John Morrison (New York) joined KKR in 2012 and is a member of the Client and Partner Group. Mr. Morrison leads KKR’s efforts in insurance company business development and helps provide solutions for KKR’s insurance company asset management clients. Prior to joining KKR, Mr. Morrison spent six years at Pacific Investment Management Company (PIMCO) where he was involved with insurance company asset raising and client coverage in both the U.S. domestic market and the Bermuda market. Previously, he worked at Sanford C. Bernstein and Citigroup Asset Management in research and portfolio management respectively. Mr. Morrison holds an MBA from the University of Chicago Graduate School of Business, and he received an undergraduate degree in Economics from Georgetown University.
A recent trip to India quickly reminded me that the country is bursting with macro-economic potential. Powerful demographics, rising GDP per capita, and a robust services industry all suggest a potentially strong growth and investment profile ahead. On the other hand, inflation, lack of infrastructure investment, high deficits and government dysfunction all have tainted India’s standing and its performance, particularly relative to its potential. In our view, India will not achieve its full potential until it does at least three things better: 1) invest more in infrastructure; 2) tackle its inflation problem and related inefficiencies; and 3) cut subsidies to help balance its fiscal situation and restore proper consumption signals in the consumer market. Unfortunately, there is no quick fix, and given the election in May 2014, there is a high probability that 2013 will be used by politicians to win favor with their constituents. Sentiment surrounding India tends to vacillate between euphoria and despair. Five years ago, India could do no wrong; today, it can do no right. At this low point in sentiment, we think there is a cyclical opportunity to surprise on the upside. Longer-term, we believe a key to success in India centers on investing prudently alongside macro themes that have enough momentum to overcome the inevitable challenges in an emerging market of this size and complexity.
Recently, on a return trip from Asia, I was able to join my colleagues from KKR India in Mumbai to learn a little more about what Mark Twain called the “cradle of the human race.” This was not my first trip, but I have not been in a while, so it was nice to get back and re-immerse myself in one of today’s most complex emerging economic growth stories.
On the one hand, the trip quickly reminded me that India is bursting with macro-economic potential. Powerful demographics, rising GDP per capita, and a robust services industry all suggest a potentially strong growth and investment profile ahead. On the other hand, it is also clear that the country has made things about as difficult as it could for itself in recent years. In particular, inflation, lack of infrastructure investment, high deficits and government dysfunction all have tainted India’s standing and its performance, particularly relative to its potential.
So, where do we go from here in India? Our thoughts are as follows:
We left India with the impression that the economy, its currency, and its public market valuation are all likely to see more gains, as the public sector will likely embrace enough change to further lift risk assets in the near term. In particular, we think that the introduction of a new minister of finance and the announcement of recent reform initiatives on foreign investment are important new positives that need to be considered. That’s the good news.
The bad news is that this country is not expected to achieve its full potential on a sustained basis until it does at least three things better. First, it should invest more in infrastructure – and in particular, additional funds need to come from the government sector, which is hampered by its limited tax revenues. Second, it should tackle its inflation problem, including food costs (which account for a full 50% of CPI)1 and related inefficiencies. Third and finally, it should cut subsidies to help balance its fiscal situation and restore proper consumption signals in the consumer market. Unfortunately, there is no quick fix to any of these three issues, and given that there is an election in May 2014, there is a high probability that 2H13 will be used by politicians to win favor with their constituents.
The country’s demographic dividend – over half of the country’s 1.3 billion people are under the age of 302 – is its most compelling macro feature in our view, and there appear to be several attractive ways to play it, including healthcare, agriculture, financial services, and housing. Importantly, India’s rising middle class is “aspirational,” so brand matters more than in many other countries we routinely visit.
On the other hand, we think that the traditional banking sector in India, particularly state-affiliated players, is likely to lag. There were excessive capital outlays related to the distribution sector in the power business, and current provisioning trends are not representative of the loss ratios we think are inevitable from over-extension of credit in this area.
Overall, India is a microcosm of two mega-trends that we see occurring throughout almost all the emerging markets that we visit. First, similar to China, Turkey, and Brazil, India is still dealing with a consumption “hangover” from the excessive government stimulus that was used to fight off economic slowdown during the Great Recession, and to date, most governments have done little to return policy to normal. Second, as central banks in the developed markets use heavy Quantitative Easing (QE) to try to reflate their economies, we think they are increasingly putting themselves at odds with emerging market leaders like India, Brazil, Turkey, and China, which are constantly battling inflation – and as a result, worry that QE tied to employment in the West could drive unintended inflation in their home markets.
As anyone who has followed Indian investments for some time knows, sentiment surrounding India tends to vacillate between euphoria and despair. Five years ago, India could do no wrong; today, it can do no right. At this low point in sentiment, we actually think there is a cyclical opportunity in India, including both public stocks and government bonds, to surprise on the upside. In addition, we think that the currency, which has been pummeled in recent months, is likely to shift from a liability to an asset, which could materially help the total return equation on India investments.
On the private side, the situation is clearly more complex. The government now understands the need for more and better foreign investment, but success in India will require patience and, probably more importantly, a flexible approach that extends across debt and equity, both public and private markets, and majority and minority stakes. It will also require the expertise to not only buy but also build businesses, given that valuations in India are traditionally expensive relative to other emerging growth countries. Think about it this way: While the country’s risk-free rate is north of eight percent, many of the quality franchises in India trade north of 20 times earnings, already implying either an extremely low cost of capital and/or an extremely high rate of growth (Exhibit 1).
