Paper tigers chinese and india capital markets

Deutsche Asset & Wealth Management www.DeAWM.com S6 SPECIAL ISSUE Paper tigers: Chinese and Indian capital markets June 2014 Global Financial Institute Your entry to in-depth knowledge in finance Dr Paul Kielstra Paper tigers: Chinese and Indian capital markets Global Financial Institute Introduction to “Global Capital Markets in 2030“ Deutsche Asset & Wealth Management’s Global markets face weakening demand in many mature Financial Institute asked the Economist Intelli- markets gence Unit to produce a series of white papers, custom articles, and info-graphics focused spe- In short, while the world’s stock of financial assets cifically on global capital market trends in 2030 (e.g stocks, bonds, currency and commodity futures) is growing, the pattern of that growth sugWhile overall growth has resumed, and the gests that major shifts lie ahead in the shape of capi- value traded on capital markets is astoundingly tal markets large (the world’s financial stock grew to $212 trillion by the end of 2010, according to McKin- This series of studies by Global Financial Institute sey & Company) since the global financial crisis and the Economist Intelligence Unit aims to offer of 2008, the new growth has been driven mainly deep insights into the long term future of capital by and markets It will employ both secondary and primary by a $4.4 trillion increase in sovereign debt in research, based on surveys and interviews with 2010 The trends are clear: Emerging markets, leading institutional investors, corporate executives, particularly in Asia, are driving capital-raising; in bankers, academics, regulators, and others who will many places debt markets are fragile due to the influence the future of capital markets expansion in developing economies, large component of government debt; and stock Paper tigers: Chinese and Indian capital markets Global Financial Institute Introduction to Global Financial Institute Global Financial Institute was launched in Novem- institutions are 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Chief social issues facing the world To accomplish this Economist mission, Global in Financial Institute’s independent, Global Financial educated, Institute’s Financial Institute Johannes website Müller, and regularly for distinguished publications professors from institutions like the University of combine the views of Deutsche Asset & Wealth Cambridge, the University of California Berkeley, Management’s those the University of Zurich and many more, all made of leading academic institutions in Europe, the investment experts with relevant and reader-friendly for investment profes- United States, and Asia Many of these academic sionals like you About the Economist Intelligence Unit The the a variety of pieces covering the financial services world’s leading resource for economic and busi- Economist Intelligence industry including the changing role relationship ness research, forecasting and analysis It provides between the risk and finance function in banks, accurate and impartial intelligence for companies, preparing for the future bank customer, sanctions government agencies, Unit financial (EIU) is and compliance in the financial services industry, and academic organisations around the globe, inspir- institutions the future of insurance A published historian, Dr ing business leaders to act with confidence since Kielstra has degrees in history from the Universi- 1946 EIU products include its flagship Country ties of Toronto and Oxford, and a graduate diploma Reports service, providing political and economic in Economics from the London School of Econom- analysis for 195 countries, and a portfolio of sub- ics scription-based data and forecasting services The the charitable sector He has worked in business, academia, and company also undertakes bespoke research and analysis projects on individual markets and busi- Brian Gardner is a Senior Editor with the EIU’s ness sectors The EIU is headquartered in London, Thought Leadership Team His work has covered a UK, with offices in more than 40 cities and a net- breadth of business strategy issues across indus- work of some 650 country experts and analysts tries ranging from energy and information tech- worldwide It operates independently as the busi- nology to manufacturing and financial services In ness-to-business Group, this role, he provides analysis as well as editing, the leading source of analysis on international project management and the occasional speaking business and world affairs role Prior work included leading investigations arm of The Economist into energy systems, governance and regulatory This article was written by Dr Paul Kielstra and regimes Before that he consulted for the Commit- edited by Brian Gardner tee on Global Thought and the Joint US-China Collaboration on Clean Energy He holds a master’s Dr Paul Kielstra is a Contributing Editor at the degree from Columbia University in New York City Economist Intelligence Unit He has written on and a bachelor’s degree from American University a wide range of topics, from the implications of in Washington, DC He also contributes to The political