Thursday, February 7, 2008

Which market will blow up next?

China isn't the only country with an overheating economy and enormous domestic problems. Here's another I'd steer clear of for now -- despite its many attractions.
By Jim Jubak

Who's next?

It's only logical to wonder after the 9% plunge in China's Shanghai stock market led to a global sell-off on Feb. 27. That ended with the Dow Jones Industrial Average ($INDU) down 416 points on the day.

There are the usual suspects, of course:
The U.S. markets, if the crisis in the submortgage market spreads to the rest of the debt market.

Japan, if investors panic at signs that the economy might be slipping back toward recession after the latest interest rate increase.

Russia, if investors decide that the country's booming stock market -- up 51% in 2006 -- and state-controlled economy too closely resemble the Chinese market that just blew up.

The $345 trillion derivative market, if some of the math whizzes that carve up risk sent too much risk to the wrong investors.

But I've got another candidate: India.
It's as big as China. It's growing just about as fast. Its economy is in more danger of overheating. And it's more dependent on speculative hot money. The Indian stock market suffered through a 30% drop in May and June of 2006, so similar volatility in the days ahead is certainly a possibility. And the country looks like it's on the road to a genuine economic and political crisis.

And, of course, with the global financial markets as spooked as they are after the Feb. 27 meltdown in Shanghai and the subsequent global sell-off, any short-term blip in a major developing market such as India could set off big ripples across the globe.

In the long term, however, I think India might be the most attractive of all global stock markets: Its population is younger than China, its educational system is expanding and improving, and its companies are more focused on creating wealth for shareholders.

Do the long-term rewards outweigh the short-term risks? Should you buy in now, determined to weather any storm, or wait for the rain to fall and the clouds to clear? Let me lay out the short-term risks and the long-term potential.

First, the short-term risks
Asset prices are high, so high that they show all the signs of a classic asset bubble. The market valuation of the main Indian stock market in Mumbai, despite that 30% downturn in 2006, had climbed to $836 billion in mid-February from $121 billion in April 2003, an increase of 591%. Property values have soared, with the value of prime office space in Mumbai up 70% in the last year.

Those high asset prices depend on a flood of easily withdrawn overseas hot money. Flows of capital into the Indian stock market climbed to $12.5 billion in fiscal 2006, up from $2 billion in fiscal 2002.

India is very dependent on global cash flows. Unlike China, India runs a trade deficit and only showed a total capital account surplus in fiscal 2006 because of that $12.5 billion from overseas investors in stocks, foreign direct investment of $6 billion in 2006 and rising corporate borrowing on international capital markets (about $6 billion in fiscal 2005). India was relatively untouched by the Asian financial crisis of 1997, but it is much more vulnerable to changes in external cash flows today.

Bank lending is out of control. Over the past three and a half years, bank credit outstanding has jumped by 76%, according to Morgan Stanley.

Inflation is out of control. Nationally, inflation recently hit a two-year high of 6.7% and is running even higher -- about 9% -- in the rural areas where two-thirds of Indians live. Inflation at the wholesale level has increased to 6% from 4% last spring.

The Reserve Bank of India, the country's central bank, raised its benchmark interest rate to 7.5% at the end of January without noticeably slowing either inflation or the lending boom. Finance Minister Palaniappan Chidambaram has thoroughly undercut the central banks efforts by urging banks not to pass on interest rate increases to lenders.

My short-term prognosis: A big domestic credit crunch -- caused when lenders stop lending and borrowers can't get the cash they need to run their businesses -- causes India to fall far short of current forecasts of 9% to 10% annual growth. Foreign investors begin to withdraw money from the Mumbai stock exchange, producing another 30% "correction." The current Congress Party government loses power. After stumbling with politically motivated attempts to reduce food and fuel prices in rural areas, a new government bites the bullet, raises interest rates and cuts bank lending enough to slow inflation and the economy. Overseas cash begins to return.

It won't play out exactly like that, of course. I don't know how deep any credit crunch might be or how much the Reserve Bank of India might have to slow the economy to reduce inflation to its 5% to 5.5% comfort zone. I don't know how long the Congress Party government might be able to cling to power. I don't know how other global markets would react to a big drop in Indian stocks.