Interestingly, of all the private initiatives we saw during our visit, we believe that the initiative by private equity and other financial intermediaries to develop mezzanine credit instruments, often with some equity upside, is among the more compelling long-term opportunities. True, this market is nascent and a global investor should be willing to take local currency risks, but we left Mumbai with the strong impression that India’s large and growing number of entrepreneurs and businessmen would help to expand this market quickly because they want to tap into a more sophisticated capital markets system that allows them greater choice beyond just traditional equity or bank loan products. And at the smaller end of the market, Indian entrepreneurs just do not have the same access to bank products that their larger peers enjoy. If we are right in our macro view, then investments in the mezzanine credit market may start to appeal to not only local investors but also to global investors, particularly those who want to earn a meaningful recurring coupon and enjoy some equity upside without a lot of the volatility and misconfigurations often associated with traditional Emerging Market (EM) public equity indexes.
Indian Credit Markets May Provide Opportunity in a Low Return World
Source: Based on KKR’s internal analysis, Data as at August 28, 2012. Note: The above reflects the current market views, opinions and expectations of KKR based on its historic experience. Historic market trends are not reliable indicators of actual future market behavior or future performance of any particular investment.
In terms of the overall global macro environment, we still think portfolios should be pro-risk taking, but we acknowledge that our view to own ‘spicy’ credit is now feeling a little long in the tooth after QE3’s implementation. By comparison, we still see significant upside in products that can take advantage of the illiquidity premium caused by Wall Street downsizing. In addition, we see real assets that can provide yield, growth, and inflation hedging as compelling.
There are many reasons to go to India — vibrant people, sophisticated cuisine, beautiful temples and mosques, and unique art. However, infrastructure is clearly not one of them. It is not that I did not know this. I do. Rather, it is that each visit reminds me how much more efficient and productive this country of 1.3 billion people could be if getting from one destination to another was not such a time-consuming adventure. In Mumbai, it starts with long lines at the airports, extends to huge traffic jams, and includes even simple things such as lack of drainage or fire hydrants in many parts of town. In rural areas, insufficient roads and storage prevent basic goods and services like fresh food and clean water from reaching homes in a timely fashion. This headwind is significant as food costs, which are nearly 50% of the total inflation basket in India, remain extremely volatile (Exhibit 41).
Geographic size is actually not the primary source of the infrastructure deficit; in fact, India is only about 33% the size of the United States and 32% the size of China by land area3. Rather, the government just does not spend enough on fixed investment, infrastructure in particular. We believe this is a direct result of its lack of tax revenue prowess.
Among the Asian Tigers, India Stands Tall
Data as at May 11, 2011. Source: United Nations World Population Prospects, Haver. Size of bubble indicates 2012 population.
Unlike China, India is Still Reaping the Benefits of Its Demographic Dividend
Total Population (in millions)
Urban Population (in millions)
Urban Population % Total
Source: United Nations, Department of Economic and Social Affairs, Population Division (2012). World Urbanization Prospects: The 2011 Revision. CD-ROM Edition - Data in digital form (POP/ DB/WUP/Rev.2011).
Despite this shortcoming, India has become an economic force in the global economy: As of 2011, the Indian economy ranked 10th in the world at $1.8 trillion, and its ranking and size are expected to increase to 8th and $2.3 trillion, respectively, by 2014 according to the latest IMF World Economic Outlook report, given its strong growth profile. Driving this growth is a favorable demographic profile (Exhibit 3) that is boosting GDP per capita, as can be seen in Exhibits 4 and 5.
Another key driver is productivity improvements throughout its population. In comparison with China, which has benefitted from a rural to urban migration, we believe India is benefitting from not just urbanization but also from rising productivity among its rural population, who are responsible for an increasing share of the country’s manufacturing and services. This is an important nuance that foreign investors may not fully appreciate. However, as we discuss below in more detail, income inequality remains an issue, as the country clearly needs to do more to promote education at the most basic level.
India has One of the Lowest GDP’s per Capita Worldwide
Data as at October 8, 2012. Source: IMF, Respective National Statistical Departments, Haver.
… and a Lot More Growing to Do
Data as at October 8, 2012. Source: World Bank, IMF, Respective National Statistical Departments, Haver.
From a GDP perspective, what defines India, particularly relative to China, is its heavy reliance on services, including outsourcing and financial services. While many emerging markets have leveraged their low-cost labor force to build out manufacturing first and then services, India has done almost the exact opposite. India’s traditional manufacturing segment was burdened by heavy regulations and a lack of reform, whereas the services sector was allowed to grow quickly and efficiently without cumbersome government intervention/oversight. Though this is a subtle point, we think it is an important one.
As one can see in Exhibit 6, India’s services exports as a percentage of total exports are now larger than those of even the United States. The country is also much more balanced across private consumption, government, private investment, and net exports than many of its large emerging market peers. One can see this in Exhibit 7.
India’s Unique Feature Is Its Service Based Exports Composition
Data as at December 31, 2011. Source: International Monetary Fund, Haver.
Economic Profile Somewhere Between the Extremes of China and Brazil
Data as at December 31, 2011. Source: India Central Statistical Organization, Instituto Brasileiro de Geografia e Estatística, China National Bureau of Statistics, Turkish Statistical Institute, Haver.
What also separates India from many of its peers, though, is that it consistently runs large deficits, both fiscal and current account. In our view, these policies are not only inefficient but they also affect investor perception about the potency of the country’s currency and the security of its government debt. Exacerbating these issues is that, as Exhibit 8 details, India’s public finances have not recovered sufficiently after the deterioration triggered by the Great Recession. Coupled with government corruption charges and the challenges to foreign investment, we believe this has been a drag on India’s GDP growth, which – at around 5.5% – is performing as poorly as it can, given its positive structural labor force growth and productivity improvements (Exhibit 10).