violence for business, through the eco- Economist Group’s management thinking portal nomic costs of diabetes HIs work has included Paper tigers: Chinese and Indian capital markets Global Financial Institute Paper tigers: Chinese and Indian capital markets Written by A Global Financial Institute research paper written by the Economist Intelligence Unit June 2014 In recent decades, the overarching economic story out of have seen faster growth in their number Between 2009 and Asia has been the transformation of the continent’s demo- 2011, according to Dealogic, they were both in the top five graphic giants into economic ones This has happened on exchanges for initial public offerings by value, and in 2012 any number of levels For example, in recent years in nomi- remained in the top 10 More broadly, Shanghai and Shen- nal GDP terms China has surpassed Japan to become the zhen also saw the fourth and fifth highest levels of share world’s second largest economy, and India already is the trading by value globally last year world’s tenth largest GDP Only a decade ago, China and India were in 6th and 13th place, respectively A number of indicators point to continued growth China currently has among the highest gross savings rates in the Dramatic growth can also be seen in the two countries’ world (51% in 2012 according to the World Bank) which capital markets Today, Shanghai and Shenzhen combined represents an increase on the roughly 40% of the 1990s have a greater market capitalisation than that of any other The country is putting capital to work privately and pub- country’s exchanges except those of the United States licly: the World Bank calculates China’s gross fixed capital India’s collective total, meanwhile, lags behind only those formation at 47% of GDP in 2012, with absolute spending in of America, China, Japan, the United Kingdom and Hong this area more than a quarter higher than that of the United Kong In terms of total securities, India has far more firms States that year India’s gross savings rate is a comparatively listed – over 5,100 on the Bombay Stock Exchange alone modest 34%, but it, too, has a substantial amount of money – than any other country; the NASDAQ and the NYSE col- in search of effective allocation And with a gross fixed capi- lectively have a little over 4,100 domestic companies, tal formation rate of 30%, India has plenty of opportunity although cross listing means the total number is somewhat for investment lower The two Chinese exchanges have fewer listings, but Which of the following economies you think will have the most important public equity markets for the global economy by 2030? Please select up to three United States 65 % China 53 % India 35 % Japan 24 % United Kingdom 22 % Brazil 21 % Germany 19 % France 8% Italy 8% Other, please specify 3% Capital will be so international that location will have little relevance Source: The Economist Intelligence Unit (August 2013) 5% Paper tigers: Chinese and Indian capital markets Global Financial Institute Which of the following countries you think will have the most important bond markets for the global economy by 2030? Please select up to three United States 68 % China 45 % Japan 30 % United Kingdom 28 % Germany 26 % India 24 % Brazil 12 % France 10 % Italy Other, please specify Capital will be so international that location will have little relevance 9% 3% 4% Source: The Economist Intelligence Unit (August 2013) It is not surprising, then, that China and India’s capital markets budget economic survey admits, “Though, the develop- seem poised to take on significant global importance According ment of the corporate bond market, has been an impor- to a 2013 Economist Intelligence Unit survey of over 350 compa- tant area and has received greater policy attention in nies active in global capital markets, 53% say that China will be recent times, it is yet to take off in a significant manner.” The among the countries with the world’s leading equity markets by country’s Economic Times newspaper goes further, citing 2030, and 35% say the same of India That would make these two low trading levels, poor liquidity in the secondary market, countries the second and third top equity markets in 2030, after and a lack of interest by banks in corporate debt, it calls the the United States, in the estimation of global executives On bond country’s corporate bond market “a mirage”.2 markets, China came second (45%) while India was sixth (24%) In contrast, China’s bond markets have seen substantial That said, China’s and India’s capital markets institutions growth in the recent years and are the fourth largest in the are a long way from being global players Even in their world in absolute size They are still dominated by govern- domestic roles, these markets are often not efficiently allo- ment debt rather than funding more diverse private sector cating the substantial capital being saved A 2013 study by endeavours According to the Asian Development Bank, World Bank researchers found that “the expansion of finan- at the end of 2013 the total of all corporate bonds repre- cial market activity since the 1990s has been more limited sented 15% of national