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August 2012 A. Gary Shilling's INSIGHT 1

INSIGHT (ISSN 0899-6393) goes to press by the third business day of the month. 2012 A. Gary Shilling & Co., Inc., 500 Morris Avenue, Springfield, NJ07081-1020. Telephone: 973-467-0070. Fax: 973-467-1943. E-mail: [email protected]. Web: www.agaryshilling.com.President: A. Gary Shilling. Editor: Fred T. Rossi. Research Associates: Colin Hatton and Luke Henninger.All rights reserved. No part of this publication may be reproduced or redistributed without the written permission of A. Gary Shilling & Co. Material contained inthis report is based upon information we consider reliable. The accuracy or completeness is not guaranteed and should not be relied upon as such. This is not asolicitation of any order to buy or sell. A. Gary Shilling & Co., Inc., its affiliates or its directors and employees may from time to time have a long or shortposition in any security, option or futures contract of the issue(s) mentioned in this report.

India: Economically BetterIn The Long Run Than China

In This Issue

December 2012

In the long run, well bet on India as the leader of major developing countries anda significant player on the global economic stage.

What Happened To China?

Until recently, most saw China as the undisputed king of emerging world powers.Indeed, until the 2008-2009 Great Recession, the adulation of China remindedus of the fascination over Japan in the 1980s when many Americans thoughttheyd soon be working for Japanese companies or run out of business by them.But the early 1990s collapse in Japanese stocks (Chart 1, page 2) and real estate(Chart 2, page 2) unveiled the earlier bubble economy for what it was, and Japanhas been in a deflationary depression ever since.

Those dazzled by China often forget that much of her rapid growth before 2008(Chart 3, page 2) was caused by the shift of global manufacturing from Europeand the U.S. to China, not by domestic-driven activity. Indeed, Chinas economy

remains export-driven, with consumers accounting for only 37.7% of GDP(Chart 4, page 5), almost off the low end of the chart compared with otherdeveloping and developed countries (Chart 5, page 5).

As discussed in many past Insights and in our recent book, The Age of Deleveraging:Investment strategies for a decade of slow growth and deflation, the global deleveraging offinancial institutions, the unwinding of U.S. consumer debt and rebuilding ofassets and the deleveraging in other sectors here and abroad will probably take

Volume XXVIII, Number 11 December 2012

India: Economically Betterin the Long Run Than China 1In the long run, India has manyadvantages for economic development,especially compared to China, thanks inpart to the systems and traditions leftover from British colonial rule.Recent issues such as the Great GlobalRecession and slow recovery and apoor 2012 monsoon as well as

government policies that discouragedomestic and foreign direct investmentand government scandals resulted inleaping fiscal and current accountdeficits, a falling currency, warnings ofa credit rating downgrade, falling stocksand reductions in Indians' ability to buygold.Even if these reforms are instituted,India still faces long-run challenges torapid economic growth such as landreforms; reduction in bureaucracy;business regulation and widespreadcorruption; much higher qualityeducation and training; reductions inincome inequality and poverty;dismemberment of castes and betterrelations among ethnic groups;reductions in rural subsidies and other

measures to speed up urbanization; andvastly improved infrastructure.

Investment Themes 24Summing Up 25

Semi-Annual U.S. Economic Outlook:Very Cloudy 40A global recession in 2013 appearslikely. The U.K. and eurozone arealready in business downturns. Japanis in or close to recession. And Chinaseems headed for a hard landing. Othercountries, especially commodityexporters like Brazil, Australia andCanada, will be dragged along.In the U.S., the fiscal cliff will probablybe averted. Housing, despite recentstrength, is still plagued with excess

inventories and a likely big wave offoreclosures. Capital spending isburdened by weak business confidenceand excess capacity. Weak householdincome makes consumer spendingsuspect. Export growth is curtailed byeconomic weakness abroad.

Commentary Noble Intentions 64

We thank you again for your understanding of the difficulties we experiencedlast month in connection with Hurricane Sandy that led us to decide not

to publish a November 2012 INSIGHTreport. The expressions of concernand support from INSIGHT readers were very much appreciated byeveryone at A. Gary Shilling & Co.To make up for this loss, we're publishing a double report this month withan in-depth look at India, which we had planned for our NovemberINSIGHT, as well as our normal semi-annual U.S. Economic Outlook.

