India’s fight against high prices

The remark appeared innocuous, reasonable even, but for a country with few respected public institutions, it was unnerving. If India’s bond market were not so tightly controlled it might have created a minor scare. At a public event on December 2nd the governor of the Reserve Bank of India (RBI), Duvvuri Subbarao, was asked by his predecessor if it would relax its medium-term goal of 4-5% inflation. This is not a strict target of the kind some Western central banks try to stick to. But it is an ambition that the RBI has long held.

Mr Subbarao replied: “I am not saying that we will definitely change the number, but we will certainly revisit our strategy.” Only last month the RBI published a paper saying the opposite. In the battle against inflation, abandoning the goal would be “nothing short of admitting defeat,” says Rajeev Malik of CLSA, a broker.

The cock-up theory is that Mr Subbarao mis-spoke. But the RBI has not backed away from his remarks, which come at a difficult time for India. Since 2008 inflation has remained high, despite the RBI’s repeated tightening. GDP growth slowed to an annual 5.3% in September; investment by firms is low; and the fear of bad debts stalks some industrialists and their banks, which want relief.

Commodity-price shocks help explain stubbornly high inflation. But the government is also to blame, thanks to its lack of reforms and high borrowing. The new finance minister announced a mini-package of economic measures in September with much fanfare, and has made it clear he now wants the RBI to cut interest rates. With a general election due by mid-2014 politicians are desperate for faster growth.

The idea that the RBI might yield to such political pressure is not so far-fetched. It is not statutorily independent. Its bigwigs are often hired from the government and return to it after their stints: the prime minister used to be governor. The one outsider among the RBI’s top brass, Subir Gokarn, who has lots of fans among investors but has been critical of the government, is yet to have his tenure as deputy governor renewed. It expires at the end of the year. The RBI also has contradictory mandates, like many central banks nowadays. As well as its monetary duties, it also acts as the government’s banker and guards financial stability. In the name of these latter two goals it forces banks to buy government bonds and purchases some itself, depressing yields. That arguably makes it complicit in the public-sector borrowing binge that fuels inflation.

Critics argue that the RBI has already been cutting by stealth, using liquidity-management tools and verbal guidance to make sure market interest rates have dropped even as the policy rate has stayed unchanged since March. Ditching the inflation target would, by this account, just be an admission that it never had the stomach to enforce it in the first place.

The RBI would put things differently. Although its empirical work has previously suggested that 5.5% is the maximum healthy level of inflation, lately something has changed. Despite a sharp economic slowdown prices have kept on rising. A big chunk of demand seems to be insensitive to what the RBI does. The government borrows regardless. Rural consumers, who are doing well and are often outside the formal financial system, are shifting to richer diets, pushing up food prices.

That leaves the RBI with a lousy option, to temper demand by disproportionately hitting the narrow range of activity that is sensitive to interest rates, in particular private-sector investment. But that means fewer new factories and roads, which damages India’s long-term potential. Clearly, it would be good if the government got its act together. Assuming it does not, though, the lesser of two evils might be higher prices and a perkier private sector.

Yet there is no guarantee investment would revive: the main problems are graft and red tape. Real interest rates are already looser than during the boom of 2003-08. Higher inflation might prompt a wage spiral. The public’s inflation expectations are uncomfortably high, at 13%, one reason why they buy so much imported gold, hurting the balance of payments. And without the RBI providing discipline of sorts, politicians might behave even more recklessly. India has many public institutions run on the basis of deferring difficult decisions for short-term gains. The RBI should think hard before joining them.

 

