India's Investment Landscape: Risks, Rewards, And Opportunities

Investing in India has its risks and rewards. On the one hand, India is the fastest-growing major economy in the world, with a substantial and transforming reform agenda in areas such as infrastructure, taxation, deregulation of certain industries, transparency, governance, and labour markets. On the other hand, there are additional risks associated with investing in emerging markets, such as country, currency, specific market, and corruption risks.

Country risk is the collection of risks associated with investing in a particular country, such as political, economic, exchange rate, or sovereign risk. India's political and economic risks have diminished under the leadership of Prime Minister Narendra Modi, and the country is underpinned by strong and long-term market regulation.

Currency or exchange rate risk refers to the change in value of a currency relative to others. In the case of India, there is a risk of the Indian rupee depreciating against foreign currencies, which could lead to losses for foreign investors. However, the Indian rupee has shown relative resilience due to its solid macroeconomic fundamentals and the Reserve Bank of India's management during volatile periods.

Specific market risk is judged by how heavily a market is exposed to one or more industries. India's economy is driven mainly by internal consumption, with an 80% exposure to the local economy, and a diverse range of industry sectors.

Corruption risk is often raised when discussing investment in India. While corruption exists in all economies to varying degrees, Prime Minister Narendra Modi has made addressing corruption a key part of his platform, and there have been major inroads into curbing it, such as the demonetisation policy and restrictions on cash payments to political parties.

Overall, investing in India offers significant benefits, including diversification and better risk-return outcomes for international investors. However, it is important for investors to carefully assess and mitigate the risks associated with investing in the country.

Country risk: Political, economic, exchange rate, and sovereign risk

Country risk refers to the uncertainty associated with investing in a particular country and the potential for losses for investors. When investing in India, there are political, economic, exchange rate, and sovereign risks to consider.

Political risk in India includes the military confrontation with China and Pakistan in Kashmir, communal tensions (Hindu-Muslim), and a north-south political and economic divide. There is also a separatist insurgency in Jammu and Kashmir. Additionally, bureaucratic red tape, an inefficient justice system, and protectionism can create challenges for investors.

Economic risk in India is influenced by a large and young workforce with a good command of English, efficient IT services, and a diverse range of industries. However, there is also high corporate debt, non-performing loans, weak public finances, and a lack of adequate infrastructure. India is a net importer of energy resources, and there is widespread poverty, inequality, and informality.

Exchange rate risk, also known as currency risk, is the change in value of a currency relative to others. In India, falling inflation and increased capital in the banking system following demonetisation may decrease the short-term need for external borrowings and stabilise the currency.

Sovereign risk refers to the risk that a foreign government will default on its bonds or other financial commitments. While India's sovereign risk is not specifically mentioned, the country's commitment to strategic autonomy and its independent foreign policy approach could impact its sovereign risk profile.

Currency risk: The value of a currency can fluctuate relative to others

Currency risk is a common challenge for investors in any international market, and India is no exception. Currency risk, also known as exchange-rate risk, arises from the change in price of one currency in relation to another. This can create unpredictable profits and losses for investors with assets or business operations across national borders.

In the context of investing in India, the currency risk primarily relates to the fluctuation of the Indian Rupee (INR) against other currencies. The relative value of the INR to a foreign currency may change between the time an international trade deal is made and when the payment is received. For example, a devaluation or rise in the foreign currency against the rupee can cause either a windfall or loss for one party involved in the transaction.

To understand the currency risk when investing in India, it is essential to consider the exchange rate dynamics and the factors influencing them. The exchange rates between the INR and foreign currencies, such as the US Dollar or the Euro, can be quoted using direct or indirect quotation. In a direct quotation, the price of a foreign currency is stated in terms of the INR (e.g., USD 1 = INR 45.30). On the other hand, an indirect quotation expresses exchange rates as the number of units of foreign currency needed to get one unit of the INR (e.g., USD 2.208 = INR 100).