Most of all, I don't know when all of this might happen. This mess took a while to create, and my suspicion is that it will take a while to correct. The core of the problem -- the imbalance between urban areas quickly growing wealthy (in Indian terms) and rural areas left behind in the boom -- isn't unique to India, and it won't be solved by just one crisis. And subduing inflation in India will require big increases in supply, since Indian companies are now operating at full capacity, and improvements in infrastructure that reduce the costs of moving food and fuel. A recent study by the Reserve Bank of India says that it will take 18 months to two years to add significant supply. I think it's reasonable to look for an Indian crisis within that 18- to 24-month parameter.

Second, the case for long-term rewards
There's no going back to the highly regulated economy of the past. Even the Congress Party, no friend of an open economy, wasn't able to resist the momentum. And with Indian companies increasingly making big bucks from the global economy, there's no reason to put the genie back in the bottle. That means future growth should be in the range of 7% to 10%, not the anemic rates of the 1980s, when growth was just a third of that.

The Indian middle class numbers 200 to 300 million, enough to make them the driver of a domestic consumer economy. With Indian per capita GDP of $3,460 in 2005 (adjusted for purchasing-power parity because money goes further in a poorer country), India is still poorer than China at $6,660 per capita in 2005, but the country has crossed the economic threshold where growth in consumption takes off. Only 10% of Indians have life insurance now, only 2% have credit cards and less than 15% have refrigerators.

Even some of India's problems have major economic upside. India's investment in infrastructure has lagged China's. In 2002, for example, the country spent only $31 billion, or 6% of GDP, on building the roads, ports, railroads and airports necessary for competing as a global economy. China in that year spent $210 billion, or 20% of GDP. But the Indian government recognizes its need to catch up.

Education is getting the attention -- and rupees -- it needs. Indian society has been soundly shaken over the last two years by studies that show that the country spends too little (just 3.8% of GDP), educates too few (only 8% of 18- to 24-year-olds go on to higher education, about half the Asian average), and teaches too poorly (although 95% of 5- to 10-year-olds go to school, 40% drop out by age 10). The government's next budget, though, is expected to show an increase in education spending to 6% of GDP.

Demographics work in India's favor. Half of India's 1.1 billion people are under 25 today, and the country is among the least rapidly aging in the world. In 2002, according to the United Nations, in the developed world 20% of the population was 60 or over. In China, the figure was just 10%, and in India, 8%. By 2050, according to projections, the percentage will have climbed to 33% in the developed world and to 30% in China, but to just 21% in India. That means that India has time to fix its problems before the needs of a huge cohort aged 60 and older begin to dip into national savings. India can take comfort in research that shows younger economies grow faster, too.

India's companies have a culture of creating value for shareholders. I know this is subjective, but it is important. If you're going to be a passive shareholder in a company, you'd better hope that the goal of the company is growing the value of all shareholders' stakes. Many Indian companies -- and some of the biggest -- have that culture, maybe because so many started life as businesses run by extended families. I think that culture takes much better care of shareholders than that of corporate China, where companies are often run to enrich local officials, managers and party elites.

India's companies show above-average profitability. Here's something much more concrete: The average return on equity for Indian companies on the Mumbai stock exchange is 21%. That's significantly above the 18.7% average return on equity for the U.S. members of the Standard & Poor's 500 Index ($INX).

In addition, Indian companies are comparatively underleveraged, with an average debt-to-equity ratio of just 70% compared with a ratio of 123% for the S&P 500 companies. That means they're got plenty of room to add debt, which will in turn increase leverage, return on equity and profitability for investors.

My long-term prognosis: India is the most attractive stock market in the world for the long haul. By that I mean over the next decade or so.

Adding it all up: After weighing the long-term pluses and short-term minuses, I'd wait for another 30% correction in the Indian stock market. The risks in the Indian economy and the global financial markets are just too great in the short run at current prices in Mumbai. And as the panic on global markets that followed the 9% drop on the Shanghai stock market on Feb. 27 indicates, there are just too many hot-money investors around the world, all hoping to be the first out the door at any sign of trouble.

If I didn't get my correction in Indian stocks by early 2008, I'd re-evaluate my calculations of risk and reward to see if the global risk picture had changed.