GDP This is more than double the than…the aggregate figures suggest.” A handful of large 2008 figure, but still well below the equivalent number for companies have dominated activity on equity and bond the United State (around 60% in 2013) Moreover, the vast markets, with the top 10 firms in India and China account- majority of Chinese corporate bonds are “enterprise bonds” ing for 62% and 43% respectively of the capital raised issued by government affiliated companies Traditional between 2005 and 2010.1 corporate bonds can be issued by smaller, private firms but that market is thinly traded and highly illiquid The ability If anything, debt markets in India are even less developed of organisations without strong state connections to tap than equity ones The Indian government, in its 2012-2013 bond markets remains an open question 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 “Indian corporate bond market still remains a mirage”, 28 November 2012 Paper tigers: Chinese and Indian capital markets Country Global Financial Institute Projected real GDP growth 2010 – 2013 Selected Stock Market Indices January 2010 – December 2013 China 40% Shanghai Composite Index -36% Shenzhen Component Index -11 India 27% NSE Nifty CMX +20% BSE Sensex +19% United States 9% DJIA +55% United Kingdom 5% FTSE 100 +22% 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) Moreover, the transparency of the Chinese bond markets is however, despite steady, robust economic growth in each a significant worry Not a single bond has seen a default, in country, India’s volatile equities have failed to keep pace part because the government and other interested parties with economic growth in the country and China’s stock have stepped in on occasion to make good insolvent par- indices have even seen substantial overall declines [See ties This makes pricing risk a fraught endeavour In Octo- Table] Looking more closely over the last decade, a rapid ber 2012, the IMF highlighted that “the apparent pattern expansion of the number of listed companies helped drive of ‘higher returns and suppressed default risk’”, already a the increase in market capitalisation for Shenzhen and the worry amongst trust companies and alternative lenders, NSE rather than this arising from rising share price alone has extended to the bond market Economic growth and market indices are only loosely Overall, then, capital markets in these countries are deliv- related in most circumstances Nevertheless, the weak ering less than they appear to on the surface Professor showing of these markets, especially in China, brings con- Venkatesh Panchapagesan of the Indian Institute of Man- cerns for those potential investors otherwise willing to agement says, “India has had 10 to 15 years of phenomenal overlook institutional deficiencies growth, but capital markets have not been the primary driver The exchanges, institutions and intermediaries have One such deficiency is the poor level of investor legal pro- not been able to a good job.” In China, especially for tections and legal enforcement Stock scandals have been smaller, private entrepreneurs without political connec- all too common Chinese authorities have pursued a well- tions, the situation is very much the same publicised crackdown in this area, which has included a freeze on initial public offerings (IPOs) between October Common weaknesses 2012 and January 2014 Meanwhile, in April 2013, three A number of issues present in both countries greatly dimin- arrests were made in a high-profile bond market scandal ish the attractiveness of their capital markets to investors The March 2013 comments of Zong Qinghou, China’s rich- and companies alike In recent years especially, one such est man, to the Wall Street Journal sum up the attitude problem has been that capital markets are unlikely des- such activity has created in the country “When the ordi- tination for investors looking to profit from Chinese or nary people invest in it, the market should reward them Indian growth Markets around the world all saw substan- with some benefits But it does not,” he says “Speculation tial drops in 2008 and some recovery in 2009 Since then, has totally cheated ordinary investors of any benefits.”4 Global Financial Stability Report, October 2012 “China’s Richest Man Says Capital Markets ‘Suck’”, China Real Time Report, Wall Street Journal, March 2013, http://blogs.wsj.com/ chinarealtime/2013/03/05/capital-markets-suck-says-chinas-richest-man/ Paper tigers: Chinese and Indian capital markets Global Financial Institute India has also had its share of business corruption, as Mr 18 million Indians own equities, and only a small percent- Panchapagesan puts it, “regulators have not been able age of household savings are held in shares, mutual funds, to provide confidence to investors as scandals come up and government debt Nor is this spread across the coun- on a periodic basis.” Even the CEO of the National Stock try: most of the money comes from a single city, Mumbai Exchange agreed in an interview last year that insider trad- Indians looking for better returns than found in banks or ing is “rampant,”5 and in August 2012, a government minis- life