The exchange rates in India are influenced by various factors, including the demand for Indian goods and products in the world market, inflation rates, interest rates, and the overall economic health of the country. Additionally, the State Bank of India and the Reserve Bank of India (RBI) play a significant role in influencing the exchange rates due to their size and intervention activities in the market.

To manage currency risk when investing in India, there are several strategies that investors can consider:

• Hedging: Hedging is a common approach to mitigate currency risk. Investors can use foreign exchange derivatives, such as forex, futures, options contracts, or other derivatives, to hedge their exposure. For instance, a US investor holding stocks in India can hedge their risk by offsetting currency fluctuations.
• Investing in Strong Currencies: Focusing on countries with strong and stable currencies, such as those with low debt-to-GDP ratios, can help reduce currency risk. For instance, the Swiss Franc (CHF) and the New Zealand Dollar are often considered stable and reliable currencies for investment.
• Global Diversification: Diversifying your investment portfolio across multiple geographic regions can provide a natural hedge against fluctuating currencies. Investing in countries with their currencies pegged to a strong currency, like the US Dollar, can also be considered. However, it's important to remember that central banks may adjust these pegging relationships, potentially affecting investment returns.
• Currency-Hedged Funds: Investing in currency-hedged funds, such as exchange-traded funds (ETFs) or mutual funds, specifically designed to reduce currency risk can be a viable option. These funds typically use forex, options, or futures to hedge against currency fluctuations. However, it's worth noting that currency-hedged funds can also reduce potential gains and tend to be more expensive than non-hedged funds.
• Forward Exchange Contracts: Banks in India offer forward exchange contracts, allowing customers to lock in exchange rates for future transactions. These contracts provide flexibility, as they can be cancelled for a fee, and are useful when the transaction has a fixed maturity date.
• Currency Options: Currency options give investors the right, but not the obligation, to buy or sell a specific amount of foreign currency at a predetermined price (strike price). American options, which can be exercised at any time during the option period, offer more flexibility than European options, which can only be exercised on the specified expiry date.

While these strategies can help mitigate currency risk, it's important to remember that currency risk is inherent in international investments, and complete elimination of this risk is often not possible. Additionally, the effectiveness of these strategies may vary depending on the specific circumstances and market conditions.

Specific market risk: India's economy is driven by internal consumption, with an 80% exposure to the local economy

India's economy is primarily driven by internal consumption, with nearly 70% of its GDP fuelled by domestic consumption. This heavy exposure to the local economy, at around 80%, presents a specific market risk that investors should be aware of when considering investing in India.

The Indian economy's reliance on internal consumption means that its growth is largely dependent on the spending habits and financial health of its citizens. This can be a strength, as a large consumer base can drive growth and create a resilient economy. However, it also means that any changes in consumer behaviour or economic shocks that affect consumers can have a significant impact on the country's economic performance. For example, a decrease in consumer spending due to an economic downturn could lead to reduced demand and slower growth.

Additionally, India's economy is also influenced by other factors, such as government spending, investments, and exports. While these factors contribute to a lesser extent than internal consumption, they can still have a substantial impact on the country's economic outlook.

It is worth noting that India's economy is diverse, with various industry sectors contributing to its growth. While financials make up 32% of the economy, other sectors such as IT, energy, and automobiles also play a significant role, each representing less than 13% of the NSE 50 Index. This diversity can help mitigate the risks associated with a heavy reliance on internal consumption, as growth in one sector can offset potential declines in others.

In summary, when considering investing in India, it is important to carefully assess the specific market risk posed by the country's heavy exposure to the local economy. While internal consumption can drive growth, it also creates a level of dependence on consumer behaviour and spending power. Understanding these dynamics is crucial for making informed investment decisions.

