan un-wind unless it can quickly move in tandem with a re-invigorated Iran and Russia to neutralize an emerging Afghan problem;
• On the economic front we are beginning to see the first phase of the massive unwind by the 2 key players: US and China. The Federal Reserve has expanded its balance sheet from less than 9% of GDP in September 2008 to ~25% of GDP currently. This massive expansion has had a disproportionate impact on asset prices and less than intended impact on unemployment in the US. Finally, the Federal Reserve has decided to scale down its level of balance sheet expansion and reduce the expansion to zero by end of 2014. China on the other hand a massive expansion in credit post the 2008 crises with M2 expansion of 175%  as against a much slower nominal GDP growth. This credit growth has stimulated sectors like infrastructure, real estate, commodity manufacturing. But this has resulted in uneconomic projects or over-capacity creating bad debts. Shadow banking structures have kept the money flow going but at higher and higher rates. This has already created 2 inter-bank seizures in the last 6 months. The communist party and the PBOC realize the follies but will move slowly but surely to wean the economy off-high monetary expansion. While these two economies unwind, emerging markets and more so commodity oriented economies will face the music and potentially, as has happened historically, a crises in one or more emerging market over the next 12-24 months. While the first sight of crises, however, is also likely to tempt the Federal Reserve to reverse course partially from its path (of reducing its balance sheet).

As these two key events play out, India will have its own political issues to deal with. The emergence of AAP as a political alternative in the medium term will further fragment the vote share and create a government with a limited life. But is this the beginning of the end of regionalism, caste and religion based politics? But this will surely not happen in 2014 and will leave it for some other time.

Indian interest rates will continue to be high as the ‘unwind’ creates currency related pressure and off-shore interest cost continue to rise. This will force a reduction in overall credit growth (domestic plus foreign). This should result in an incremental swing of savings towards financial assets (bank deposits, corporate bonds and bit towards stocks) as real estate continues to see pressure from tight liquidity and high rates. Private investment cycle continues to be in the future by at least 12-18 months. Oil prices are the joker in the pack and any significant down move will result in a positive impact on inflation, CAD and the fiscal situation. However, a word of caution will continue to dominate as the massive unwind unfolds and any crises in an emerging market could spark a significant collateral damage on India at least temporarily.

I do not expect the stock markets to do anything great in 2014. Staple consumption story has been overplayed with rural demand expected to re-adjust given lower MSP growth. Exporting sectors like Pharma & IT (although 6-8 months already in play) and high quality cyclicals are the place to be.

Ranbir and Katrina will possibly marry in 2014. And, like Socrates said,” By all means, marry. If you get a good wife, you'll become happy; if you get a bad one, you'll become a philosopher.” Finally, there will be more philosophers amongst us.