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Home > Media > Tackling Structural Weaknesses

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Tackling Structural Weaknesses
Emerging Markets Report
February/March 2010

Ending the fiscal stimulus, tackling India’s deficit and introducing a unified tax system are the key announcements investors will be hoping for in the Indian government’s annual budget presented on Friday 26th February.

The Union Budget, announced in late February, is the second since last year’s general election in India. According to Nitin Jain, principal fund manager, long only strategy, at Kotak Mahindra (UK) Ltd, it will be one of the most important in recent years as it looks set to focus on big policy initiatives. Investors have been cautious in recent weeks as they await the Budget and Nitin Jain’s view is that the measures likely to be taken will have a significant impact for sustainable growth in the mid-to-long term. “The stimulus package introduced by the government in response to the global financial crisis has boosted domestic demand by keeping more money in the hands of consumers”, says Jain. “But the economy is now performing much better and we expect to see most of the stimulus withdrawn in this budget.

He continues: “Many investors have become concerned about India’s fiscal deficit. Whilst better than expected economic growth will help reduce the deficit anyway, we expect the government to announce measures which will tackle it directly. One likely measure is the reduction in fuel subsidies. The government currently spends hundreds of millions of dollars every year subsidising the price of petrol, kerosene and gas. Given oil prices have fallen from the highs of the last two years this seems like a good time to start reducing this burden on government expenditure. Markets would also be keenly watching the extent of the stake sale program in state owned companies, proceeds of which will go towards reducing fiscal deficit.

At the heart of India’s renewed commitment to fiscal discipline is a wider commitment to an entire package of economic reform. It is Indian premier Singh’s desire to propel Asia’s third-largest economy towards 9% annual GDP growth through a combination of economic modernisation, infrastructure spending, and the corollary attracting of new foreign capital inflows. It is a comprehensive programme that has impressed the World Bank’s private sector funding arm, the International Finance Corporation (IFC) sufficiently to designate India as its biggest single investment portfolio, ahead of Russia (please refer to box below, Indian Private Equity Deals Pick Up Pace).

“It’s not surprising that government ministers have being hinting towards a withdrawal of fiscal stimulus. More of a push on reducing the deficit and correcting the structure to something more neutral will play well in the markets,” holds Jain. “That said, a degree of stimulus will need to remain in some areas. Alongside other likely measures like introducing a unified Goods and Service Tax, reforming social security, and tackling inflation, these measures will help lessen the possible impact of future risk and encourage corporate investment, which is India’s biggest growth driver.”

A road map for roll out of unified Goods and Service Tax (GST), for the manufacture, sale and consumption of goods is expected to be announced in the budget. The proposed tax will replace the current system where each state in India has its own sales tax set at different rates. The GST will be shared between Central government and individual states in order to remove loopholes, remove anomalies in the way the manufacturing and service sectors are treated, and make tax easier to collect. Other big policy announcements may relate to infrastructure, agricultural reform, and energy—perhaps with an announcement on investment in expanding power generation capacity, notably through nuclear and wind technology. On the Infrastructure front, India has already seen a lot of activity on the road sector in the last couple of months. “The budget will need to look beyond current global difficulties such as the recent heavy selling by foreign investors worried about the Eurozone economies,” says Jain. “While the next six months might be noisy, we expect the year to bring GDP growth of around 8%.” That seems feasible. Figures released at the beginning of January by the central bank that industrial production in India increased by 11.7% last November, from a year earlier, after gaining 10.3% in October. “A gradual exit from fiscal stimulus will do a lot to consolidate the platform for reform promised by the Indian government and lay the foundation for faster economic growth,” adds Jain.

The government now needs to put a number of important elements in place to help encourage both fiscal discipline and an expansionary economic growth programme. The first is the mobilisation of the internal savings and investment markets. According to local analysts, some $400bn or so is currently held in domestic savings accounts. The second is to encourage additional inward foreign direct and indirect investment flows. To this end, the state has taken some small encouraging steps. Last November a government decree stated that all profit-making, listed, state-run companies will be obliged to float at least 10% of their shares to private investors. Over the next five years, this could generate anywhere between $40bn and $50bn; though to date most of the floatation activity of Indian corporations, with notable high profile exceptions such as Tata Group DRs, is listing on the myriad domestic stock exchanges. However, there remains scope for the opening up of private market participation in companies such as national trading company MMTC and national iron-ore producer NMDC.

