Covid-19 has changed our world and shone a bright light on previously unacknowledged vulnerabilities, such as the great, teetering tower of global supply chains, writes Fiona Rintoul.
Overexposure to China is a common concern not just because of Covid-19, but also the US-China trade war, and India – a democracy with a huge population that is much younger than China’s and where English is an official language – potentially stands to benefit.
According to a study sponsored by the United Nations Conference on Trade and Development (UNCTAD), the US diverted imports worth US$755 million from China to India in the first half of 2019. Meanwhile, Japan is already providing incentives to its companies to move their manufacturing out of China. Apple supplier Wistron announced in March that it wants to have 50% of its global manufacturing base outside China by 2021.
“Companies and countries find themselves overexposed and look for credible alternatives to de-risk and diversify their exposures,” says Ramesh Mantri, investment adviser to Ashoka India Equity (AIE) Investment Trust. “India can be a large potential beneficiary of this emerging trend along with Prime Minister [Narendra] Modi’s push towards the ‘Make in India’ vision, which envisages India as the next global manufacturing hub.”
“Can be” is right. Movement towards India is in early chapters.
“We have to remind ourselves that the infrastructure in India is pretty weak, as is the supply chain,” says Asian equities specialist Joshua Crabb, senior portfolio manager at Robeco.
The $755 million of US imports diverted from China to India in the first half of 2019 looks relatively small in the context of the $21 billion worth of total goods diverted by the US in that period. Other larger beneficiaries included Taiwan ($4.2 billion), Mexico ($3.5 billion), the European Union ($2.7 billion) and Vietnam ($2.6 billion).
Push and pull
Diversification of supply chains is not the only reason manufacturers may look to leave China. Rising labour and manufacturing costs (China’s labour costs are twice those of India) are also a factor, and in that respect other east Asian countries, such as Vietnam and Thailand, may offer a better alternative.
“India has historically not been integrated with the global supply chains,” says Praveen Jagwani, chief executive of UTI International Private Limited. “An anti-China push does not naturally translate to a pro-India pull. Developing an ecosystem of physical, legal and regulatory infrastructure to take advantage of this global disruption takes time.”
There is also the inertia factor. Covid-19 may have exacerbated existing concerns about overexposure to China, but it could put a brake on rerouting decisions too. India can very quickly come up with the required land to facilitate new manufacturing facilities, but it will take much longer for production lines and supply chains to be changed in the current climate, according to Ken Wong, client portfolio manager at Eastspring Investments.
“These tend to be much stickier,” he says. “Given the current global pandemic situation, companies might have to think more carefully when it comes to increasing capex and moving manufacturing capabilities from one place to another.”
Nonetheless, the Modi government is developing the ecosystem that Jagwani says is required for the country to take advantage of global disruption. For David Cornell, chief investment officer of Ocean Dial, which runs the India Capital Growth fund, corporate tax reform in late 2018 was a marker in the sand.
“India cut its corporate tax rate from the least competitive in Asia at over 30% to 22%, which was not quite the most competitive in Asia but getting very close to it,” he says.
At the same time, the cost of capital is coming down, and much-needed infrastructure is being built. Cornell also sees India tackling important issues such as land reform, labour reform, compliance, bureaucracy and corruption. As a result, it has shot up the World Bank Ease of Doing Business index from 134th to 63rd position.
“Ironically, as GDP growth has shrunk, ease of doing business has gone in the opposite direction,” he says. “Modi is using technology as much as he can to remove the bureaucrat from the decision-making process about attracting foreign investment.”
A friendlier face
In 2019, India became the world’s ninth-largest recipient of foreign direct investment, attracting deals worth $51 billion. Incrementally, FDI flows are growing more quickly in India than in China, as India moves to make its FDI rules more foreign-friendly in the face of a fiscal position that Crabb describes as “not super-strong”.
“Historically, India wasn’t that inviting to foreign capital, but that has started to change,” he says. “They’ve started to loosen up in the bond markets and increasingly around ownership of other assets in the market.”
It’s a pattern that is familiar from China and other emerging markets – though, in India, Crabb believes investors are waiting to see more government-led infrastructure investment, which hasn’t been as high as expected. Like China, India offers foreign investors something more than cheap labour. With a population of almost 1.4 billion, it is a huge market in waiting.
“India’s large domestic consuming population is the appropriate bait for foreign corporations to shift manufacturing to India,” says Jagwani. “The lure of local scale provides a safety net for an export-orientated manufacturing plant.”
With ever more focus on ESG, India may also offer investors comfort in terms of non-financial elements such as rule of law and judicial process. But for foreign companies, market access is complicated by local content rules that favour local businesses. Crabb notes that Walmart, for example, encountered local hurdles when trying to crack into the Indian market.
“That should also be taken into the mix,” he says.
But the Indian market’s sheer size perhaps compensates. Right now, India has a huge import bill, importing equipment that it then uses to assemble onshore. Import substitution of consumer electrical items such as mobile phones, washing machines and LED lighting is therefore a big theme.
“Ninety percent of this was imported from China, so India is starting to manufacture it domestically, not only to provide their enormous domestic market but also as an export base to compete with China and others,” says Cornell.
Alongside import substitution with local manufacturing, India is emerging as a global destination for electronic manufacturing services. According to Mantri, large producers of electronic appliances such as Apple, Samsung, Xiaomi and LG have significantly scaled up their manufacturing in India.
“India’s mobile exports have grown twelvefold in the last two years, and India is now geared to become one of the leading mobile handset manufacturers globally,” he says.
Another growth area Mantri highlights is speciality chemicals. He sees India benefiting from a shift of the global chemical supply chain away from China, with large global chemical companies doing “big deals” to invest/partner with Indian chemical companies for strategic sourcing.
“India’s competitive advantages include strong chemistry skills, low labour costs and strong local compliance to environment norms,” he says.
Cornell notes that growth is also strong – 8-10% per year – in the related sector of pharmaceuticals, driven in part by huge domestic demand for pharmaceutical products. As Indians adopt a more Western lifestyle, they are getting more Western diseases, such as diabetes.
All in all – partly but not exclusively because of a shift away from China – India could be on the cusp of massive development. There are many challenges for investors, including currency fluctuations.
“People are learning that the hard way,” says Cornell.
But the opportunity is huge, and this could be the point of departure.
“It will take five years or a generation before India starts to compete meaningfully,” says Cornell, “but we think we may be at the beginning of that journey.”
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