In a previous article I had mentioned that foreign investors’ bullishness on India was based on three broad pillars. These were demographics, robust domestic entrepreneurship, and tremendous low-hanging fruit in terms of productivity improvements possible through small policy changes. I had also mentioned that amid all the noise around India, and in the deep gloom surrounding the country, investors had forgotten these long-term structural positives. To these three long-term positives I would like to add another: the flow of funds argument. It is, to my mind, clear that over the coming decade, there will be a continuous reallocation of financial assets towards the emerging market (EM) world, as large pools of long-term capital in the West diversify and reduce their home-country bias in asset allocation.
One of the clear takeaways from a recent trip to the United States was exactly this. There was a near-universal statement of intent from investors we met of raising their portfolio weightage of EM assets. Most wanted to double their EM allocations over the next five years. The other clear trend was a desire to move away from private equity towards public markets in their EM asset allocation. There was a strong feeling that private equity had not really worked (especially in India), and it was pointless to lock up capital for 10 years when your return profile was very similar to public market investing. The other discernible trend was an acceptance that long/short investing in EM equities was a difficult strategy to implement. For the first time, I sensed many allocators of capital would prefer to use a long-biased strategy to access returns in these markets.
In this context, I came across an interesting report titled “Small fish in a big pond”, written by Rashique Rahman of Morgan Stanley. In this report on EM flows, the author tries to quantify the size of expected flows into the EM asset class over the coming years.
Rahman’s report points out that the average allocation in developed market (DM) cross-border portfolios is around 10 per cent. This includes EM debt and equity and reflects a near doubling in EM exposure in 10 years. Within the 10 per cent, however, the classic longer-term pools of capital – pension/endowment and insurance funds – have a lower EM weight. His own work and surveys indicate that the pension/endowment and insurance funds have about six to 6.5 per cent of their assets in EM investments.
Rahman then goes on to try and outline the size of the investable pool that could come into the EM asset class over the coming years. He estimates the global pool of investable institutional assets to be over $128 trillion; out of this $77 trillion is the so-called conventional investor base of pension, insurance and investment funds. The majority of this conventional investor base is domiciled in the US (about 45 per cent), with the UK and Japan being the next largest (at about eight per cent each).
Rahman makes the point that based on consultant recommendations, surveys and anecdotal evidence, most funds will take their allocations to between 10 per cent and 15 per cent over the coming years. Given that these conventional pools of capital have a current weight of about 6.5 per cent, this implies a further doubling of weight.
The report actually goes on to make the case that eventually most funds should have a near 30 per cent weightage in EM assets, based on portfolio theory and maximising your portfolio risk/reward trade-off. The folks at Morgan Stanley point out that EM economies already account for 36 per cent of global GDP, and EM share in global capital markets is already near 20 per cent, and both are rising — so a 30 per cent EM weight is not as outlandish as some would think. Already, some of the more progressive endowments are at an EM weightage of greater than 20 per cent.
Whether we ever get to 30 per cent is an open question. But the minimum movement the report expects is a 3.5 per cent increase in the conventional investor base’s EM weight over the coming five years. Even such a modest jump would move over $2 trillion into EM financial assets. Just for context, $2 trillion is about 33 per cent of today’s combined value of all EM bond and equity markets.
The Morgan Stanley report adds that over and above these foreign flows, there is huge potential for increased flows into financial assets in most large EM markets as their own local pension and insurance industries develop. This point is especially the case in India, given that the country’s percentage of household financial savings in equities is at multi-year lows. When investor confidence revives, domestic flows will be a huge factor in market performance.
Beyond the flow of funds argument, the interesting aspect of the Morgan Stanley report is the case it makes for a larger portion of these financial flows to move into EM debt, especially local currency debt. EM debt has better portfolio optimisation characteristics and is more under-allocated compared to EM equities.
As for India, we have to get our local corporate debt markets to be far more dynamic. In the long term, banks will not be able to continue with the asset-liability mismatches they are running today in funding infrastructure. Projects need to be able to raise long-term debt locally and larger corporations will have to be able to access debt markets and disintermediate the banking system. If the Morgan Stanley report is right, there will be significant flows searching for local-currency debt assets; we have to be able to provide avenues to absorb this incoming capital. Today, access to our local-currency corporate debt markets is limited, constrained by both quotas and limited quantities of tradeable paper. This needs to change to absorb the incoming capital.
In these times of deep depression and gloom surrounding India, it would make sense to take a step back and see the big picture. There are many structural positives creating a tailwind for the country. No matter how much we try to shoot ourselves in the foot, at some stage we will come out of this funk. Don’t underestimate the investment attractiveness of a large domestically oriented economy growing at seven per cent, with 15 per cent earnings growth. Investors will find India attractive once again — as soon as we stop doing all that we can to make it unattractive. There will be significant flows into the EM asset class over the coming years. From a tactical perspective, everyone may be avoiding India right now, but structurally India will get more than its fair share of these huge expected inflows.
The author is fund manager and CEO of Amansa Capital