A Perspective on India

A CHALLENGING 2008
After four consecutive years of strong gains, Indian equity markets have shown signs of a
slowdown in 2008. The downturn could be attributed to a combination of factors, including
weakening global sentiment and concerns regarding domestic inflation and growth. Globally,
there has been a reassessment of the risk premiums attached to equities as an asset class in
light
of weakening growth and uncertainty about the extent of the impact to credit markets.
In India, recent data has pointed toward a moderation in industrial production and rising
inflationary pressures. Positive foreign institutional investor (FII) flows, combined with strong
inflows from domestic insurance companies and mutual funds, were all large contributors for
capital inflow and clearly led to momentum buying in certain sectors. However, as liquidity
flows have begun to decline, a reversal of last year’s trends has begun to take place. Many of
the sectors that had moved ahead of fundamentals last year due to momentum buying, such
as
consumer goods and information technology, have not sustained investor interest. This year,
as
trends have begun to reverse, many investors are focusing more on fundamentals.
SEPTEMBER 2008 INVESTMENT INSIGHT

Franklin Global Advisers

INDIAN ECONOMY
Key implications—demand and investment
Economic growth in India has been above trend for the past few years and has been aided by
the
availability of capital, low domestic interest rates, and strong FII flows. These factors have
helped push domestic consumption and investment in recent years. The Reserve Bank of India
(RBI) began to tighten rates over the last couple of years in order to moderate strong credit
growth and avoid a bubble scenario. Rising rates and input costs appear to have impacted
growth in interest rate sensitive sectors and RBI’s efforts to contain credit growth have clearly
had an impact. The slowdown in industrial production numbers is an indication of the same
trend. However, we should keep in mind that the composition of the index of industrial
production is outdated and that India is predominantly a service-led economy.
73.1 -37.4 MSCI India Index
17.4 -6.5 FII flows** (US$ billion)
-3.8 -24.5 BSE IT
34.7 -14.6 BSE FMCG
149.4 -47.6 BSE Power
92.2 -63.1 BSE Realty
81.0 -47.2 BSE Bankex
117.5 -52.1 BSE SmallCap
89.4 -47.3 BSE MidCap
75.4 -34.0 S&P CNX Nifty
64.7 -34.4 BSE Sensex
2007 YTD 2008* % Change
All returns in USD.
*As of 31 July 2008.
**FII flows as of 30 June 2008.
At this stage, the Indian economy is facing headwinds in terms of
inflationary pressures and policy responses (fiscal and monetary) to
tame increasing prices. We expect economic growth and consumer
demand to be impacted by recent price increases and higher
borrowing costs. The expected wage increases as a result of the Sixth
Pay Commission recommendation and farm loan waiver could boost
consumption, but are likely to worsen the fiscal deficit.
CORPORATE INDIA
Key implications—earnings growth
In recent years, strong economic fundamentals and readily available
capital boosted the confidence of Indian companies, which have
delivered earnings growth of nearly 30%. Growing confidence was
also reflected in the sharp rise in the number of overseas acquisitions
made by leading companies as they sought to increase their global
footprint. As a result, Indian stocks have traded at a premium due to
consistently superior return on equity and better growth prospects.
Return on Equity (ROE) Trend (%), 1995–2007
Franklin Global Advisers
Following an 8.8% growth in the first quarter of 2008, the Indian
economy grew by 7.9% in the second quarter owing to moderation in
industrial output. In our view, domestic consumption and
improvement in farm output are likely to support GDP growth.
While consensus estimates for GDP growth in fiscal year 2009 are
being revised to around 7–8%, India is likely to remain one of the
fastest-growing economies in the world, despite the downshift in
global economic growth.
India GDP Growth (% YOY), 1991–2008
Source: Bloomberg, 8 July 2008.
Source: Citigroup, May 2008.
While RBI tightened domestic liquidity and also restricted overseas
borrowings, Indian companies benefited from strong FII flows
(cheaper money through primary/secondary market offerings). As a
result, rising demand due to increasing disposable incomes together
with strong economic growth boosted the bottom line.
Given the recent monetary tightening and lack of FII flows, Indian
companies are likely to face some difficulties raising capital for their
expansion. However, the government and central bank have recently
undertaken steps to improve access to capital by relaxing overseas
borrowing terms, which should also help in tempering the weak
rupee. The latter is likely to help the export competitiveness for India
given that other Asian currencies have been appreciating against the
U.S. dollar.
