India's Booming Stock Market and Its Outlook Ahead

VOL1. NO. February 2006 India's Booming Stock Market and Its Outlook Ahead India's stock market in 200 was driven by expanding inflows of foreign capital into the country on the back of expectations for continued high economic growth and the booming economies of BRICs (Brazil, Russia, India and China). There was also increasingly active stock investment by domestic investors. The result was that the Mumbai Stock Exchange's SENSEX index, India's key stock index, soared 43% in just one year. This report gives an overview of the trends behind the securities investment in India sending stock prices on an upward course, along with the outlook for the market and the various investment risks involved. 1. India's Stock Market in 200 India's stock market in 200, despite undergoing temporary corrections, rode an upward trend to hit a series of all-time highs (Figure 1). India's two major stock indexes, the SENSEX stock index on the Mumbai Stock Exchange (BSE) and the NIFTY Stock Index on the National Stock Exchange (NSE), rose 43% and 36%, respectively, in the year. Among Asia's major stock indexes, the increases in India were topped only by those in South Korea and Japan (Figure 2). By industry, banking and telecommunications performed well, lifted by booming domestic demand, as did electrical machinery and industries related to construction. Growth sectors like software services and chemicals also boosted stock prices. Figure 1: Stock Index and Market Capitalization Figure 2: Stock Index Performance in Major Asian Countries (point),000 8,000 6,000 4,000 2,000 - Market Capitalization(BSE) SENSEX Index 98 99 00 01 02 03 04 0 (Rs.trillion) 2 (source) Compiled by the Economic Research Office, Bank of Tokyo Mitsubishi UFJ, from Bloomberg database 20 1 Korea Japan India Jakarta Singapore Hong Kong Thailand Taiwan Malaysia Shanghai Shenzhen (%) -20-0 20 30 40 0 60 (note)percent change end 200/2004. (source) Compiled by the Economic Research Office, Bank of Tokyo Mitsubishi UFJ, from Bloomberg database 1

2. Rapidly Increasing Influx of Foreign Capital Contributing significantly to India's rising stock prices has been an influx of foreign capital. A look at the trend of its balance of payments statistics shows that, while the current account figures since late 2004 have declined due to booming domestic demand and sharp increases in oil imports amid steep rises in crude-oil prices, the capital account balance remains in the black, far exceeding India's current account deficit. This is chiefly because of the influx of foreign capital through securities investment (Figure 3). Figure 3: Balance of Payments bil.us$ 1 0 - Other Capital Short Term Loans Banking Capital Commerical Borrowings External Assistance Portfolio Investment Foreign Direct Invesment Capital Account - 00/6 01/6 02/6 03/6 04/6 0/6 Current Account (source) Compiled by the Economic Research Office, Bank of Tokyo-Mitsubishi UFJ, from Reserve Bank of India The main players in securities investment have been foreign institutional investors (FIIs) (Note 1). The net amount invested by FIIs in India's stock market in 200 was about US$.7 billion, up from the previous year's US$8. billion. This was a record high, topping US$ billion for the first time (Figure 4). In addition to good business results and expectations for high economic growth, a substantial reduction in October 2004 in the capital gains tax for non-residents (Note 2) is thought to have encouraged FIIs to invest more in Indian securities. Apart from the investments by FIIs, there has been an increase in investments in the Depositary Receipts issued overseas by Indian companies. In January-October 200, these investments totaled about US$1.6 billion, almost four times higher than the results for all of 2004 (about US$40 million). This reflects an increasingly active trend for Indian companies to procure funds in overseas stock markets because of their good business performance and consequent need to raise business fixed investment funds. In May 200, in fact, Infosis Technologies, one of India's major IT companies, issued American Depositary Receipts (ADRs) and procured about US$1 billion in Japanese and U.S. stock markets. In November of the same year, ICICI Bank, India's largest private bank, raised about US$1.4 billion via a public offering of its shares, the largest amount ever procured by a private company in that country. In Japan there has been active investment in India through Indian stock investment funds. The first such funds in India were created in September 2004. As of the end of 200, there were eight funds (excluding those that include Indian shares among their components, for example, BRICs funds), with net assets rapidly growing to a total value of about 470 billion. Along with foreign investors, domestic investors contributed greatly to the rising Indian stock prices as they stepped up their activities. Traded amounts -- purchases and sales -- in 200 by domestic mutual funds both hit all time highs, and net investment reached about Rs.130 billion (about US$3 billion). This resulted as the trading trend changed so that buying exceeded selling by a large margin (Figure ). (Note 1) Investment in India's domestic securities by non-residents is permitted only for FIIs that are registered with the Securities and Exchange Board of India (SEBI). Non-residents can also invest via depositary receipts that correspond to Indian stocks and are listed on overseas stock exchanges. Depositary receipts issued mainly in Europe and listed on the London Stock Exchange are called Global Depositary Receipts (GDRs), 2