India’s Public Finances Have a Structural Problem
Source: Ministry of Finance, Department of Economic Affairs, Economic Division, “Indian Public Finance Statistics 2011-2012”, http://finmin.nic.in/reports/IPFStat201112.pdf
India’s Government Revenues are Low Relative to Other Countries
Data as at October 8, 2012. Source: IMF WEO estimates for 2012.
Looking ahead, our base view is that Indian GDP does in fact recover in 2013 and beyond. While 9-10% GDP is probably no longer a potential outcome, our research shows that 6.0-6.5% is achievable on a more sustainable basis. Given that we anticipate global growth may average just 3.5-4.0% or so over the next 3-5 years, we think India’s trajectory still looks quite compelling, particularly its consumption-related stories. Key to our thinking is that positive demographics and productivity trends are the secular long-term drivers that should keep Indian GDP growth among the highest in the world. We also believe that the country can reduce its fiscal deficit closer to 6% in the next few years, though we still anticipate inflation running in the high-single-digit range, well above the central bank’s unofficial target of 5%4.
From an investment perspective, India remains somewhat of a macro-economic oxymoron, filled with huge strengths and weaknesses that overlap at times to create both huge opportunities and risks. As discussed below, we believe the key to success in India centers on investing prudently alongside macro themes that have enough momentum to overcome the inevitable challenges in an emerging market with the size and complexity of India.
Growth has Slipped Significantly
Data as at 2Q12. Source: United Nations World Population Prospects, International Labor Organization, Central Statistical Organization, India, Haver.
India Credit Ratings Reflect Macro Concerns About Deficits
S&P’s Issuer Debt Rating
Moody’s Issuer Debt Rating
Fitch Issuer Debt Rating
The above are long term foreign currency debt ratings Data as at November 28. 2012. Source: Bloomberg.
In the following section we drill down on some of the key macro trends in India we think are worthy of investor attention.
Demographics Are the Country’s Crown Jewel.I have been doing macro long enough to acknowledge that I am considered somewhat of a “wonk,” or at least that is what my friends call me when it comes to demographics. I am fine with this nerdy label as I feel strongly that demographic trends drive both economic growth patterns and investment flows. India’s positive demographics are also an important reason to look past some of the issues that surround its massive government inefficiency.
Simply stated, India – like Brazil, Turkey, and Indonesia – is among the global elite in that 50% or more of its population is below the age of 30 (see footnote 2). In fact, the median age of the country is 25.7 years (Exhibit 12), which is about 10 years younger than China (34.9) and the United States (37.0). As a result, as Exhibit 13 shows, growth in India’s working age population from 2010 to 2030 is supposed to be positive 31%. This compares to negative 1.1% for China during the same period. Such strong growth bodes well for GDP per capita, which in our view, could grow as much as 8% per year over the next 4-5 years (Exhibit 14).
Median Age in India is About 10 Years Less Than the US and China
Data as at May 10, 2011. Source: United Nations World Population Prospects, Haver.
Growth in the Working Age Population Between 2010 and 2030 is Expected to Be 31% Versus -1.1% for China
Data as at September 26, 2012. Source: United Nations World Population Prospects, Haver.
GDP Per Capita Tripled Over the Past Decade; We Think There is More Ahead
Data as at October 8, 2012. 2016 estimate per IMF. Source: IMFWEO Oct 2012.
Like its Latin American peer Brazil, India is also experiencing a dramatic shift in the composition of its population. As one can see in Exhibit 15, the poorest part of the population is expected to shrink to “just” 22% of the overall population by 2025 versus 80% in 1995. During this same period, we expect the middle income and upper middle income segments to grow meaningfully. All told, by 2015, India’s middle class should be north of 250 million, and it could reach close to 600 million by 2025 versus a total U.S. population of 350 million at the end of the same period (Exhibit 16). If our estimates are accurate, the middle class may account for 41% of the country’s population by 2025 versus just 14% today5.
The Middle Class in India Is Expected to Be 41% of the Population by 2025…
Defined according to household income in Indian rupees (2000) per day of less than 90 thousand for the Poorest, 90-200 thousand for Poor, 200-500 thousand for Middle Class, 500-1000 thousand for Upper Middle Class, and more than 1000 thousand rupees (2000) per day for the Rich. Data as at May 30, 2007. Source: McKinsey Global Institute, “The Rise of India’s Consumer Market”, May 2007.
…and in Absolute Numbers, India’s Middle Class Population May Soon be Larger Than the Entire U.S. Population
Defined according to household income of 200-500 thousand for the Middle Class and 500-1000 thousand for Upper Middle Class in 2000 Indian rupees per day. Source: McKinsey Global Institute, “The Rise of India’s Consumer Market” May 2007, United Nations World Population Prospects May 2011.
We believe a key reason for the ongoing surge in GDP per capita is the underlying shift in the country’s rural population. While urbanization is usually the biggest trend fueling an increase in GDP per capita, India is unusual (Exhibit 17) in that its urbanization is now taking place mainly in its biggest cities. This trend is quite different from what investors have been witnessing in other large emerging markets like China (Exhibit 18), where urbanization had been more widespread.
The country is also now benefitting from its rural population becoming more productive on its own without having to move into urban areas. We believe two things are happening. First, India is increasingly building manufacturing and service capabilities in its rural areas. Without question, these developments boost productivity and growth relative to traditional agrarian activity. Second, many traditional farmers are becoming more industrious and savvy in the way that they allocate their land and related resources.
Up Until 1988, India was Actually Ahead of China in the Traditional Urbanization Process
Data as at September 20, 2012. Source: The 2012 Revision of the World Population Prospects, Haver.