However, while remaining privatisation programmes in the country could generate as much as $347bn for state coffers over the coming decade, a meaningful infrastructure development programme in India would have to be of the order of $500bn to $1trn to provide sustainable and deep change. Moreover, the government has to tackle economic segments, such as agriculture, which were severely impacted by severe droughts in the north of India, and by severe floods in the south. This in turn will put severe pressure on the government to increase its domestic food subsidies. Elsewhere in the economy, the government has singularly failed to introduce rigor into the excise tax collection segment; in fact tax collection at all levels through the economy. Excise tax revenue alone fell, compared with 2008. Corporate tax, which accounts for 35% of the government’s total annual take increased by only 9% through 2009, compared with government estimates of a 15.64% increase in revenues.

INDIAN PRIVATE EQUITY DEALS PICK UP PACE

As news emerged in late January that Singapore state investment firm Temasek Holdings is in talks to buy a stake worth $170m in GMR Infrastructure Ltd’s energy unit, direct private equity investment deals in India appear to be gradually rising in number once more. In this particular regard, it is easy to see why GMR Infrastructure is appealing. India's power sector is seeing a flurry of plant constructions as the world’s second-fastest growing economy is hungry for electricity to run its factories and light its homes. Demand far outstrips supply of power, leading to frequent blackouts in urban and rural areas. GMR Energy runs three power plants in India with a combined capacity of 822 megawatts (MW). It is also developing power projects of another 3,200MW capacity. With FMR International in particular mind, apart from running several power plants, GMR Group also builds and operates highways and airports. The company runs the domestic and international airports in Delhi and Hyderabad.

Separately, reports are emerging that ICICI Venture, an arm of India’s second largest bank, ICICI Bank, is looking to raise between $150m and $200m from overseas investors for its India-focused fund. The private equity firm already manages more than $2bn of assets. Vishakha Mulye, the head of ICICI Venture, confirmed with Indian journalists that the company would begin roadshows for international investors as early as the beginning of February, but declined to give details of the amount of funds it seeks to raise.

Meantime a $100m Oman India fund that will invest in various sectors in both countries is expected to be launched shortly. Oman is looking forward to invest in India’s small and medium enterprises, according to an official statement by the Omani minister of commerce and industry, Maqbook Ali Sultan, while he was in India attending a summit organised by the Confederation of Indian Industry. The fund is expected to invest in a broad range of business segments, including tourism, telecommunications and real estate. Bilateral trade between Oman and India is worth around $2.5bn, with India importing oil and gas, fertilisers, limestone, chrome and copper. Over 100 companies are located in Oman, which has trading links with India extending over centuries.

Separately, and also in late January, Financial Information Network and Operations (FINO), a provider of banking technologies, has raised growth capital of INR700m ($15m) from HSBC Private Equity Asia and existing shareholders Intel Capital and International Finance Corporation (IFC). HSBC and Intel have also purchased the entire of Legatum Ventures' stake in the company. FINO’S software platforms allow banks to serve under banked segments of the Indian population, managing micro deposits.

According to FINO, the banking industry in India has shown tremendous growth in the last decade; however, this has not reached segments of the population, especially under-privileged sections of the society. The company estimates that there are around 500m to 600m people who are financially excluded in India and hopes to take advantage of this market. IFC South Asia director Paolo M Martelli says that, “IFC’s continued support to FINO reflects our commitment to making financial services accessible to rural and urban communities who have not enjoyed such access before, thereby assisting development at the base of the pyramid in India.”

FINO reportedly originally raised $20m from IFC, Intel Capital, IFMR Trust, Legatum and other investors back in January 2007 and therefore is well known to the participants in this latest transaction. Indian financial services firm Edelweiss Capital has held the first close of a fund focused on special situations, the EW Special Opportunities Fund, on $105m. While there are no specifics with regards to investment or fundraising targets, the fund will “seek to invest in transactions presenting special investment opportunities in India.” Edelweiss Alternative Asset Advisors (EAAA), the overseas alternative asset advisory subsidiary of Edelweiss Capital, is sponsoring the fund.

According to a spokesperson for EAAA, “India continues to offer attractive returns on alternative assets, and interest in India-focused alternative funds is on the rise.” Edelweiss Capital has a group net worth of over $520m, a pre-tax profit of $71m for financial year 2009 and a market capitalisation of about $800m. Its businesses are broadly divided into investment banking, brokerage services, asset management and financing.

Among the spate of new private equity deals, New York-based India Equity Partners is set to acquire a 25% stake in IL&FS Education and Technology Services (IETS) for little over INR140 crore, acquiring shares owned by Orix Corporation (Japan), Sera Fund and HDFC. IETS is an education and cluster development initiative of Infrastructure Leasing & Financial Service (IL&FS). Two officials, involved in the deal, said on the condition of anonymity, the private equity firm would pick up nearly 20% in secondary sale by the three existing partners and 5% will be acquired through fresh issue of shares by IETS.

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