and those issued in the United States and listed on the New York Stock Exchange, American Depositary Receipts (ADRs). (Note 2) As a result of change in the capital gains tax in October 2004 for non-residents in India, investment in securities for one year or more became exempt from the ongoing % capital gains tax. The same tax was reduced from 30% to % for investment of less than one year. Figure 4: Portfolio Investment into India by Foreign Institutional Investors Figure : Sale/Purchase of Equity by Domestic Mutual Funds in India (bil. US$) 12 8 bil. Rs.) 800 600 400 Net Purchase/Sales(right scale) Gross Purchase Gross Sales 200 10 0 6 200 0 4 2 00 01 02 03 04 0 source Compiled by the Economic Research Office, Bank of Tokyo Mitsubishi UFJ, from CEIC database -200-400 00 01 02 03 04 0 source Compiled by the Economic Research Office, Bank of Tokyo Mitsubishi UFJ, from CEIC database -0-0 3. Outlook Ahead and Investment Risk (1) Promising stock market in the medium or long term Since prices have been increasing fast in India's stock market, concern is rising among some investors that the market is overheating. But stock prices are climbing in tandem with overall good business results, and the stock prices at their current level are not overvalued. The recent price earnings ratio (PER) of about 20% is within the average range seen in the past. Unlike in the early 1990s, when there was an equity boom fueled by excessive expectations for deregulation, and in 2000, when the stock market surged due to the IT bubble, the stock market continues stable with stock prices at a relatively low level (Figure 6). In the long term, India has good prospects for high growth in the stock market because of an increasing labor force and expanding domestic markets. Another reason is that the Indian government is stepping up efforts to improve the country's infrastructure including railways, roads and airports. And still another is that more capital will flow into the country as the government relaxes regulations on foreign capital. Figure 6: Trend of Price Earnings Ratio in India s Stock Market (Times) 60 0 40 30 20 0 PER(monthly average) Average(1991-200) 91 92 93 94 9 96 97 98 99 00 01 02 03 04 0 source Compiled by the Economic Research Office, Bank of Tokyo Mitsubishi UFJ, from CEIC database 3