India’s Urbanization Has Been Concentrated Towards the Largest Cities
Source: United Nations, Department of Economic and Social Affairs, Population Division (2012). World Urbanization Prospects: The 2011 Revision. CD-ROM Edition - Data in digital form (POP/ DB/WUP/Rev.2011).
Given these tailwinds, we think India is in a strong position to enjoy further substantial gains in productivity and GDP per capita because the country’s transformation is still in its early days (Exhibit 19). According to studies done by Nomura Securities and the Federal Reserve Bank of India, a full 57% of the population is still in agricultural related positions today versus just 30% in services and 13% in industry. But from a GDP contribution perspective, agriculture only accounts for 17% of the country’s economy versus a much more robust 56% for services and 27% for industry (Exhibit 20). As this 57% of the population transitions towards more manufacturing and services jobs, we believe it should drive significant GDP growth for the foreseeable future. Also, as the government implements more productive and more efficient pay-for-work programs in rural areas, we believe it too will boost GDP per capita.
India is Enjoying a Sustainable Productivity Boom
Data as at April 19, 2012. Source: Credit Suisse “The Great Indian Equalization”, Ministry of Statistics & Program Implementation.
India Is More Service Based While China Is More Manufacturing Based
Data as at December 31, 2011. Source: India Central Statistical Organization, Instituto Brasileiro de Geografia e Estatística, China National Bureau of Statistics, Haver.
a rising middle class means certain sectors, including housing, education, healthcare, retailing and financial services, should prosper.
During our travel around the emerging markets the last 17 years, our research has shown that there is a multiplier effect on consumption as GDP per capita reaches $1,000 and above: Demand for branded consumables typically soars, healthcare preferences change, and home ownership becomes a priority (Exhibit 23). This pattern is significant for India, which is now just crossing the $1,000 threshold, and it seemed clear from our visit with executives across a variety of industries that they are seeing a transformational change in consumer behavior.
It is also significant because, given the sheer size of India, the dollar amount of consumption created by its rising middle class is unprecedented. As one can see in Exhibits 21 and 22, India will likely be the third-largest consumer market in the world by 2030 as measured in PPP dollars and the largest by 2050 (according to the OECD). This makes sense to us as the country has over one billion people and according to the IMF, nominal GDP is still growing by 12% or more annually.
India’s Middle Class Will Grow Sharply Over the Next 40 Years
Middle Class Population (in millions)
Source: Centennial Group projections 2011, OECD Asia 2050 Realizing the Asian Century.
…And Should House the World’s Biggest Consumption Market
Top 10 Countries: Middle Class Consumption (Trillions of 2005 PPP dollars)
Data as at January 31, 2010. PPP = purchasing power parity. Source: Brookings Institution, OECD Development Centre Working Paper No.285 DEV/DOC(2010)2.
As part of our effort to learn more about consumption trends, we spent quite a bit of time with leading executives from Quick Service Restaurant (QSR) companies, including international vendors like McDonald’s as well as some of the local players. Without question, it seems clear from all our conversations that eating habits, including location and food preferences, are changing rapidly. In major cities like Mumbai, adults are now eating out 30-35% of the time, and more importantly, given the tight housing conditions, coffee houses and restaurants are becoming important places for social gatherings, particularly among India’s youth6. It also seemed clear from these meetings that branding matters. As one real estate executive said, “India’s middle class is aspirational, and it is both contagious and competitive.”
As the Income Brackets Evolve, So Too Will Consumption Patterns
Data as at May 2007. Source: McKinsey Global Institute, “The Rise of India’s Consumer Market”.
Healthcare is another sector that we think holds a lot of potential for private investors on a long-term basis. At the moment, the government is trying to improve upon its status as one of the lowest public allocators to healthcare services. Today, the healthcare industry is a $66B industry, of which 29% is public and 71% is private spending7. However, the industry is expected to reach US$280B by 2020, implying an annualized growth rate of 15.5%8.
Driving this strong growth are initiatives to attack both inefficiencies and deficiencies. According to the World Bank, there are just 9 hospital beds and 7 doctors per 10,000 people. As Exhibit 24 highlights, that is well below the figures for China and Brazil. If there is good news, it is that some of the shortfall in public spending is being offset by more efficient private spending, particularly by the growing middle and upper income segments. As noted above, private spending on healthcare is already twice the level of public spending (Exhibit 25). However, as the chart also shows, overall aggregate spending on healthcare in India is just too low, and as the middle income consumer continues to flourish, we expect to see major growth in basic services like clinics, wellness facilities, and private hospitals, similar to what we see in other emerging markets like Brazil.
HealthCare Facilities and Services are Lacking
Hospital beds as of 2009, India latest as of 2005. Physicians as of 2010. Source: World Bank, Haver.
India’s HealthCare Spending is Among the Lowest in Emerging Markets
Education is another area that deserves both private and public sector attention if India is to fulfill its potential as an economic powerhouse, in our view. Though India’s primary resource is its outsized and youthful population, the current level of skill, education, and training is low relative to many other countries. Our belief is that India should mimic its peers in Latin America and spend much more heavily on basic education rather than on university level programs. Without question, we believe this type of initiative has been key to greater income equality we now see first-hand in countries like Brazil.
On the public side, we estimate that total spending on education is just 3% of GDP versus 5.4% in the United States and 5.7% in Brazil (Exhibit 27). Given such inadequate spending by the government, productivity is being hampered as more than one-third of adults in India remain illiterate (Exhibit 26). Importantly, thus far the private sector is not making up the difference, with the private education market currently estimated at just 2% of GDP or roughly US$39 billion.
