What Is The India-China Investment Rebalancing All About?

Shashank Shah (name changed) started buying small quantities of ETFs or exchange-traded funds which track Hong Kong’s Hang Seng Index in early March. Shah, who manages a Rs 500 crore family office portfolio, sold it at the end of March for a tiny profit but plans to re-enter later. 

It was the first time in his life that he was dipping his toes in a Chinese asset. The direction of the world’s second-largest economy over the previous few months and ensuing rock-bottom valuations were the main attractions for him, he told The Core on the condition of anonymity, as the family office does not speak to the media. The Shanghai Composite Index hit its lowest level in five years on February 2, 2024. China reported a 7.1% growth in exports (analysts do not see a slump in March affecting the growth trajectory) and a 7% uptick in industrial output in the first two months of this year. 

Shah is not the only one to have noticed the shift. A Mumbai-based investor said he had been studying China for weeks and is ready to jump in now. International investors too have begun rebalancing their portfolio. Lazard Asset Management, Manulife Investment Management, and Candriam Belgium NV cut their exposures to India while adding China stocks, Bloomberg reported last week. 

“It’s a very strategic play,” said technical analyst Damanick Dantes, who owns global strategy firm Dantes Outlook. “Short-term momentum indicators have shifted negatively on India versus China, similar to what occurred in October 2022. However, after that signal, China’s outperformance was short-lived, and the relative uptrend in India/China resumed,” Dantes told The Core over a video call from New York.

Investors looking at India are baulking at high equity valuations. The BSE Sensex closed above the 75,000 mark for the first time on April 10. The hope that a Bharatiya Janata Party government led by Prime Minister Narendra Modi will return to power underpins investor optimism. Shanghai-based investment bank Haitong’s Indian arm, Haitong Securities, said it remained convinced of the Indian market’s long-term strength, and expected to see a strong pick up post elections. In an April 5 note, Haitong pointed to “a proven incumbent, the likelihood of a declining interest rate environment, and the country coming off the drought effects of an El Nino” as factors underpinning the rise.

Passive inflows will also increase as India’s weightage in the MSCI’s Global Standard Index has risen to 18.2%, narrowing its gap with China, which is at 25.4%. Five years ago, India’s weightage was 8% while China’s stood at 31%.

“Dedicated global emerging market investors are only moderately overweight India despite all the current issues affecting China,” Christopher Wood, global head of equity strategy at Jefferies wrote in a February report titled India’s March onto the Global Stage. “[The current] lack of exposure to India by global investors is, frankly, absurd,” Wood wrote.

A unique competition, inviting and forbidding at the same time, is taking shape between India and China. It’s based on momentum and liquidity in the short term. But structural shifts intertwined with strategic interests will determine long-term outcomes. It will also pose a dilemma for investors. While India, as the world’s largest democracy, a growing economy, and a large market, is a naturally attractive destination for global capital, China offers less hassle, manufacturing prowess, and consumption power far greater than its neighbour. But there is hostile regulatory upheaval in China, while India may be on the verge of coming good on the tantalising promise it has always held out. 

“The degree of difficulty to make money in China today is very high,” said Ajay Krishnan, director and lead portfolio manager at Wasatch Global Investors. “And since we do not get paid for the degree of difficulty, we might as well go where it is easy to make money.” 

Krishnan, who manages about $600 million under the Wasatch Emerging India Fund, said the competitive intensity in China is prohibitive, which compresses the return on capital. By contrast, Indian firms tend to maintain, and in some cases improve, their return on capital. 

“So the good stewards of capital were the ones who gained share and maintained share,” he told The Core on a call from his base in Salt Lake City, Utah. “That was the fundamental difference between India and China.” He saw tailwinds emerging in India in 2018 because of three trends: financialisation, formalisation, and digitalisation. 

What China Wants

China dreads the infamous K-shaped economy and has been proactively curbing commercialisation of sectors such as education and financialisation of its economy, a departure that has riled the West. 