Oil remains a key factor given that oil imports account for close to
75% of India’s crude oil requirements. The fluctuations in oil prices
will affect India’s balance of payments and put further pressure on
the rupee, but the large foreign exchange market (forex) reserves and
strong invisibles should provide a buffer.
Crude Oil Prices, 2002–2008
175
225
275
325
375
425
475
Jan-02
Jul-02
Jan-03
Jul-03
Jan-04
Jul-04
Jan-05
Jul-05
Jan-06
Jul-06
Jan-07
Jul-07
Jan-08
Jul-08
0
25
50
75
100
125
150
WTI US$ Per Barrel (RS)
CRB Food Index (LS)
CRB Commodity (LS)
0
5
10
15
20
25
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007E
India EM World Asia Pacific ex-Japan
Source: FactSet, MSCI, Morgan Stanley Research, June 2008.
5.3
1.3
5.1
5.9
7.3 7.3
7.8
4.8
6.5
6.0
4.4
5.8
3.8
8.5
7.5
9.4 9.6 9.0
0
1
2
3
4
5
6
7
8
9
10
FY91
FY92
FY93
FY94
FY95
FY96
FY97
FY98
FY99
FY00
FY01
FY02
FY03
FY04
FY05
FY06
FY07
FY08E
Franklin Global Advisers
India’s Fixed Income Markets
The growth of local currency debt markets can play a crucial role in
a developing country’s economic performance and financial stability.
The pressing needs of India’s large fiscal deficit have fueled a
thriving market for government securities, commonly termed
“G-Secs.” In contrast, the country’s corporate debt market is widely
regarded as small, illiquid and lagging in development.
In the early 1990s, India launched a series of debt market reforms
with the decision to cease administering interest rates and using adhoc
treasury bills to automatically monetise central government debt.
Consequently, India converted to a market-determined interest rate
environment where the RBI conducts monetary policy through its
benchmark repo rate, cash reserve requirements and open
market operations.
Subsequent RBI reforms have included the use of additional types of
government securities, plus efforts to consolidate numerous small,
illiquid issues. The central bank also elongated the yield curve of
government debt—a key development for the valuation of other
fixed income securities—by progressively introducing longer
maturity issues. It currently issues long-term debt with maturities
from five to 30 years, as well as short-term debt in the form of
91-, 182- and 364-day Treasury bills.
Source: CapitalLine, Morgan Stanley Research, June 2008.
FIIs gained access to the G-Sec market in 1997, and during the
present decade, this market has continued to mature through a series
of government, central bank, regulatory and exchange initiatives:
• 2001: NSE launches value-at-risk system for measuring risk
in G-Secs
• 2002: NSE creates benchmark NSE Government Securities Index
• 2003: Retail trading in G-Secs commences
• 2003: NSE introduces trading in interest rate futures
• 2005: Electronic order matching platform launches
• 2006: Short sales permitted
• 2006: Passage of the Government Securities Act permits stripping
of G-Secs (actual implementation of STRIPS is planned for
2008/2009)
Some of these initiatives have been less successful than others.
Compared to India’s active equity derivatives market, the
development of bond-related derivatives, which can improve market
liquidity and risk management, has been minimal. The NSE currently
offers interest rate futures contracts on notional T-bills, zero-year
zero-coupon bonds and 10-year coupon-bearing bonds. The RBI
continues to study ways to further this market’s growth.
India’s corporate bond market also lags far behind the G-Sec market
in overall development—a trend India shares with several other Asian
emerging markets. Borrowing from banks tends to be the more
popular route for Indian corporate financing. Additional factors such
as disclosure requirements, plus the overall cost and length of the
issuance process, favour private placements over public issues.
Developing Asia: Debt Securities as a % of GDP
As of 31 December 2007
The balance sheets of Indian companies are currently in good shape,
with the help of strong cash flows, low debt-equity ratios, and newlyadded
capital stock. But margins are expected to moderate due to
changes in the macroeconomic environment as well as the fact that
30% year-on-year growth was not sustainable and was cyclical
in nature.
Corporate India Balance Sheets, 1994–2007
-10
-5
0
5
10
15
20
25
30
35
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
0.4
0.5
0.6
0.7
0.8
0.9
1.0
1.1
1.2
Cash to Total Assets (LS)
YoY Change in Debt (LS)
Debt to Equity (RS)
0
50
100
150 China
India
Indonesia
South
Korea
Malaysia
Philippines
Thailand
Corporate Debt Securities as a % of GDP
Government Debt Securities as a % of GDP
Sources: Asia Bond Monitor (ABM), April 2008; Asian Development Bank;
AsianBondsOnline (ABO) website; and Morgan Stanley Capital International Inc.
