Last month, the McKinsey Global Institute (MGI) published a 95 page report (The emerging equity gap: Growth and stability in the new investor landscape) arguing that over the next decade, there is likely to be a shortage of equity investors globally. This is based on two arguments:
- Demographics and the regulatory aftermath of the financial crisis are reducing the demand for equities from investors in developed markets.
- Global wealth is shifting to emerging market investors who have historically had less appetite for equity investment.
The second prong of this argument is clearly debatable. Had there been a think tank examining such questions in the nineteenth century, it too would have worried about the shifting of wealth from the UK (which was then the dominant source of risk capital for the world) to newer rivals. We do know with hindsight that with increasing wealth, the rising powers of the nineteenth century went on to become major sources of risk capital to the rest of the world. That could well happen again, but it will not happen unless today’s emerging markets create the preconditions for a vibrant equity market.
MGI is therefore on much stronger ground when it discusses the policy steps that emerging markets should take to develop their equity markets – strengthen the legal and regulatory foundations of equity markets; expand channels for households to access equity markets; and enable the growth of institutional investors. (pages 55-56).
All of this is of great relevance to India which has thrived during the last two decades on foreign risk capital. India has a large domestic savings pool and could perhaps at a crunch get by on only these savings. But two-third of household financial savings go into risk free assets like currency, deposits and small savings. Most of the remaining third goes into insurance and retirement funds which in turn invest a very large part of their resources in government bonds and other safe assets. Only around 1% of household savings go into equities. India may have nearly enough aggregate savings, but there is an acute shortage of risk capital.
Foreign portfolio capital has bridged this gap during the last two decades. Since these capital inflows exceed the aggregate savings shortfall, a part of the capital flows ends up as foreign exchange reserves which finance profligate governments in the developed world (and post 2008, this lending is far from being risk free).
Without foreign risk capital, it would have been impossible for the Indian private sector to come anywhere near the growth rates that it has achieved in the last two decades. But we must recognize that the reliance on foreign risk capital is a short term fix to the shortage of domestic risk capital. As we saw in 1998 and again in 2008, this dependence creates serious vulnerabilities. When foreign portfolio flows reverse, risk capital disappears and weak balance sheets cannot raise money at all. (Strong balance sheets can perhaps raise debt locally). Secondly, capital inflows can ignite asset price bubbles and outflows can prick the bubbles. Asset prices in India often depend on global risk aversion even more than on domestic sentiment.
It is true that Indian equity markets have been one of the great success stories of financial sector reforms (the contrast with the dismal state of the corporate bond market is particularly glaring). But we must not forget that even this success consists principally in the fact that foreign equity risk capital is largely intermediated through Indian markets (by contrast, the Indian corporate debt market moved offshore because of poor regulatory choices).
Creating a pool of domestic risk capital will take a long time and that is all the more reason why we must start soon. We will need a lot of things to get there – well developed and liquid markets, institutional support to facilitate easy access, sound regulatory regimes to provide investor protection and confidence, and finally investor education and awareness.
India would need to do all this in its own interest. What MGI is saying is that India (and other emerging markets) might be forced to do this even faster because the foreign pool of risk capital may be about to dry up.