insurance choose gold Although this partly reflects the ter revealed that three regulatory officials from the Securi- cultural importance of the metal in the country, it is also ties and Exchange Board of India (SEBI) itself were being very much an investment choice A report by Morgan Stan- investigated for corruption ley in June 2012 found that between 2008 and 2011 the value of gold purchases totalled eleven times the money Such problems are not unique to these two countries, and going into equities and by the latter year it accounted for the authorities are at least taking some steps to address 10% of household savings In June 2013, the finance min- them Nevertheless, cleaning up the markets is absolutely ister publicly encouraged Indians to stop buying so much essential for them to grow, as investors in both countries gold, for good reason: in the fiscal year ending March 2013 are already accustomed to seeking profits elsewhere half of the country’s current account deficit came from the import of $54 bn worth of the metal Since the summer, In this case, though, the particular vehicles vary by coun- Indian gold imports have dropped due to increased gov- try Traditionally, savers in China had little option but low- ernment restrictions and duties, although purchases of paying accounts in state-owned banks In the last decade silver have risen Now the Chinese may have caught the the products available have diversified rapidly but, Simon gold bug as well: lower purchases by Indians and a rapidly Gleave – regional head of financial services, KPMG Asia- growing interest in the metal among Chinese made the lat- Pacific – notes, bank deposits remain popular “Investment ter the world’s largest importers of gold in 2013 sophistication is pretty low,” he adds This is exacerbated by government restrictions on interest rates and capital flows If savers are looking to invest outside of capital markets, Those looking for other choices have tended to put money companies also often prefer to look elsewhere for fund- into real estate – a property bubble is another issue facing ing Bank loans have a number of advantages over other the country – or into trust companies financing Mr Panchapagesan explains, “The Indian banking system is highly relationship driven Firms can get all The latter are private companies that promise high returns kinds of sweet deals In India creditors don’t force firms into often attained via lending to companies where state- bankruptcy If a business gets in trouble, they call the bank owned banks will not As the government has tried to and restructure loan If I am a CEO, why would I go to the reduce lending in recent years by political fiat, such institu- capital markets where I have to be transparent? I go to my tions have filled the gap In January 2014, meanwhile, the bank, where I am not penalised even if I don’t pay.” Further- People’s Bank of China reported that the shadow bank sec- more, large corporate groups often tap into retained earn- tor provided more than 30% of aggregate financing for the ings as such activity arouses little shareholder opposition whole economy, up from 23% a year earlier Worse still, the in India country has seen worrying growth in completely unregulated informal lenders The IMF estimated in October 2012 Similarly in China, large companies often find exchanges an that collectively such loans totalled the equivalent of 6% to unappealing place to seek capital Corporate savings rates 8% of GDP, with interest rates often upwards of 20% in China are already high – for much of the last decade they have been around the same proportion of GDP as house- A majority of household savings in India also goes into hold savings Financing from retained earnings can be an banks, which have traditionally paid little real interest easy option, especially for bigger firms As for those which According to SEBI, out of a population of over 1bn, just need cash, says Mr Gleave, “bank loans are much cheaper “Insider trading: Large corporates should come together to decide on disclosure code, says Ravi Narain, NSE”, Economic Times, 11 March 2013 Paper tigers: Chinese and Indian capital markets Global Financial Institute and easier They don’t see any point in raising capital Why currency, and allows little access by foreigner investors bother with all the costs?” to its capital markets except through a number of limited schemes The government mulls reform, but as Mr Gleave In both China and India, then, poor capital market results explains, the “question is what steps to take to achieve in recent years and ongoing corruption issues are likely to [open markets] and in which order Do you deregulate the continue underpinning business preferences for raising exchange rate or interest rate first? Do you reform equity capital via bank loans, and investor preferences for other markets first? Do you open the currency or float it first? investment vehicles These are fundamental question marks over how you go from quasi state controlled financial markets to free ones.” Differing paths Real progress will have to await officials deciding on a more Each country also has specific issues that will inhibit the