Looking ahead, estimates are for the private education market to grow to at least US$64 billion over the next five years (10.2% CAGR9). Probably more important, though, is that many of the private initiatives being introduced tend to be more focused on vocational training and technical education, not the elementary or primary education10 that we think is so desperately needed by the country.
One-Third of the Indian Population is Illiterate
Literacy as at 2010 or latest available, Pupil-to-teacher ratio as at 2010. Source: World Bank, UIS UNESCO, Haver.
Public Spending on Education is Just 3% of GDP
Data as at December 31, 2009, Vietnam as of 2008, India as of 2006. Source: World Bank, Haver.
Within financial services, there is also significant opportunity for investors. In particular, there is a reason that certain leading non-banking financial services companies have consistently delivered solid returns to shareholders: They have succeeded by focusing on one of the biggest opportunities in India—credit extension, including mortgages, to a rising middle class. As of the latest census data (2011), listed total households were just 276 million, which pales in comparison to the population of 1.24 billion people (see footnote 2). I am no math major, but this equates to roughly 4.5 persons per house versus 2.7 persons in the U.S., 3.0 in China, and 3.3 in Brazil (Exhibit 28). We believe as this gap narrows, it should be constructive for all housing-related activities. Moreover, our research shows that only 153 million or 55% of homes are made of concrete (Exhibit 30), which is the preferred building material for India’s climate conditions. As individuals continue their steady migration towards bigger and better homes, there is a significant opportunity for financial services companies to provide access to mortgage and other lending products (Exhibit 29).
India Needs a Lot More Homes
Data as at September 22, 2012. Source: Report of the Technical Group on Urban Housing Shortage (TG-12) (2012-17) dated September 22, 2012, China National Bureau of Statistics average persons per household in 2011, and Brazil 2010 Population Census Summary www.censo2010.ibge.gov.br
Mortgage Penetration is Low
Data as at December 31, 2010. Source: HDFC estimates for India, European Mortgage Federation.
To date, most housing activity in India has been in urban areas, which is consistent with what we see in other emerging markets. Between 2001 and 2011, India’s urban housing stock grew at 4.3%, outpacing urban population growth of 2.6% by 170bp (Exhibit 31). Despite the rapid growth in urban housing throughout India, the ratio of people to homes is 4.8 to 1 in cities, which is just slightly above the ratio for rural areas at 4.411.
We also take comfort that leverage levels and consumer profiles appear reasonable in India. Using (Housing Development Finance Corporation (HDFC) as a proxy for the market, we learned that the average home price was around 2.1 million rupees (around $40,000), with an after-interest cost of around 10.25% gross and 6.4% net after certain deductions as percent of income12. Moreover, HDFC’s loan to value ratios are around 65%, and most customers are 33-36 years old, typically older and more settled than first-time buyers in other emerging markets we visit.
Only 55% of Houses in India are Made of Concrete
Data as at September 22, 2012. Source: Report of the Technical Group on Urban Housing Shortage (TG-12) (2012-17).
India’s Urban Housing Stock is Growing at a Rapid Clip
Data as at September 22, 2012. Source: Report of the Technical Group on Urban Housing Shortage (TG-12) (2012-17) dated September 22, 2012.
As we mentioned earlier, another area within financial services where we are long-term positive is the growing mezzanine and nascent high-yield market. Local and developed market investors who want exposure to India and its currency can buy high-quality credit with yields that often dwarf what is available in the U.S. and Europe after Quantitative Easing III (QE3) and Outright Monetary Transactions (OMT). Also, we believe the duration of these investments leaves investors less susceptible to the exit costs of volatile stock market indices. At the same time, there is an increasing supply of credit instruments from small but fast-growing Indian companies that either 1) want access to capital outside bank loans or the sale of equity or 2) just can’t get access to capital. These instruments are an innovative way to access financing at reasonable terms, expand the investor base, and create a more efficient capital structure (Exhibit 32 and 33).
INR Bond Issuance Volumes Moderated In 2011 on Account of a High Interest Rate Environment
Source: Citigroup report 2011: A Year of Contrasting Halves, January 2012.
Non-Traditional Lenders Are Now Taking Market Share From Traditional Financial Intermediaries
Source: Citigroup report 2011: A Year of Contrasting Halves, January 2012.
On the wholesale side of the financial services industry, we have much greater reservations. It appears that many banks lent far too much to power distribution companies and now are paying the price. The blackout in July 2012 marked the largest power outage in the world to date, affecting more than 600 million people or 9% of the world’s population. It also highlighted the severity of India’s infrastructure problems and the shortage of capital. The power companies ran out of money because they were forced to sell power at prices materially below their costs of production,13 which is leading to higher loan losses (Exhibit 34).
Not surprisingly, bank loans to the power sector are now being called into question, and as a result, liquidity has dried up. This situation is significant as existing loans to the power sector are 8% of total credit in India (Exhibit 35). In the latest turn of events, a restructuring was announced in September under which 50% of short-term loans to the sector will be taken over by state governments and converted to bonds, while the other half will be restructured by banks. In our view, the bigger picture issue is that the power sector’s misfortunes are among a series of missteps (including telecom and airlines) that are hampering India’s effort to fix the infrastructure issues that are holding back economic growth.
Non-Performing Asset Ratios Driven by Restructured Loans
Data as at March 31, 2012. Source: Reserve Bank of India.
The Risks of Bad Loans Are Spreading Beyond Power Towards the Infrastructure Sector
Data as at August 31, 2012. Source: CLSA Asia-Pacific Markets, RBI.