Financialisation means the dominance of an economy by companies engaged in financial services such as investments and intermediation. Unlike traditional banking, which aggregates money to serve other parts of the economy, primarily manufacturing, the financial services industry adds layers of complex instruments and structures to maximise the return on capital. Companies begin to focus on numbers instead of products and R&D, as profits become sacrosanct. The pushback from shareholders of energy companies against their environment, sustainability and governance objectives is an example of prioritisation of return on capital above all else. 

"China faces a fork in the road—rely on the policies that have worked in the past, or reinvent itself for a new era of high-quality growth," the International Monetary Fund's Managing Director Kristalina Georgieva said in a meeting of senior Chinese officials and executives from global companies at the China Development Forum in March. But past practices are exactly what China wants to break away from. 

Yao Yang, dean of Peking University's National School of Development and one of the country’s most influential economists, said China has learnt from the American experience that too much financialisation of the economy is harmful to manufacturing. Yang identifies financialisation as the main reason for the “hollowing out” of US industry and believes the adjustments China is making will cause short-term pain but will leave the economy healthy in the long run. 

The financial services sector accounted for more than a fifth of US GDP, while manufacturing was only half that in 2023. Its share was 8%, while industry contributed 31.7% to China’s  GDP in the same year. Financialisation was acknowledged to be at the root of the 2008 Global Financial Crisis that originated on Wall Street. It also creates a secondary problem that weakens countries. As the government is always the last resort in crises, the losses of the financial sector eventually get shifted to it and reduce the fiscal headroom. The US’ debt-GDP ratio jumped from 63% in mid-2008 to over 80% in one year. It had climbed to 121% at the end of 2023. By contrast, China’s debt to GDP ratio reached 286.1% at the end of 2023 and it wants to avoid the US experience at all costs. 

Investors, however, do not want to get caught in policy whiplash. “With China, there is still a bit of black box conundrum,” Malcolm Dorson, head of emerging markets strategy at Global X ETFs, a unit of Mirae Asset, told The Core over a Zoom call from New York. 

Not that Indian regulators are not tightening the screws. But the key difference is that Indian regulators have been quite transparent about their concerns. 

“Investors have a firm understanding of what the RBI [Reserve Bank of India] and the government are trying to set up and what they're trying to protect,” says Dorson, who manages an active India ETF launched in August last year. “That's very different from the Chinese government waking up one morning and making an announcement that we're not going to allow after-school tutoring anymore, or that we're only going to allow one hour of video game playing and things of that nature.” 

He believes the Chinese government's actions are much deeper in domains within different sectors and sub-sectors with less transparency about what it’s trying to accomplish. The general impression is that China’s approach to regulation here is to make them more fair and competitive in the long term. 

That speaks to why Washington is getting jittery. 

The US-China Equation

Beijing is determined to reform its economy and how industries behave in society to align with President Xi Jinping’s “common prosperity” doctrine. With the state as the key supplier of strategic capital, it is also pulling out all stops to deploy resources for rapid advancement in technologies, whether in communications, energy, or space. 

Its companies claim to have made miniature atomic energy batteries, have demonstrated a technology to directly split seawater to produce green hydrogen, and send people to space. China already has a commercial aircraft in the market even as the world’s leading aeroplane makers Boeing and Airbus face headwinds. Despite the US cutting off China’s access to chip technology, telecom and electronics giant Huawei managed to build advanced semiconductors. 

“The character of China’s economic revival will be slightly different,” said Amitendu Palit, senior research fellow and research lead (trade and economics) at the Institute of South Asian Studies at the National University of Singapore. “It is giving up on mass-produced goods and focusing on high-end items.” Palit, who specialises in international trade, investment policies, free trade agreements, and supply chains, said China is by far the leader in artificial intelligence and is also heavily subsidising the industry. Chinese inventors secured 40,000 patents in 2022 compared to the US’ 9,000.

The shift, although worrisome for the US, is good for India as it vacates some labour-intensive fields for others to step in. Apple shifting gadget production out of the country, including to India, is a good example.

