If there’s one thing Raamdeo Agrawal has learned over 22 years as an investor, it’s that the stock markets “always come up with a story every four or five years.” Soya processing and leasing companies caught the Indian stock markets’ imagination in the early 1990s. Then came the Y2K rush and the dot-com boom in the late 1990s, followed by yet another binge on IT software stocks, he recalled.

Agrawal, co-founder of Motilal Oswal Securities, an investment services firm in Mumbai, made money by investing in all those boom phases, even if he didn’t initially understand “the difference between hardware and software.” At the 13th Wharton India Economic Forum in Philadelphia in March, he participated in a panel discussion on “Rational Exuberance in the Indian Capital Markets.”

Agrawal was more bullish about the outlook for the Indian capital markets than his fellow panelists. Seth Freeman, CEO and chief investment officer at EM Capital Management of San Francisco, a hedge fund that invests in India, among other markets, is also a long-term bull on India. But Sandeep Naik, principal at Apax Partners India Advisers, a private equity fund with global headquarters in London, noted he was worried about capital formation trends and India’s ability to sustain a targeted GDP growth rate of 7% to 8.5%.

Senthil Chengalvarayan, president and group editorial director, business media, at Television 18 in India and the discussion’s moderator, pointed out that share values in the Indian stock markets are trading at between nine and 11 times earnings these days, compared with 22 times a year ago. “When do you see the market turning?” Chengalvarayan asked, noting the coming Indian general elections and the fact that foreign investors have taken a double whammy in seeing both their Indian investments and the rupee lose value. “Foreign investors have pulled out about US$16 billion in the last 17 months from India,” and it’s unclear whether that trend will continue, he said.

A Hedging Opportunity

Time was when global investors looked at developing markets like India to hedge some of their investments. “That myth has clearly been shattered,” Naik said, referring to the erosion in stock values over the past year. He noted some key factors that contributed to that trend: “huge redemptions” by foreign institutional investors causing a net outflow of US$15 billion last year (compared with a net inflow of US$17.4 billion in 2007); a 25% drop in domestic equity issuance; and a 95% drop in foreign issues by Indian companies.

India needs to build upon its recent successes to sustain its growth story, according to Naik. He listed its accomplishments in recent years: household savings have climbed to between 23% and 24% of GDP and stayed at that level; corporate savings have doubled from 4% to 8%; the government’s savings rate has moved from negative territory to reach 3% of GDP; and foreign institutional investments have grown 40% in the past six years to account for 6% of GDP.

Even though foreign investments have slowed and the country’s external debt position has worsened a bit, leverage hasn’t really been an issue, said Dominic Barton, chairman of McKinsey’s Asia-Pacific practice and the firm’s incoming global managing director, during a keynote address earlier at the conference. “When you look at the soundness of the banking system, India stands out there; I used to criticize the Reserve Bank of India for not being as open or aggressive as the Chinese, but in some ways, that conservatism has helped the country.”

While lower foreign investments have had some negative impact, especially on infrastructure, broad averages aren’t too meaningful, said Barton: “There are large pockets of growth. If the Bharti [telecommunications company] executives were here, [they would tell you they] have been having one of the best years ever.” Sectors that might be somewhat vulnerable to the crisis include textiles, chemicals and real estate, but it varies by institution, he added.

Resilient Amid Global Doom

Barton outlined possible scenarios on how the global economic crisis will play out. At one extreme, the economy could rebound right away, within the year; at the other extreme is a long freeze, where the recession might last more than five years. “Most people think it’s going to be somewhere in between — that the global economy will be battered, yet resilient. My own view is that the recovery will be somewhere around the end of 2010, but again, specific sectors might have different views. Even in the worst scenarios, we see growth for India.” Structurally, compared to some other Asian countries, India is better positioned to survive the crisis, said Barton.

However, the country faces formidable challenges if it has to sustain a GDP growth rate of 7%, according to Naik. The country needs about US$1.3 trillion in capital formation to reach that goal, he said, quoting a recent McKinsey study. Assuming household savings stay constant, corporate savings decline, and government spending and capital inflows stay at current levels, India faces a net deficit of about US$200 billion to achieve a 7% GDP growth. “If you knock out that US$200 billion, you are looking at a 5.5% GDP growth rate,” Naik said. “If household savings come down and corporate savings fall further, you are looking at a 4.6% to 4.7% GDP growth rate.”

This less optimistic scenario could become a reality because of what Naik views as the government’s “populist culture of waivers and subsidies and increasing expenditure” in the current election year. Government expenditure has gone up 16% over the past year, and aggravating that is an 8% decline in government receipts year over year. As a result, the public deficit will end up at 11% of GDP, he predicted.

Darkening that outlook are widening bond spreads and a reluctance among private banks to lend, Naik added. “The SMEs (small and medium enterprises), which employ close to 25 million people and constitute 30% of credit, are not getting loans because banks can get a bigger spread lending to bigger corporations.”

In an effort to make credit available to the SMEs, the government is forcing public sector banks to lend, but that will translate into higher nonperforming assets, Naik warned. Public sector banks’ nonperforming assets were 2.4% for all of 2008, but grew to 4.4% last December. “Unlike in the U.S., where the financial sector distress eats into the real sector, in India the real sector issues are creeping into the financial sector,” Naik noted. “A near-term possibility is the government may have to bail out some banks.”