investors have gone off India

• Corruption is dreadful in India, as shown by a current “season of scams”—over mobile-phone licences, the Commonwealth games and more. Politicians, notably the ruling Congress party, are now feeling the public’s ire. Worries have also grown that graft is scaring away foreign businesses.
• Circumstantial evidence points that way. A spokesman for a big Western firm mutters into his cappuccino about a recent High Court decision, which if upheld would cost his company billions. It was so strange, he says, it could be explained only by judicial graft. A representative of a British media firm, SIS Live, which broadcast the Commonwealth games from Delhi, in October, is furious—along with other contractors—at being left millions of pounds out of pocket because, he says, payments have been frozen by investigators digging up evidence of corruption at the event.
• Across the board, surveys regularly tell how graft is an unusually heavy tax on Indian business. An annual one published on March 23rd by PERC, a Shanghai-based consultancy, shows investors are more negative than they were five years ago. Of 16 mostly Asian countries assessed, India now ranks the fourth-most-corrupt, in the eyes of 1,725 businessmen questioned. Being considered worse than China or Vietnam is bad enough; being lumped with the likes of Cambodia looks embarrassing.
• Outsiders may get an exaggerated view. India’s democracy, with a nosy press and opposition, helps to trumpet its scams and scandals, more than happens in, say, China. Yet locals tell similar tales. A cabinet minister frets that there is so much ghotala(fiddling), “it tells the world we are all corrupt. It may be a dampener to investment.” Others agree. KPMG this month reported on 100 bosses who were asked about their own experience of graft. One in three said it did deter long-term investment.
• Judging how much difference it makes is tricky. Right now, investors may be spooked as much by the fight against graft as by the corruption itself. Arpinder Singh of Ernst & Young in Mumbai says foreigners, especially those with some connection to America, increasingly hire firms like his to help them comply with America’s Foreign Corrupt Practices Act. Once a foreigner holds more than about 5-10% equity in an Indian firm, it is seen as having some responsibility for how it is run.
• Now even Indian firms, if they want to raise money abroad, or if their bosses want to protect their own professional reputations, are doing the same. As other countries, such as Britain, bring in tough anti-graft laws like America’s, the trend will continue. Yet many Indian firms still fail to comply with higher standards, so deals falter. Mr Singh ticks off a list, “in infrastructure, ports, toll roads, irrigation, microfinance”, of deals he has worked on that collapsed over “governance problems”.
• None of this is enough to prove that graft, alone, is scaring off business. Pranab Mukherjee, the finance minister, insists there is no correlation between corruption and foreign direct investment (FDI). Jeffrey Immelt, the boss of GE, in Delhi last week, cheerily agreed, insisting that a fast-growing market trumps all other concerns.
• But something is keeping investors wary. In 2010 the country drew just $24 billion in FDI, down by nearly a third on the year before, and barely a quarter of China’s tally. There is no shortage of other discouragements: high inflation, bureaucracy, disputes over land ownership, and limits on foreign ownership in some industries.
• Even so, India is home to an unusually pernicious form of corruption, argues Jahangir Aziz of JPMorgan. Elsewhere graft may be a fairly efficient way to do business: investors who pay bribes in China may at least be confident of what they will get in return. In India, however, too many crooked officials demand cash but fail to deliver their side of the bargain. Uncertainty, not just the cost of the “graft tax”, may be the biggest deterrent of all.