Under Xi, the country has also built powerful alliances with Russia and in West Asia, a major source of energy and capital. Apart from its rising economic, technological and military might, some of its friends are the US’ arch rivals, which agitates the latter even more. On her recent trip to China, treasury secretary Janet Yellen, once a big supporter of Beijing, pretty much asked it to stop competing so intensely with the US. Contrary to Peking University dean Yao’s analysis, Yellen said the “hollowing out” of industrial production in many parts of the US happened after China joined the WTO, which cost her country two million jobs. She said China’s huge manufacturing capacity was a widespread global concern and it should instead focus on boosting domestic consumption. 

Although the West would like India to step into China’s shoes, it is difficult for supply chains to delink or even move substantially away from that country. 

According to an India macro analyst at one of the largest US mutual funds, who spoke to The Core on condition of anonymity, one China-related worry is that the US government may prohibit asset managers from investing there. 

Wasatch’s Krishnan said the overall sentiment is negative. Some of the state pension plans have been mandating fund managers to not have any investments in China. He, however, cautioned that the negativity is primarily led by the West. “The mistake people make is to extrapolate that to the whole world. China is doing a masterful job of building relationships in the Middle East,” he said. 

“In the US, we get this jaundiced view that we don’t like China so no one else will like it either. The truth is somewhere in the middle,” he added. 

Short Term, Long Term

“Going long emerging markets still means going long China, although overweighting India has paid off very well in recent years,” said technical analyst Dantes. “From a technical perspective, the MSCI India Index's long-term uptrend remains intact, but is starting to wane relative to the MSCI China Index.” 

The long-term India story is currently riding on capital expenditure. While the government has stepped up infrastructure building, Krishnan, who visited India in February, believes unlike earlier misfired promises, the manufacturing capex cycle is taking off, which will help create much-needed basic jobs for a huge unskilled and semi-skilled workforce. 

“For the first time in the 20 years that I have followed Indian companies, I’m seeing real movement in manufacturing,” said Krishnan.

The RBI’s quarterly order books, inventories, and capacity utilisation survey showed that capacity utilisation in manufacturing rose to 74.7% in October-December 2023 from 74% in the previous quarter. The central bank believes there is an uptick in private capex and consumption.  

Not everyone shares that optimism. “These small, imperceptible upticks have happened in the past. I will not place my penny on a turnaround in capital expenditure,” said Mahesh Vyas, managing director and CEO of private research and survey firm Centre for Monitoring Indian Economy. “The capex story is not getting any worse. It is not getting better (either) yet.”  

Although India’s per capita income has crossed $2,000, which has historically been the threshold for countries to leap towards becoming middle-income nations, its growth rate is hobbled by an inability to generate enough jobs, which in turn would raise incomes and boost consumption, triggering a virtuous cycle of growth. 

China’s household savings has climbed to a mammoth $19.3 trillion. Meanwhile, India’s household savings rate has been plummeting. The latest RBI data on the flow of financial assets and liabilities shows that households’ net financial assets plunged from 11.5% of GDP in FY21 to 5.1% of GDP in FY23. In gross terms, it fell from 15.4% to 10.9% of GDP. It can reverse only if more jobs are created and incomes go up.  

Barclays recently said that India’s ability to maintain growth rates will fundamentally depend on its ability to self-finance investment to maintain macro-stability. That would require household savings to go up 2.7% by 2030. 

Election Worries

“Despite Modi’s 70% plus approval rating, polls have been wrong in various elections across the world the past few years,” Global X’s Dorson said. “The continuation of Modi's vision and economic policies are baked into the India story.”

And although there are concerns about one-party dominance, they may not matter much, according to the earlier-quoted macro analyst. “Electoral autocracy (in India) is a fact of life which Western governments will ignore for strategic reasons. Nobody expects a rapprochement with China.” 

Dorson, meanwhile, sees a 15%-20% fall in valuation in case of an election surprise. Many investors will exit. “But a lot of people who have been staying away from India for valuation concerns will start doing their homework because that structural demographic backdrop would still be there.” He said it could turn into an opportunity, because valuations will become attractive.