Corruption risk: Abuse of power for personal gain is a concern in all economies

India is a desirable investment destination for many global companies. It has a highly skilled workforce, a large English-speaking population, a growing domestic market, and a stable, democratic government. However, corruption is a significant challenge for companies investing in and operating in India.

Abuse of power for personal gain is a concern in all economies, and India is no exception. In a 2017 Transparency International survey, nearly 7 in 10 individuals in India admitted to paying a bribe to access public services, the highest bribery rate in the Asia-Pacific region. Corruption is particularly prevalent in the judiciary, police, public services, and public procurement sectors.

The World Economic Forum identifies corruption as one of the top three most problematic factors for doing business in India. Widespread red tape, a cumbersome bureaucracy, and a high tolerance for corruption present operational risks for companies.

To address these challenges, India has a regulatory structure in place to fight corruption, with the Prevention of Corruption Act (PCA) as the main law governing corruption. The PCA focuses on the bribe taker, making the receipt of a bribe by a public official punishable under the law. Several other Indian statutes also cover corruption-related activity, and the government has implemented reforms to address corruption.

To successfully manage corruption risk in India, global companies must continuously strive to formulate ways to address and manage this challenge. Implementing a risk-based anti-corruption compliance program suited to the company's operations in India is crucial. Such programs should take into account India-specific operational and regulatory risks, the nature of products and services, government interactions, and the reliance on third-party intermediaries.

Successful compliance teams utilize local individuals with compliance experience who understand local customs and culture. They provide anti-corruption training in the local language and conduct a risk ranking of third-party intermediaries within an integrity due diligence program.

By focusing on growth, maintaining a strong internal control system, and implementing a customized and effective anti-corruption compliance program, global companies can successfully navigate the corruption risks associated with investing in India.

Inflation and oil price risks: Higher oil prices can impact India's inflation, trade, fiscal balances, and consumer disposable income

India is a net importer of crude oil, fulfilling approximately 85% of its energy needs through imports. As such, the country is vulnerable to the impacts of higher oil prices, which can affect several aspects of its economy. Here are some key considerations regarding the risks of investing in India in relation to oil price inflation:

Impact on Inflation

Higher oil prices can contribute to inflation in India in several ways. Firstly, as a major economic input, rising oil prices can directly influence the overall rate of price increases across the economy. This dynamic was evident during the 1970s, when there was a strong correlation between inflation and oil prices. While the correlation has weakened since then due to a reduced reliance on energy, oil prices can still exert inflationary pressure, especially if supplemented by more expensive renewable energy sources.

Additionally, crude oil is a key ingredient in petrochemicals used to make plastic. Therefore, higher oil prices can increase the prices of many products made with plastic. Consumer prices also factor in transportation costs, including fuel prices, further contributing to overall inflation.

Trade and Fiscal Balances

Higher oil prices can negatively affect India's trade and fiscal balances. As a net importer, India's import bill is expected to increase with rising oil prices, leading to a heavier financial burden. This increased expenditure on oil imports can widen the country's current account deficit, impacting its balance of trade with other countries.

Furthermore, higher oil prices can impact the fiscal deficit. The Indian government bears the difference between the market price and the controlled price of oil and gas end-products, such as kerosene, diesel, and liquefied petroleum gas (LPG). As oil prices rise, the subsidy burden on the government increases, potentially widening the fiscal deficit as a percentage of GDP.

Consumer Disposable Income

Rising oil prices can influence consumer behaviour in India. Higher prices at the pump can lead to reduced disposable income for consumers, as they spend a larger portion of their income on fuel. This can, in turn, affect their demand for goods and services, particularly discretionary spending. Lower consumer spending can impact economic activity and influence inflation dynamics, especially in sectors heavily dependent on consumer demand.

Monetary Policy and Interest Rates

Higher inflation and lower economic activity due to oil price increases can impact India's monetary policy. Central banks may need to maintain higher interest rates for longer to control soaring prices. This can have spillover effects on consumption and investment behaviour in the economy.

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