(2) Attention needed against short-term risks On the other hand, investors in Indian stocks must be careful about short-term investment risks. Established in 187, the Mumbai Stock Exchange (BSE) in India has a long history. Indian companies actively use not only bank loans but also funds raised through issuing shares and other means of procurement in capital markets. The BSE is better equipped than stock exchanges in other developing countries. The number of Indian companies listed on both the BSE and the National Stock Exchange (NSE) as of year-end 200 totaled about,800, the largest number of listed companies in any country of the world (Table 1). But the total market capitalizations of the BSE and NSE are each about US$00 billion, one-eight the size of the Tokyo Stock Exchange. Trading volumes on both exchanges are low, so investors must keep in mind that stock prices are likely to fluctuate there, just as they do in other emerging markets. If foreign investors' sentiment chills and they begin to withdraw their funds from India in droves, stock prices will drop sharply. Below is a review of major factors that are assumed to trigger the flight of capital. Table 1: Major Indicators of Stock Markets in the Major Industrial Countries and Asian Economies Market Capitalization (bil.us$) Number of Listed Companies Total Value of Share Trading (bil.us$) NYSE 13,311 2,270 14,12 Tokyo SE 4,73 2,31 4,427 Nasdaq 3,604 3,164,087 London SE 3,08 3,091,674 Euronext 2,707 1,29 2,901 Hong Kong Exchanges 1,0 1,13 464 Korea Exchange 718 1,619 1,204 Bombay SE 3 4,763 19 National Stock Exchange India 16 1,034 314 Taiwan SE Corp. 476 696 8 Shanghai SE 286 833 239 Singapore Exchange 27 686 116 Bursa Malaysia 181 1,019 2 Thailand SE 124 04 96 Shenzhen SE 116 44 14 Jakarta SE 81 336 42 Philippine SE 40 237 7 source Compiled by the Economic Research Office, Bank of Tokyo Mitsubishi UFJ, based on World Federation of Exchanges The first risk factor on the economic front is weather, because economic growth in India can decline significantly for weather-related reasons. India's economic growth recently has continued in the 7% to 8% range, driven chiefly by strong domestic demand. In the agricultural sector, however, the harvest always depends on the amount of rainfall during the monsoon season, a long-standing pattern for the sector. Although in terms of agricultural production the sector's contribution to GDP has slipped to about 20%, the agricultural sector cannot be disregarded. That is because farmers and their families represent about 70% of India's total population, a fact useful in predicting the future course of consumption. If agricultural production decreases due to a drought or bad weather, consumption by farmers will fall as their incomes decline. This in turn will lower the rate of economic growth, a possible factor for a correction of stock prices. On the political front, investors need to consider the risk caused by a delay in implementing the government's policy. India's Manmahan Singh government stresses its policy on the reform and liberalization of the economic sector. The purpose is to promote economic growth by deregulating to attract foreign capital. But because of its consideration toward the left-wing groups who support it from outside the Cabinet, the government is compelled to proceed carefully with the 4

privatization of state-owned companies. Since the formation of the coalition government, the left-wing groups have consistently held to the position that profitable state-owned companies must not be privatized. Because of this, the scheduled sale of % of government shareholdings of Bharat Heavy Electricals Ltd (BHEL), India's large state-owned heavy electrical equipment manufacturer, has been put on hold. And the liberalization of the retail sector that the government was actively studying at the strong request of foreign companies has been carried out in a very limited manner, with 1% foreign ownership permitted only for a single brand shop. Nevertheless, in the case of Maruti Udyog, India's largest automobile maker, and others that have been operating profitably but that have already been effectively privatized, the left-wing groups do not object to the additional sale of their state-owned shares. This demonstrates their flexibility regarding certain aspects of the government's policy. Thus, these developments should be closely watched in the future. But even if stock prices enter a correction, there will be little uncertainty about the balance of payments. Now, with concern growing about increasing imports due to strong domestic demand and surging oil prices, India has about US$140 billion in foreign exchange reserves, a level equivalent to payment for 13 months of imports. The nation's short-term debt is tending to increase as short-term funds flow into India, but the ratio of such debt to all foreign debt is a low 6.7% as of the end of September 200. Given that India's ratio of current foreign exchange reserves to short-term foreign debt is a high 1,661%, there is little risk that India will suffer a payment imbalance in the short term. Needless to say, in order for India to stabilize its balance of payments in the medium to long term, the important issue for the government is to actively introduce foreign direct investment, or acquire long-term funds, through deregulation and infrastructure improvement and expand exports by boosting Indian companies' competitiveness. In addition, it is essential that India's economy be restructured into one less affected by the weather. This requires carrying out agricultural sector reform and improving irrigation. But if the government tries to accelerate deregulation one-sidedly, confrontations will intensify with the left-wing groups and might shake the stability of the government. To avoid this, the government, in collaboration with the left-wing groups, needs to pursue reform while addressing issues related to the poor and the agricultural sector that the left-wing groups consider critical. Additionally, to eliminate what might become a negative factor for the promotion of securities investment and foreign direct investment, it is very important that India maintain a policy of pursuing peace with its neighbor Pakistan. Aki Fukuchi, February 2, 2006 The Bank of Tokyo-Mitsubishi UFJ, Ltd. Economic Research Office 2-7-1, Marunouchi, Chiyoda-ku, Tokyo 0-8388, Japan This report is intended only for information purposes and shall not be construed as solicitation to take any action. In taking any action, each reader is requested to act on the basis of his or her own judgment. This report is based on information believed to be reliable, but we do not guarantee its accuracy. The contents of the report may be revised without advance notice. Also, this report is a literary work protected by the copyright act. No part of this report may be reproduced in any form without express statement of its source.