As I think about the Indian economy, I am reminded of a famous quote by William A. Foster that “Quality is never an accident; it is always the result of high intention, sincere effort, intelligent direction, and skillful execution; it represents the wise choice of many alternatives.” We would argue that the Indian government has not made “the wise choice of many alternatives” when it comes to macro-economic policy of late. In particular, the government has spent too much time and money encouraging consumption, and it now runs a central government fiscal deficit of 8.7%. This is not ‘new’ news, as India’s fiscal deficit exceeded 7% in 12 of the last 15 years14.
In our view, India needs to tackle at least four major problems in order to structurally “turn the corner.” First, the country needs to invest more on infrastructure at the expense of consumption. In particular, government spending in this area has actually fallen to 25% of total capital spending in 2010 from 51% in 1980 (Exhibit 36). The absence of government investment in key areas like infrastructure and public transportation has led to huge economic inefficiencies that are wreaking havoc in areas like agriculture and exports.
Reliance on Private Investment has Grown
Data as at December 31, 2010. Source: India Central Statistical Organization, Haver.
India Needs a Lot More Capital to Catch Up with China and Brazil
Data as at September 29, 2012. Source: IMF WEO, Haver.
A key metric we follow is investment per capita. As Exhibit 37 shows, India invests only $478 per capita, less than one-fifth of China’s investment spending and barely 6% of US spending. Recent trends are even more discouraging. As one can see in Exhibits 38 & 39, private investment growth was negative in 2Q12, and private and government project delays have surged year-to-date. Prime Minister Manmohan Singh recently acknowledged that “supply bottlenecks which constrain growth” need to be removed,15 but as Exhibit 39 shows, the government’s track record of following through on such claims remains unimpressive.
Post the Financial Crisis Private Investment Has Fallen Significantly
Data as at 2Q12. Source: India Central Statistical Organization, Haver.
Freeing the Project Pipeline Could Revive Capex and Encourage Much Needed FDI
Data as at September 30, 2012. Source: Citi Research, CMIE.
Second, India needs to address its inflation problem, which is running near 10% (Exhibit 40). As one travels around the country talking to local businessmen and women, it becomes apparent that high inflation is not only destroying purchasing power but is also creating an uncertainty premium that makes capital allocation difficult. Of all the inflation concerns that should be considered, we think the government should focus first on food costs, which are approximately 50% of CPI (Exhibit 41). In addition, the government needs to rein in ‘temporary’ social programs that were implemented at the end of the Great Recession and now appear to be more permanent in nature.
Inflation Has Declined But Still Remains Uncomfortably High, Keeping Policy Rates High
Data as at September 30, 2012. Source: Ministry of Commerce and Industry, Ministry of Statistics& Programme Implementation, Reserve Bank of India, Haver.
Inflation Is Very Sensitive to Food Prices
Data as at April 18, 2012. Source: Reserve Bank of India, Ministry of Statistics& Programme Implementation, Haver.
Third, the government needs to raise taxes and cut expenses, including subsidies. In particular, after granting subsidies during the Great Recession to stoke growth, the government failed to roll these incentives back in 2010. As a result, subsidies as a percentage of GDP jumped to 2.4% this year from 1.4% in 2007 and 2008, which has had a clear impact on the country’s deficits and inflation rate16.
We acknowledge that India has been successful running large deficits for decades. But that was then. Today, as the world becomes more interconnected, imbalances matter even more, and we view the recent threat of a ratings downgrade as an early warning that greater discipline is required by both politicians and central bankers. Beyond the potential ratings downgrade, the currency recently suffered a 20%+ fall before recovering. That type of performance is extremely damaging to the foreign investors who cover domestic shortfalls in funding with their capital. As Exhibit 44 shows, this trend has not been lost on the investment community, as India is increasingly covering its deficits through ‘hot’ money flows instead of longer-term foreign direct investment (FDI).
India Runs a Trade Deficit…
Data as at 2Q2012. Source: India Central Statistical Organization, Haver.
…Primarily Due to the Thirst for Oil
Data as at 2Q2012. Source: India Central Statistical Organization, Haver.
Unlike the Recent Past, Funding is No Longer Coming Through Direct Investment
Data as at 2Q2012. Source: India Central Statistical Organization, Haver.
Fourth, the government needs to make India an easier place to do business. Critics clamor that India is a “democracy that has run amok.” We think that is an overstatement, but the country needs to push a more pro-business agenda and build a more predictable environment. See below for details, but according to the World Bank’s “Doing Business 2012” report, India ranks 132 out of 183 countries in terms of ease of doing business (Exhibit 45). If there is good news, it is that tax-paying, regulated businesses do not face quite the same headwinds in India that they face in some other high-profile emerging markets, including China, Mexico, and Brazil. As a result, the drag from the shadow economy is much smaller (Exhibit 46).
The Regulatory Environment Makes Doing Business in India Difficult
Ease of Doing Business
Ease in Starting a Business (1=Easy)
Days to Start a Business
Time to Prepare Taxes (Hours)
Ease in Getting Credit (1=Easy)
Protecting Investors Rank (1=Strong)
Ease in Getting Electricity (1=Easy)
Ease of Enforcing Contracts (1=Easy)
Years to Resolve Insolvency
Corruption (0=More Corrupt)
Data as at December 31, 2011. Source: The World Bank, “Doing Business 2012” ISBN: 978-0-8213-8833-4, Transparency International’s Corruption Perceptions Index where 10-Less Corrupt 0-More Corrupt.
Despite a Low GDP Per Capita, India’s Shadow Economy is Relatively Small
Shadow economy for year 2007 from The World Bank Development Research Group: Poverty and Inequality Team & Europe and Central Asia Region Human Development Economics Unit July 2010. GDP per capita for the year 2011 as per IMF WEO Oct 2012.