comprehensive roadmap Mr Gleave says that government ability of their capital markets to take on a global role officials are currently debating these matters intensely, but For China, this begins with the extent of restriction on he does not expect any detailed decision on them for a exchange activity The shares available in Shanghai and year or two Even then, the result will inevitably be experi- Shenzhen are, for the most part, minority listings of state- mental, as no country has ever taken this path before owned companies or their subsidiaries Mr Gleave notes that this “is something that needs to change before you The problem for Indian companies is not related so much can build bigger equity capital markets The government to market access; the country has more equity market list- is determined not to sell majority stakes.” Meanwhile, ings than any other Rather, Indian markets’ suffer from a growth-oriented small and mid-sized enterprises face marked lack of liquidity despite high national savings rates regulatory hurdles to listing and accessing capital through Of the roughly 5,100 firms listed on the BSE, over 2,000 are these markets described by the exchange as “illiquid” The more active National Stock Exchange of India formally labels about a Another core problem is the restrictions facing inves- quarter of its approximately 1,600 listings the same way tors wishing to directly access Chinese markets China These, though, are the most extreme cases, with many has a highly regulated financial sector, a non-convertible 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 May 2013=100) 110 100 90 80 70 01-May-13 01-Jun-13 Nifty BSE Sensex 01-Jul-13 Rupee vs Dollar Source: The Economist Intelligence Unit (October 2013) 01-Aug-13 01-Sep-13 Paper tigers: Chinese and Indian capital markets Global Financial Institute exchange, the MCX-SX, opened for business in February selling off $5.6bn worth of debt and $1.8bn worth of equi- 2013, and in its initial month saw trading in only 71 of the ties Stock market indices dropped as did the value of the 1,118 listed shares rupee in the face of substantial capital repatriation The sell-off continued at a slower pace in July but in the first In practice, most estimates say that only a few hundred half of August FIIs, although continuing to be net sellers of the largest Indian companies can be described as truly of Indian debt, were putting money back into the coun- liquid Mr Panchagesan notes, “These are the household try’s equities Then, on 16 August, the government, wor- names The others are not going to grow.” Incidents of ried about continued pressure on the rupee, announced stock fraud among thinly traded shares little to enhance limited controls on Indian companies investing abroad their attractiveness As for secondary debt and deriva- This sparked rumours that broader currency controls on tive markets, liquidity is even tighter The country’s major foreign investors in India were under consideration, lead- exchanges even offer incentives to derivative traders to ing to another round of selling: $1.1bn in FII money left use their facilities in a bid to improve liquidity equity markets by the month’s end while FII debt divestment continued apace Perhaps as a result of this need for capital, foreign investment restrictions in India have for some years been far less Government assurances that no such controls were in the than those in China Registered Foreign Institutional Inves- offing; the appointment of Raghuram Rajan – known to be tors (FIIs) can in aggregate buy up to 24% of the equity in in favour of further foreign investment – as governor of the almost every Indian company In practice, the restrictions reserve bank on September; and the latter’s rolling back are even looser, with some 300 companies having special of controls on Indian companies as well as bringing in fur- exemptions allowing FIIs to purchase anywhere from 30% ther liberalisation of certain foreign investment rules has to 100% of capital According to the Reserve Bank of India, changed perceptions From Rajan’s appointment to mid- only five companies currently cannot receive further FII September, net FII debt divestment has slowed to a trickle, investment and 15 have reached their limit of investment and FIIs put $1.1bn back into Indian equities from non-resident Indians or persons of Indian origin Broad lessons from these events should be drawn with Easy access for foreign funds can bring dangers as well caution They certainly show the potential influence of as benefits, in particular because low domestic invest- foreign money – and therefore foreign crises – on Indian ment gives this money outsized influence in Indian capi- capital markets, but last summer may not be represen- tal markets: roughly a third of the daily turnover on the tative An IMF study of FII investment in Indian markets National Stock Exchange is driven by FII activity Events between 2000 and 2011 found little evidence that changes from the summer of 2013 are a notable example of what in foreign investment as a result of long tail events abroad can happen Starting in late May, India’s equity markets affected Indian equity