Column: Investment Insights

2014: Politics and Portfolios Poised for Passion Play by Jagannadham Thunuguntla – Chief Strategist of SMC Global Securities.

23rd January 2013

In 2014, political developments will play a defining role for investors across the world. The year is slated to witness 40 national elections covering as much as 42 percent of the world’s 7.2 billion people located in countries that contribute more than half the world’s GDP (Gross Domestic Product). The elections will not only produce a political earthquake, but will also paint a clear picture for global Foreign Institutional Investors (FIIs) as to where to park their funds across geographies.

While investors will be worried about questions regarding leadership succession (including in the concerned central banks) and other political risks in countries going to the elections this year such as India, Indonesia, Afghanistan, Turkey, the European Union nations, South Africa and Latin American countries, and elsewhere, there will be increased pressure on newly elected governments to deliver more enduring economic gains in the year 2014. Inflationary trends, impact on public finances, overcoming bottlenecks to reforms and measures to tackle the obstacles to growth are expected to be the main concerns of both investors and governments across the world during the current year.

The capital markets play the role of the “central nervous system” for present day political economies because many important functions of existing political and economic systems are strongly influenced or controlled by the workings of the capital markets. So, when Foreign Institutional Investors (FIIs) examine any particular political economy as an investment destination, they take equally into account not only national and sub-national, i.e. state/province level factors but international and transnational political factors as well that may impact the capital markets. Apart from the political factors, some of the other economic factors that determine the allocation of their funds across national economies include currency movements, capital market gains, Central bank easing, and flows from tax havens.

Growth behind the Great Wall is cementing the rising tower of BRICS

In recent times, we have seen a structural shift in economic power from the US and the developed world to China and the developing world. The United States is no longer the world’s only growth engine. Today the BRICS nations (Brazil, Russia, India, China and South Africa) led by China have begun to play a significant role in the global economy.

China’s growth model in the main depends on the twin pillars of investment in fixed assets and exports. Now, it is in the process of re-balancing its economy, moving from reliance on manufacturing and exports to greater domestic consumption and the services sector. Also, the continuous development of the Chinese bond market is supporting the country’s economic growth. In fact, as has been famously predicted by Goldman Sachs, China is expected to become the world’s largest economy by 2050.

Consequently, global investors too have expanded their focus from only the US and a few other mature markets to other emerging economies.

BRICS : “I for India” or “I for Indonesia”?

In this context, the recent mayhem in the Indian economy and in its currency exchange rates have given rise to a new theory doing the rounds among global investors. They are now asking: “Will Indonesia substitute India in the BRICS?”

Both the economies (India and Indonesia) are growing quite fast, but Indonesia, after weathering the Global Financial Crisis (GFC) in 2008, has recovered enough to grow at a pace that is at par with its growth rates immediately before the crisis (for example, during 2004-2008), something that India has not only failed to do, especially during the last three years, but its growth rate is now on the brink of going even below the psychologically significant rate of 5 percent.

Consequently, Indonesia’s solid performance during the same period when India has been sliding, has actually forced thinkers to wonder whether Indonesia can soon become a more appropriate country to represent the alphabet “I” in the BRICS group of high-performing emerging economies. As of now, Indonesia has been blessed with solid public finances, strong growth, a burgeoning consumer market, and plenty of resources to keep the economy buoyant for many years to come. These factors have won favor with investors over the past few years.

But if we compare the demographics of the two economies, there is a vast difference. India has a population of 1.2 billion as against only 240 million of Indonesia’s. India is the world’s largest democracy in terms of the size of population and Indonesia is only the third largest. Thus, one cannot deny that both the countries have a burgeoning consumer base and are democracies with investment grade ratings.

India’s pace of growth has slackened due to “policy paralysis” or stalled economic reforms caused by destructive political brawling as much as an inability of the government to go forward with bold decisions. The deadly combination of global headwinds on the one hand and disastrous domestic policies on the other have now plunged India’s growth rate to a 10-year low.

The unfortunate record of low productivity, limited Foreign Direct Investment (FDI) and lack of policy reforms have made India perhaps the most vulnerable among its BRICS peers. On the flip side, if we compare its growth rate with other economies in the world, India is one of the world’s fastest growing economies and has seen sizeable capital inflows in the form of Foreign Portfolio Investments (FPI).

In fact, in calendar year 2013, India received the world’s third-highest inflow from Foreign Institutional Investors (FIIs) and still witnessed its  worst-ever growth performance in recent times due to adverse global and domestic influences. Going forward, factors such as the outcome of the general elections to be held a few months later this year, the degree of economic recovery that will be achieved and the size by which the US Federal Reserve pares stimulus spending will spell the interest of capital market participants and investors in India in 2014. Nevertheless, it is expected that as inflationary pressures gradually ease, and as confidence in the economy returns with the possible paring of interest rates, Indian markets will continue to be a favorable spot for foreign players to park their funds.

In 2014, both the economies are going for general elections: India by May and Indonesia in April. As of now, both the countries are struggling with tumbling currencies, ballooning inflation and stubborn Current-Account Deficits (CAD). Further, the business environment in both countries is plagued by poor infrastructure and weak institutions.

In 2013, both the countries were badly hit by the selloff in emerging-market assets amid concerns regarding QE tapering in the US, weaker domestic macro fundamentals and policy uncertainty. The good news is that in recent years, Foreign Direct Investment (FDI) has been at record levels in Indonesia, much more than what was attained before the 1997 Asian economic crisis, on the back of relatively low labor costs, availability of abundant and key natural resources and a large and growing domestic market, reflecting constructive demographics, high per capita GDP growth and speedy growth of the middle class. Having said that, 2013 has, however, witnessed limited Foreign Direct Investment (FDI) compared with the previous years as investors have remained cautious ahead of the general elections. The total Foreign Direct Investment (FDI) in Indonesia in the first three quarters of the 2013 calendar year was US$ 10.4 billion. Since 2010, Japan has been the largest investor in Indonesia.

Are “CIVETS the next BRICS”?

After BRICS, global investors have now slightly shifted their focus to what is known as the “CIVETS” economies. CIVETS are six favoured emerging market countries, namely Colombia, Indonesia, Vietnam, Egypt, Turkey and South Africa because of their diverse and dynamic economies, sophisticated financial systems and young, growing populations. However, unemployment, corruption, and inequality are persistent problems of CIVETS economies.  These economies have a great variety of exports, both primary products and natural resources and also have geostrategic locations. These countries have seen increased Foreign Direct Investment (FDI) in the past few years.

Conclusion

To conclude, the capital market is a game of probabilities and elections present a spike in the number of possibilities. The common question on the minds of many market participants in the election year is “how will the upcoming elections affect investment perspectives?” There is a high correlation between politics and capital markets. But given that both the countries (India and Indonesia) are going for elections, stock markets are likely to experience significant swings because in both the countries many tough economic policies have been postponed with governments seen to be hurrying to announce populist measures to attract votes. As of now, as far as investors and investment destinations are concerned, market behaviour is likely to be highly unpredictable as there is no clarity as to how the future will unfold in these two highly significant economies.