Economic Research and Investment Strategy

A. Gary ShillingsINSIGHT

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another five years or so to complete.Meanwhile, the Eurozone financial crisispersists, the result of combining theTeutonic North with the Club MedSouth under one currency with nocommon fiscal policy and none likely.As a result, the major markets forChinese exports will be subdued formany years.

They Are Aware

Chinese leaders are well aware of thenecessity of shifting to a much moredomestically-driven economy, and areworking in that direction. They wantChinese households to spend more andsave much less than the current rate ofalmost 30% (Chart 6, opposite page).They save because in a Confuciansociety, providing for ones family isimportant. Also, they save to educatetheir one child-per couple and to coverhealth care and retirement costs sinceChina lacks the equivalent of Medicareand Social Security. In 2010, the Chinesegovernment promised basic health carefor all Chinese by 2020, but thats stilleight years away, and basic care inChina is pretty basic! In some ruralhospitals, a practical nurse is the mosthighly-trained medical practitioner.

China has also increased minimumwages 20% to 30% in the last year toenhance consumer incomes andpurchasing power. But higher wages,notably for factory workers producinggoods that foreign companies will export,are driving low-skilled manufacturingjobs to cheaper venues like Vietnam,Bangladesh and Pakistan.

Furthermore, Western companies areincreasingly resisting the requirementsthat they transfer technical expertise toChinese partners as the price of gettingpermission to produce in China. Manybelieve that much of the success ofChinese manufacturers is due tovoluntary tech transfers or stolenintellectual property.

CHART 1

Nikkei 225 Index

Source: Yahoo Finance

Last Points 12/3/12: 9,458

Jan-84 Feb-88 Feb-92 Mar-96 Apr-00 Apr-04 May-08 Jun-12

5000

10000

15000

20000

25000

30000

35000

40000

5000

10000

15000

20000

25000

30000

35000

40000

CHART 2Japanese Urban Land Prices

Source: Japan Real Estate Research Institute

Last Point 1Q 2012: 67.9

six-city average; 1Q 2000=100

1980-I 1985-I 1990-I 1995-I 2000-I 2005-I 2010-I

50

100

150

200

250

300

50

100

150

200

250

300

CHART 3

Chinese GDP

Source: Chinese National Bureau of Statistics

Last Point 3Q 2012: 7.4%

year/year % change

2005 2006 2007 2008 2009 2010 2011 2012

5%

6%

7%

8%

9%

10%

11%

12%

5%

6%

7%

8%

9%

10%

11%

12%

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These forces probably lay behindChinas recent significant reduction inher real GDP annual growth rate targetfrom 8% to 7.5%. And that target isprobably high for future years as herone child-per-couple policy spawnspopulation declines (Chart 7, page 4),especially among new labor forceentrants. Those 15-24 years old arealready dropping in number and areprojected to drop from 250 million in1990 to 150 million in 2030. As a result,Chinas labor force age 15-65 is expectedto peak in 2014.

Estimates are that ample labor boostedGDP growth by 1.8 percentage pointsannually since the 1970s, but thecontraction will knock growth by 0.7percentage points by 2030. At the sametime, better conditions in rural areashave cut the availability of cheap laborin coastal cities as fewer move therefrom the hinterland.

Indias Advantage

In contrast with China, India has had noeffective constraints on populationgrowth and her number, 1.24 billion in2011, vs. Chinas 1.34 billion last yearwi ll so on be bigger (C ha rt 7) .Furthermore, the age distribution ofIndia (Chart 8, page 4) is quite differentthan that of China (Chart 9, page 4) as aresult of Chinas one-child policywhich is now being reconsidered inview of its negative influences on long-term labor force and economic growth.Consequently, the dependency ratio,the ratio of children and seniors to theworking-age population, is expected to

continue to fall in India in comingdecades but rise in China (Chart 10, page5)

Younger people, of course, tend to bemore geographically mobile, flexible interms of occupation and creative. Butthese advantages only translate into moreproductivity and economic growth ifthey have the proper education andtraining as well as job opportunities.