Brazil,absolutely the most attractive emerging market right now

• scene at the BM&FBOVESPA, Brazil’s main stockmarket, earlier this month encapsulated Brazil’s thriving alternative-investment industry. A champagne-sipping crowd milled around José Carlos Reis de Magalhães, the boss of Tarpon, a local private-equity firm, on the floor of Brazil’s slick, renovated exchange. They were toasting the successful initial public offering (IPO) of Arezzo, Brazil’s largest shoe retailer. Tarpon had bought a 25% stake in Arezzo for 76m reais ($43.8m) in 2007 and seen its investment nearly quintuple in value in three years. Tarpon’s own share price is up by 143% from a year ago. The firm counts big endowments, like Stanford University, among the investors in its $3.5 billion fund.
• Tarpon is not the only part of Brazil’s private-equity and hedge-fund industry to have attracted international attention. In September Blackstone, a private-equity giant, paid $200m to take a 40% stake in Pátria Investimentos, a local private-equity firm. In October JPMorgan Chase’s Highbridge hedge fund, the world’s largest, bought a majority stake in Gávea Investimentos, a $6 billion Brazilian fund. Brazil is “absolutely the most attractive emerging market right now,” says the boss of a big American private-equity firm. Other economies may be bigger but investments there are seen as politically riskier. The Brazilian government is less hostile in its attitudes toward private, and foreign, investment.
• Sceptics recall the last time people declared a golden age for private-equity investment in Brazil. Foreign firms and banks flocked there in the 1990s. When shocks from the Asian crisis pulsed through the country, and Brazil devalued the currency in 1999, plenty flocked out again. Some local firms survived the bloodshed: GP Investments, Brazil’s largest private-equity firm, is still going strong, as are a handful of others from that era. But most global firms left and didn’t come back until 2006, when investment activity started to rev up again.
• Brazil is returning to a bigger, more resilient economy. OECD countries saw their GDP decline by 2.7% over the course of 2008 and 2009; Brazilian GDP grew by 4.9% during that time, and by a further 7.5% last year. It is now the world’s eighth-largest economy and could overtake Britain, France and Italy to become the fifth-largest by the end of this decade. The commodities boom is one source of growth: Brazil is the largest exporter of sugar, coffee and meat, and second only to America in soyabeans. Consumer spending is vibrant. The country is the world’s second-largest market for cosmetics and the third-largest for mobile phones. Its hosting of the 2014 FIFA World Cup and 2016 Olympics will require at least $50 billion in infrastructure investments, many of them privately funded.
• Money is pouring in, as investors throng funds’ offices on bustling avenues like Faria Lima in São Paulo and Paiva de Ataulfo in Rio. Local hedge funds managed around $243 billion in assets at the end of 2010, up by 23% from 2009, according to the Brazilian Financial and Capital Markets Association, an industry group (see chart 1). Private-equity firms oversee $36 billion.
• There are several reasons for this explosive growth. One is the maturing of the country’s capital markets. Laws protecting minority shareholders’ rights, for example, have fostered confidence. Brazil’s exchange is now the fourth-largest in the world by market value. That is a boon for hedge funds, which need liquid instruments to trade, and for private-equity firms, which use IPOs to cash out their investments.
• Investors are freer to choose where to put their money, too. Brazil’s 400 or so pension funds, with assets of around $342 billion, have been allowed to place money more freely with alternative-investment firms since 2009. Pensions now account for around 22% of investments in private equity and venture capital, according to Claudio Furtado of Fundação Getulio Vargas, a university. Valia, the $6.8 billion pension fund of Vale, a miner, has increased its allocation to private equity from 1% of assets three years ago to 6% in 2011.
• The Brazilian government’s sunny view of hedge funds and private-equity firms also helps explain their growth over the past few years. In many countries governments treat private-equity firms and hedge funds with either loathing or teeth-grinding tolerance. Partly because bank loans are very short-term, the tone from Brazilian officials is different. “As a country and an economy, we need private equity and venture capitalists to invest and to help our entrepreneurs,” says Maria Helena Santana, who runs the CVM, Brazil’s equivalent of America’s Securities and Exchange Commission (SEC).

• When Brazil’s government raised the tax on foreign investment in fixed-income instruments last year from 2% to 6%, private-equity firms complained. The government promptly changed it back—but only for them. BNDES, Brazil’s development bank, has put $1.1 billion into private-equity funds, and is the industry’s top investor. Private equity accounted for a higher proportion of GDP in 2010 than in most other emerging markets (see chart 2).

• Another reason for the rise in alternatives is a decline in interest rates. The benchmark Selic rate stands at 11.25%, much lower than the 26.5% it was set at in 2003. The threat of rising inflation may have reversed that trend in the short term but rates are expected to keep falling in the long run. Brazilian investors can no longer reap extraordinary returns just from parking their money in risk-free bonds. Maurício Wanderley of Valia says he looks for returns of 25-30% on his private-equity investments, and so far they’ve been “above our expectations”. Brazilian hedge funds have posted annualised gains of 17% over the past three years, according to EurekaHedge, a research firm. (North American funds have managed 8.6% on an annualised basis in that time.)
• The buzz around Brazil will put those returns under pressure, however. Alvaro Gonçalves of Stratus, a Brazilian private-equity firm, appears dismayed at the speed with which “armies” of global investment firms are arriving. Rather than fly in for visits, they now want to set up offices and hire local deal-makers. The competition is causing salaries to rise. Jon Toscano of Trivèlla Investimentos, a private-equity firm, estimates that executive salaries have nearly tripled in as many years.
• Greater competition has less effect on the hedge-fund industry, since there are many trading opportunities. But for private-equity firms, where the number of deal opportunities is smaller, there are huge consequences. Prices for deals have already gone up in the past year—although most investors say that companies are still not as expensive as they are in China or India, where there is even more competition.
• The three largest private-equity deals in Brazil’s history took place in 2010, all of them carried out by foreign firms. Stakes in consumer-related companies are particularly prized. Carlyle Group, an American buy-out firm, did three deals in 2010, involving a lingerie company, a travel firm and a health-care company—all of them bets on Brazil’s middle class. Many local firms are ramping up their efforts to look for deals beyond São Paulo and Rio, where most of the foreign firms are based.
• Ballooning deal prices may also drive crafty local firms to invest more money abroad. 3G Capital bought Burger King, an American fast-food chain, for $4 billion last year because the management felt Brazil had become too expensive and that global firms were too busy chasing deals in emerging markets to notice the opportunities at home. “You can do a buy-out in the United States of a global brand, a well-known company, and really face no competition,” says Alexandre Behring of 3G.