values.6 Moreover, the summer FII and currency saw marked instability [see chart] This has sell off has to be seen in perspective: from January to mid- had little to with the country’s economic fundamentals, September 2013, FIIs were responsible for a net inflow of although a growing current account deficit was already $12.6bn in equities and the outflow on the debt side has affecting confidence in May and continued throughout the been $1.6bn In other words, even where outside condi- period Instead, the announcement late in that month by tions were worrying, foreign investors seem to have been the United States’ Federal Open Market Committee that it prudentially reducing their holdings rather than abandon- planned to taper quantitative easing led nervous foreign ing the country investors to repatriate money in anticipation of possible turmoil on American and world markets Similarly, the speedy imposition of currency controls on Indian companies abroad might suggest that, if highly The majority of such activity was in June, with FIIs taking pressed Indian policy makers may restrict investor freedom Ila Patnaik, Ajay Shah, Nirvikar Singh, “Foreign Investors Under Stress: Evidence from India,” IMF Working Paper WP/13/122, May 2013 10 Paper tigers: Chinese and Indian capital markets Global Financial Institute just when foreigner might need their capital most On the Conclusion other hand, the damage caused by rumours, the rapid Asia’s emerging giants clearly have the potential to estab- reversals of these measures and disowning of controls on lish capital markets of global importance Change is occur- foreigners, and the attendant recovery in equity values and ring at the margins and both countries have taken steps the rupee might equally suggest that the government has to curb corruption India recently appointed a Standing shown a strong commitment to free markets even while Council of Experts on the international competitiveness under stress and seen the rewards of the Indian financial sector, tasked with, among other things, looking at capital market reform In July 2013, the At the very least, though, events of last summer’s events Chinese government nearly doubled the aggregate allow- show that the large proportion of foreign capital in Indian able quota under the Qualified Foreign Institutional Inves- capital markets adds to the risks which potential investors tor (QFII) scheme – the main vehicle for allowing foreign need to consider money to enter Chinese markets – though the new total of $150bn is still relatively small and by early 2014 only The different problems and investor preferences in the roughly a third of that amout had been issued in actual two countries each lead to their own kind of inefficiency QFII licenses Furthermore the government has relaxed China’s large pool of capital is finding ways to fund eco- restrictions that required at least 80% of foreign assets be nomic development outside of traditional capital markets held in fixed income assets This is positive in some ways: a low cost of capital for government has enabled extensive infrastructure develop- However for the capital markets of these countries to ment that might not otherwise have been possible On the become global actors more change will be needed Both other hand, whether capital is being allocated efficiently countries need institutional strengthening so that inves- is far less clear In India, on the other hand, savings are not tors are able to trust companies seeking money on equity translating into substantial liquidity, despite an openness and debt exchanges Doing so holds out the possibility of to foreign investment Money is more likely to go into gold much more efficient capital allocation, and therefore more than into shares 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 11 Disclaimer Global Financial Institute Deutsche Asset & Wealth Management represents the asset management and wealth management activities conducted by Deutsche Bank AG or any of its subsidiaries Clients will be provided Deutsche Asset & Wealth Management products or services by one or more legal entities that will be identified to clients pursuant to the contracts, agreements, 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or services by one or more legal entities... invested Publication and distribution of this document may be subject to restrictions in certain jurisdictions © Deutsche Bank · June 2014 R-34277-1 (3/14) Your input is important to us For enquiries and feedback, please contact: Dr Henning Stein Head of Global Financial Institute henning.stein@db.com ... included Paper tigers: Chinese and Indian capital markets Global Financial Institute Paper tigers: Chinese and Indian capital markets Written by A Global Financial Institute research paper written...2 Paper tigers: Chinese and Indian capital markets Global Financial Institute Introduction to “Global Capital Markets in 2030“ Deutsche Asset & Wealth Management’s Global markets face... Economic Times, 11 March 2013 Paper tigers: Chinese and Indian capital markets Global Financial Institute and easier They don’t see any point in raising capital Why currency, and allows little access