Valuation Discipline Is Required In India
What often makes India a challenging market is that valuations, particularly on the private side, look expensive, especially relative to some of its emerging market brethren. Investors have consistently been willing to pay a premium to gain access to India’s fast-growing and dynamic economy, particularly its consumer sector. One can see this in Exhibit 47. Also, as we show in Exhibit 48 below, much of India’s equity market capitalization is in high-quality private sector companies that warrant higher valuations than state-run companies in countries like China.
India Has Generally Traded at a Valuation Premium of 10-25% Above Emerging Markets
Data as at October 31, 2012. Source: Factset Aggregates.
Unlike China, India’s Equity Market is More Diverse and Less Dominated by State Owned Entities
Sector % Market Cap
India BSE 500 Index
China HSCEI Index
Data as at September 30, 2012. Source: Bloomberg.
In recent months and on the heels of a lot of confusion surrounding government policy and appetite for foreign investment, India’s market has returned to more attractive levels. As seen in Exhibit 49, equity valuations are now back to more modest levels relative to history. However, as Exhibit 50 shows, other emerging markets trade even more attractively than India.
Public Equity Valuation Below Average…
Data as at October 31, 2012. Source: Factset.
…But Not the Cheapest Emerging Market Out There
NTM Forward Price-to-Earnings Ratio
NTM = next twelve months. Data as at October 31, 2012. Source: Factset Aggregates.
As we look ahead, our base view is that equity investors need to be somewhat tactical when it comes to India. Near-term, we think that the recent sell-off has made shares of many Indian companies much more attractive. That said, because Indian equities embed such strong long-term growth characteristics, an investor has to have greater confidence than we do in government reform to believe that the multiple has bottomed and is headed up on a consistent basis. Rather, our research shows that, while we have likely reached a bottom, we still expect India’s trading multiple to vacillate somewhere between 12-14x over the next few years as the country works through some of its macro-economic headwinds.
Weak Equity Market Performance, High Inflation, and High Real GDP Have Brought Market Cap as % GDP Roughly Inline with Other Emerging Markets
Data as at July 10, 2012. Source: World Bank, Haver.
India has the Largest Number of Domestically Listed Companies
Number of Listed Domestic Companies
Data as at April 18, 2012. Source: World Development Indicators, Standard & Poor’s, Global Stock Markets Factbook and supplemental S&P data. Listed domestic companies are the domestically incorporated companies listed on the country’s stock exchanges at the end of the year. This indicator does not include investment companies, mutual funds, or other collective investment vehicles.
Importantly, our base view is that the current reform momentum could get sidelined next year in the run-up to the 2014 elections as government officials cater to their political base in the form of increased benefits and social welfare. If we are right, then we think the bounce we are predicting in the near term will start to moderate. Thereafter, it will not be until sometime in 2014 that the government can initiate the sustained reforms that we think are required for long-term growth and multiple expansion.
There is little question that India is a nation full of macro potential. In particular, India aligns well with our preferences for positive demographic trends and a rising middle-class consumer. Moreover, given that GDP growth is directly linked to labor force growth and productivity, India will likely grow materially faster than the rest of the world for at least the next decade. This tailwind, we believe, is not up for debate.
What is in question, however, is whether India’s public and private sectors can turn this robust growth and expanding GDP per capita into strong investment returns for investors. India needs better infrastructure, lower inflation, and fewer government handouts, including subsidies. While reining in these excesses may slow growth in the near term, it would place the country on a much more stable footing for the long term. In addition, the country needs to do more on the education front to both improve overall income levels and ensure that they do not become too concentrated at the high end. Finally, the country needs to reduce the bureaucracy that is the source of its reputation as a “democracy run amok.”
Looking ahead, we think that investors will continue to enjoy some solid reform initiatives over the next 3-6 months before the politicians again focus on pleasing their constituents ahead of the 2014 elections. If our view is accurate, then we think that any weakness in 2013 could create opportunity for long-term investors to consider deploying capital in the sectors we view as attractive for the long term: consumer, healthcare, logistics, real estate, retailing, education and financial services. In addition, we see the development of a more extensive credit market, including the burgeoning mezzanine market, as a significant opportunity.
India: Positive Demographics, High Growth; But Twin Deficits, High Public Debt, High Interest Rates, High Inflation, and Not Easy to Do Business (Ranked by Working Age Population Growth, 2030 vs. 2010)
GDP Composition per respective government statistical agencies for the year 2011 or latest available. Shadow economy as per World Bank Development Research Group Poverty and Inequality Team & Europe and Central Asia Region Human Development Economics Unit as of 2007. 2013 estimates for government finances, current account % GDP, real GDP, GDP per capita, and Inflation as per IMF WEO Oct 8, 2012. Population growth as per United Nations World Population Prospects September 26, 2012 update. Ease of Doing Business Index (1=Most Business-Friendly Regulations) for the year 2011 per “Doing Business 2012”. External debt-to-GDP as of 2010 per World Bank. Private Credit % GDP as of 2011 per World Bank.
2Total population is estimated at 1258 million and the percent of India’s population below the age of 30 for the year 2012 is 57% as of September 26, 2012. Source: United Nations World Population Prospects.
3As of September 20, 2011. Source: World Bank World Development Indicators.
4Global Source Partners Monthly Report by Ajay Shah, India: Uphill Battles dated November 28, 2012.
5Interpolated to 2011. Source: McKinsey Global Institute “The ‘Bird of Gold’: The Rise of India’s Consumer Market, May 2007”.