• Back in Brazil, some worry that the new entrants’ preference for big leveraged buy-outs (LBOs) could damage the industry’s unusually wholesome reputation. In Brazil private-equity deals are mostly unleveraged, and often involve minority positions in medium-sized companies. That’s partly because high interest rates make debt crushingly expensive—the average rate for a commercial business loan is 29%. But even if credit becomes more readily available, Brazilian firms are nervous of it. Brazilian managers reel off the names of highly leveraged buy-outs that have tanked in the West. “I hope we can avoid the image that we are raiders and vultures,” says Mr Gonçalves. “This is the profile that these large LBO firms left in markets, and we don’t want them to do that here.”
• It is more likely that the foreigners will have to adapt to Brazil than the other way round. Unlike China and India but like many other emerging markets, Brazil has only a limited number of large firms to invest in. Private-equity investors won’t be able to swim in a sea of $500m and $1 billion deals. Given the scarcity of long-term financing, some are looking to lend instead. “A large part of our plan is to provide credit and growth-equity capital” in Brazil, says Glenn Dubin, the boss of Highbridge.
• Although Brazil’s equity markets are liquid, concentration remains a problem for hedge funds. Eight companies account for more than 50% of the market value of the BM&FBOVESPA. Shorting the shares of smaller firms is expensive because it is hard to find shares to borrow. Larger funds have to be patient when building up positions. Luis Stuhlberger of Credit Suisse Hedging-Griffo, Brazil’s largest hedge fund, says it is like being “an elephant in a bathroom. You have to move very slowly, otherwise you break everything.”
• Funds must also comply with strict requirements for transparency and liquidity. Brazilian hedge funds must report their net asset values daily and their positions on a monthly basis. These are then posted publicly on the website of the CVM for anyone to see. Thanks to the country’s long experience of volatility and inflation, most investors do not agree to long lockup periods for their money. As a result, many funds offer daily liquidity, which means they do not have much flexibility with their strategies and cannot take illiquid positions.
• Some managers complain that Brazil’s regulatory system costs them their edge, because others know what they are up to. But most don’t seem to mind too much. Transparency brings legitimacy to the industry and calms investors, many say. Frauds like Bernie Madoff’s, which have dented investor confidence in hedge funds in America and Europe, are less likely to go unnoticed in Brazil. “Madoff would never happen in Brazil,” says Eduardo Lopes of Ashmore, an emerging-markets fund.
• Indeed, other markets are moving closer to a Brazilian-style system of regulating alternative investments. Hedge funds and private-equity firms have been mostly unregulated in America and Europe, but that is set to change. Later this year, America will start to require funds to register with the SEC and disclose some of their holdings to regulators. In France hedge funds now have to report their short positions; it is possible that other countries in Europe will enact similar requirements. “The financial crisis showed that many of the choices we made before are good choices,” says Ms Santana of the CVM.
• There are still plenty of risks in emerging markets, of course. Inflation remains a worry, and Brazil’s battle to keep down the value of the real has led to other capital controls on top of the tax on foreign investment. The BOVESPA index has declined by 6% in the past month. But here too, Brazilian alternative-investment managers claim an edge because they have been through rocky markets many times before. “They’ve basically taken as much chemotherapy as you can take and survived it,” says a foreign fund manager.
• Many managers in China and other emerging markets are familiar only with good times, so some investors worry that they might not perform well if the economy stumbled. Arminio Fraga, a former central-bank governor who founded Gávea, thinks the volatile global economic environment will play to Brazilian managers’ strengths in the coming years: “There are a lot of things out there that look familiar to us, given Brazil’s history.”