‘Savings Are Just Piling Up’

Agrawal read the numbers differently. Consumer credit in India has yet to take off from current levels of 13% of overall credit, the bulk of which is in the form of home mortgages. “There is no ‘retail’ credit … in India; credit card loans are 0.3% to 0.4% of GDP. All the savings are just piling up.” The country’s savings rate has the potential to increase to between 40% and 45% of GDP, which could support 9% to 10% of sustained growth, he added. “There could be some challenges because of the sudden outflows of global capital for some time…. But after that, I can’t see any challenge for the funding of India’s [GDP] growth target of 8% to 8.5%.”

Barton noted that it was important to think about context in the midst of the current economic storm. India, he said, had been a dominant economy in the world during the last 2,000 years. What happened in the last 200 years was “an aberration,” and the country is “on a long-term trend moving back to where it was before.” In the next decade, the increase in India’s middle class consumer population will be huge, he predicted, adding that the country was already in the top three markets in the world for numerous products. “That population will not go away, even if the rate of growth slows. If you’re any kind of consumer retailer and you’re not deadly serious about what’s going on in India, you’re missing the boat and will be [facing] some severe difficulty,” said Barton. He also noted that the number of youth in India would grow exponentially: “That demographic alone is going to drive a lot of the success in the economy over time.”

Although the world as a whole may be worrying about being overleveraged, India “still has a long way to go,” said Barton. “The financial system’s depth has been increasing, and that’s very important for economic growth — providing credit for consumers. Today, four of the top 10 banks in terms of market capitalization are Chinese. You will see one or two Indian companies on [that list] in the next several years. And the opportunity for investment in infrastructure, in terms of roads, power and so forth is huge, but there is a financing gap that needs to be closed. That’s going to be an important imperative for the government to think through, but if there’s ever a time to double down on the infrastructure, it’s now.”

The Next Trillion Dollar Opportunity

Agrawal, in fact, sees on the horizon the “next trillion dollar opportunity for India.” India took a full 30 years — from 1977 to 2007 — to grow from a US$100 billion economy to US$1 trillion. “The next trillion is going to happen in the next five to six years,” he said. There is “no magic here,” he added; India can achieve that goal if it grows at a compounded annual rate of 8% to 9% and its currency stays stable.

The implication of this GDP growth for stock values is that discretionary spending would increase and some businesses (outside of basic industries) “would see exponential growth,” according to Agrawal. “The markets are not seeing those opportunities in the current down draft,” he said, making a case to buy now: “Pessimism produces the best prices.”

Naik broadly agreed with Agrawal and said he is a “long-term bull on India,” but felt the recipe to get its capital markets out of the current depressed state is “a mix of government intervention, an increase in domestic consumption among the middle class, and a change in the way banks look at [lending in] the current situation.”

Naik felt the current economic climate offers India’s corporate sector opportunities to clean up its act: Companies need to focus on their product portfolios to emphasize value for money, divest noncore assets, cut costs with lean technologies, restructure balance sheets to cut debt and free up working capital, and possibly consider consolidation in some cases. Agrawal agreed: “In this downturn, the only option for companies is to cut costs.”

All the same, Naik felt the scope is limited for “negative surprises in India,” even as he suspected that a few more companies exist out there “that are riding the tiger.” That was a thinly veiled reference to the recent case of India’s Satyam Computers, whose founder and CEO Ramalinga Raju confessed to orchestrating a billion-dollar siphoning of funds over several years; he is currently in jail, awaiting trial. Naik said “the good news” in the Satyam episode is that many companies are setting up or looking into forming corporate governance committees. (See: “Scandal at Satyam: Truth, Lies and Corporate Governance“)

Calling Foreign Investors

Meanwhile, Agrawal suggested a possible silver bullet to kick-start the stock markets: “We should send request forms to all the FIIs (foreign institutional investors) to start buying. That will do the trick,” he said. He pointed out that the FIIs’ share of India’s stock market capitalization has fallen from 20% of US$1.8 trillion in January 2008 to between 10% and 11% of the current US$500 billion. “At some point, the power of domestic buying will overtake foreign investments,” Agrawal predicted. “And when foreigners actually want to buy, the market will go up 10% every day. Because when they want to buy, we want to buy.”

Foreign investors like Freeman said his fund has “a very long-term India strategy,” and that some of the foreign money leaving India is “not hot money, but a function of overall asset allocation strategies.” Also, attractive investment opportunities are opening up in markets outside India, including in the U.S., in the current economic environment. He saw the regulatory paperwork foreign investors have to plod through in India as perhaps a disenchanting factor, if there was one.

Freeman, however, is not one to let those concerns interfere with his bets on India. “We have always promoted India as a destination for foreign investment,” he said. “Things will settle down and of all emerging markets, India is going to be the first destination for foreign investors.”

Agrawal’s guiding philosophy is to be an optimist in the stock market. “I have been a bull on India for the past 20 years and it has paid me very well,” he said. Every market downturn, like the current one, purges “all the poison, and then you have four or five years of partying. That’s how it has always been.”

India’s stock markets peaked last in January 2008, Agrawal noted, adding that he hoped they will bottom out in the next 12 to 15 months. “Then there will be a nice story [of a] global boom for five to six years,” he predicted. “So what will be the story in 2014-15? … Most likely, the appointment will be kept, and you will see the boom. And you will not believe that it has come.”