6Source: “Will Global Coffee Giant Starbucks Conquer India”, Time World, January 31, 2012.
7Source: World Health Organization, Global Health Expenditure Database, data for year 2010 retrieved on October 5, 2012.
8Source: India Brand Equity Foundation (IBEF) “Healthcare, November 2012” www.ibef.org, KPMG “Emerging trends in healthcare” dated February 17, 2011.
9Source: KKR GMAA estimates based on education and consumption data from the Indian National Sample Survey Organization Consumer Expenditure Survey, which puts private education expenditure at roughly 2% of GDP, and IMF WEO Oct 2012 nominal GDP estimates.
10The Right of Children to Free and Compulsory Education Act or Right to Education Act was passed on 4 August 2009 and put into force on 1 April 2010, giving every child, aged six to fourteen, the right to education. Under this act, schools must allocate a minimum of 25% of seats for free and compulsory elementary education. Source: Government of India, Ministry of Human Resource Development http://mhrd.gov.in/policy_initiatives, Right to Education, http://www.rteindia.com/
11Source: Report of the Technical Group on Urban Housing Shortage (TG-12) (2012-17) dated Sep 22, 2012.
15“The most important area for immediate action is to speed up the pace of implementation of infrastructure projects. This is critical for removing supply bottlenecks which constrain growth in other sectors”, Prime Minister Manmohan Singh. Source: The Wall Street Journal, September 15, 2012.
16Citigroup, Budget documents as at April 30, 2012.
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Steve Schepps (New York) joined KKR Capstone in 2009. Mr. Schepps leads KKR's Global Cross-Portfolio Indirect Procurement Program. In this role he leverages the combined portfolio spend in commonly purchased indirect (non-inventory) expense areas in order to reduce the costs paid by portfolio companies. Prior to joining KKR, he was a Director of Consulting Services at CGI Inc, and a Vice President at Silver Oak Partners, Inc. Previously, he was a strategy consultant at the Mitchell Madison Group and served as a Captain and Senior Pilot in the U.S. Air Force.
Jeff Rowbottom (New York) joined KKR in 2009 and is a Managing Director and head of KKR Capital Markets for the Americas. At KKR, he has played a significant role in arranging financings for portfolio companies including First Data, TASC, Del Monte, Academy Sports + Outdoor, Samson Resources, NXP, Toys R Us and US Foods. Prior to joining KKR he was a Managing Director and head of U.S. High Yield Capital Markets at Barclays Capital. Previously, he was a senior member of the Goldman Sachs High Yield Syndicate desk. Jeff received a B.S. from the State University of New York at Albany and an M.B.A. from Columbia University. He is active in non-profit organizations including Autism Speaks and is a board member of the Melanoma Research Alliance. He is active in non-profit organizations including Autism Speaks and is a board member of the Melanoma Research Alliance.
Mattia Caprioli (London) joined KKR in 2001 and is the head of the Services industry team in Europe within KKR’s Private Equity platform. He has played a significant role in many investments including Legrand, Toys 'R' Us, FL Selenia, PagesJaunes, AVR, Van Gansewinkel, Alliance Boots, Inaer, and Bond Aviation. Currently, Mr. Caprioli serves on the boards of directors of Alliance Boots, Legrand, and Inaer. Prior to joining KKR, Mr.
Elizabeth Hammond (New York) joined KKR’s Client and Partner Group in 2009. Prior to joining KKR, she was a Director at Citi Alternative Investments where she was involved in Consultant Relations and had responsibility for managing the RFP team. Ms. Hammond has over 15 years of experience working in asset management sales and marketing. Her prior experience includes Siguler Guff, Deutsche Asset Management and Lynch & Mayer. She holds a B.S. from the College of Charleston and an M.B.A. from Fordham University.
Heramb R. Hajarnavis (Mumbai) joined KKR in 2010 and is responsible for the development of KKR’s private equity efforts in India. Prior to joining KKR, Mr. Hajarnavis was a Managing Director and co-head of the Principal Investment Area in India for Goldman, Sachs & Co. where he was involved in the execution of numerous investments including Mahindra & Mahindra, Sudhir Gensets and TVS Logistics. Mr.
Gary H. Jacobs (New York) joined KKR in 2008 to provide risk management, derivative structuring and trading insight to the Capital Markets business. Since 2009, he has been focused exclusively on capital management within Treasury. Prior to joining KKR, Mr. Jacobs was a Managing Director at Citigroup within the Equities division where he spent 16 years trading options, derivatives, convertibles and cash equities. Mr. Jacobs received a B.A. from Columbia College and an M.B.A. from New York University.
Johannes P. Huth (London) joined KKR in 1999 and is a Member of KKR and Individual Partner of Kohlberg Kravis Roberts & Co Partners LLP. Mr Huth is responsible for KKR's operations in Europe, the Middle East and Africa. He has participated in investments including Wincor Nixdorf, Zumtobel, Demag Holdings, MTU Aero Engines, DSD, Selenia, Kion Group, NXP Semiconductors, Pro7 Sat1, BMG, Wild, and Württembergische Metallwarenfabrik AG (WMF).
Jason Muenzen (New York) joined KKR in 2011 and is a member of KKR Asset Management’s Equity Strategies team. Prior to joining KKR, Mr. Muenzen was a Vice President in Goldman Sachs Principal Strategies (GSPS), where he traded products across the capital structure. Prior to Goldman, Sachs & Co., Mr. Muenzen started his career at Deutsche Bank in the Operations Training Program, working primarily in the Operations Risk Department. Mr. Muenzen received his B.S., magna cum laude, from Ithaca College, and his M.B.A. from the Leonard N.