“Developing Asia” is defined as countries included in the MSCI Emerging Markets
Asia Index. Corporate debt securities include those issued by financial institutions.
India data is as of 30/06/07.
Franklin Global Advisers
Source: PricewaterhouseCoopers estimates (using UN population projections),
March 2008.
OUTLOOK
In the near term, India is likely to encounter some turbulence due to
various factors, such as policy responses to rising inflation ahead of
national elections, absence of FII flows until the global scenario
improves, and earnings growth moderation. While these factors
would impact market sentiment in the near term, we believe that
India remains an attractive country for a variety of reasons:
• Structural economic drivers such as positive demographics and
high savings rates should drive long-term economic growth.
• The economy is primarily driven by domestic consumption and
investment, providing relative insulation from global slowdown.
- Although domestic consumption is likely to be impacted by
increased prices and borrowing costs, the Sixth Pay
Commission recommendation and farm loan waiver
are positives.
- The government’s infrastructure spending and capital
expenditure (capex) plans of corporate India are likely to
sustain the investment cycle. Capex could slow down if the
demand situation deteriorates and global capital flows
moderate further.
• Strong forex reserves and a relatively low external debt-to-GDP
ratio should mitigate the impact of the current account deficit.
• India, we believe, is likely to be one of the fastest-growing
economies in the world, despite the expected near-term slowdown.
• Corporate margins are expected to moderate in this environment to
a sustainable level, making stock picking more relevant. While
there can be no assurance, we expect earnings growth to be in the
range of 15–20% over the next three to five years.
We believe that the recent volatility in the equity markets has been
revealing attractive opportunities in India for long-term, bottom-up
investors. Current valuations appear to have already factored in
lower growth prospects and we believe Indian markets appear
attractive. In our view, Indian equity markets are well positioned
from a long-term perspective given their strong fundamentals.
17 7 17 3 Indonesia
10 5 10 3 Turkey
6 5 6 6 Australia
17 10 17 7 Mexico
8 9 8 7 Korea
88 (Rank 3) 22 (Rank 4) 88 (Rank 3) 7 (Rank 12) India
17 17 17 8 Russia
26 15 26 8 Brazil
9 10 9 9 Spain
9 10 9 10 Canada
10 13 10 14 Italy
14 15 14 17 France
14 15 14 18 UK
14 20 14 22 Germany
129 51 129 23 China
19 28 19 32 Japan
100 100 100 100 U.S.
2050 2007 2050 2007
GDP in PPP terms
GDP at market
exchange rates in
US$ terms
Country
(Indices
with U.S.
= 100)
Projected Relative Size of Economies in 2007 and 2050
(U.S. = 100)
India Projected to Become the Third Largest Economy in 2050.
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FTIN INVI 09/08
Important Information
All investments are subject to certain risks. Generally, investments offering the potential for higher returns
are accompanied by a
higher degree of risk. Stocks and other equities representing an ownership interest in a corporation have
historically outperformed
other asset classes over the longer term but tend to fluctuate more dramatically over the shorter term.
Small or relatively new
companies can be particularly sensitive to changing economic conditions due to factors such as relatively
small revenues, limited
product lines, and small market share. Smaller-company stocks have historically exhibited greater price
volatility than larger-company
stocks, particularly over the short term. Bond and other debt obligations are affected by changes in
interest rates and the
creditworthiness of their issuers. High-yield, lower-rated (“junk”) bonds generally have greater price swings
and higher default risks.
Foreign investing, especially in developing countries, has additional risks such as currency and market
volatility and political or
social instability.
The information contained in this piece is as of its date, unless otherwise indicated, and is not a complete
analysis of every material
fact regarding the market and any industry sector, a security, or a portfolio. Statements of fact cited by the
manager have been
obtained from sources considered reliable but no representation is made as to the completeness or
accuracy. Because market and
economic conditions are subject to rapid change, opinions provided are valid only as of the date of the
material. The manager’s
analysis of issues, market sectors, and of the economic environment may have changed since the date of
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particular securities are only for the limited purpose of illustrating general market or economic conditions,
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September 2008. Because market and economic conditions are often subject to rapid change, the analysis
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