CHART 4

Chinese Consumption, Exports and Investment

Source: World Bank

Last Points 2011: exports 29.3%; investment 46.8%; consumption 37.7%

as a % of GDP

1980 1985 1990 1995 2000 2005 2010

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

55%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

55%

Exports of goods and services (% of GDP)

Gross fixed capital formation (% of GDP)

Household final consumption expenditure (% of GDP)

CHART 5G-7 and BRIC Personal Consumption-to-GDP Ratio

Source: World Bank and Organization for Economic Cooperation and Development

2011

71.1%

64.4%

61.3%

60.4%

60.3%

58.0%

57.7%

57.3%

57.1%

52.1%

37.7%

35% 40% 45% 50% 55% 60% 65% 70% 75%

U.S.

U.K.

Italy

Japan

Brazil

India

France

Germany

Canada

Russia

China

CHART 6

Chinese Household Saving Rate

Source: Chinese National Bureau of Statistics

annual average

2003 2004 2005 2006 2007 2008 2009

20.0%

22.5%

25.0%

27.5%

30.0%

20.0%

22.5%

25.0%

27.5%

30.0%

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Think what you may about colonialism,British control of India for severalcenturies left her with a vigorousdemocracy and a parliamentary formof government. As in the U.S., thisform of government is very useful inrunning a large, religiously diversecountry where the central governmentis constrained by increasingly powerfulstates and weak coalition governments.When India gained independence fromBritain in 1947, there was no significanteffort to return to Mogul Empire orother authoritative regime where , as inChina, the Mao Dynasty simply replacedthe dynasties of oldin the name ofthe people, of course!

The British also left India with a railwaysystem that facilitated the relativelyeasy movement of people and goods inthat vast country. In contrast, Chinadoes not grant resident status to farmerswho move to urban areas in search ofwork.

English Language

And, of course, the British gave Indiathe English languagevery useful intodays English-dominated world and ahugely unifying force in a country withhundreds of languages and dialects. Inthe Indian state of Karnataka, less than50% of the people speak Kannada,supposedly the majority language. Inthe north, many speak Marathi, in thewest Tulu and Konkani, Tamil in thesouth and Telugu in the west. Andacross the state, many speak Urdu. Allthese people are native-bornKarnatakans.

India also inherited her legal systemfrom the U.K., very different than theCommunist party-dominated courts inChina, complete with show trials andforgone convictions, as demonstratedby the recent trial and conviction of GuKailai, wife of disgraced party leaderBo Xilai.

India also has a number of large and

CHART 7

Population Projections for India and China

Source: World Bank

millions

2010 2015 2020 2025 2030 2035 2040 2045 20500

200

400

600

800

1,000

1,200

1,400

1,600

1,800

0

50

100

150

200

250

300

Total India - left axis

Total China - left axis

15-24 India - right axis

15-24 China - right axis

CHART 9

China 2010 Population Distribution

Source: United Nations

millions

CHART 8India 2010 Population Distribution


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sophisticated companies such as theTata complex that can compete globally.In contrast, China is burdened withgovernment-controlled banks and otherhugely-inefficient state-ownedenterprises that still produce 50% ofGDP and employ a quarter of theworkforce.

Indias vigorous free press also camefrom Britain, although officials recentlyblocked the twitter accounts of someprominent journalists who had beencritical of Prime Minister ManmohanSingh. The government said it blockedcontent that promoted violence betweenMuslim settlers and an indigenous groupin the northeast of the country thatkilled 80 people. Furthermore,executives from Google and Facebookare facing criminal prosecution for notremoving Web content that Indianofficials consider objectionable eventhough both companies say they followedthe letter of the law. Internet use inIndia is leaping but still tiny comparedwith the U.S. and even the other BRICcountries (Brazil, Russia, India andChina) (Chart 11).

Free Market Orientation

For the first half-century ofindependence, Indian politics weredominated by the Congress Party andits socialistic orientation and attempts toemulate the Soviet Union. In the 1950s, steel, mining,machine tools, water, telecommunications, insurance,electricity generation and other industries were effectivelynationalized.

Innovation was stifled by the Industries Act of 1951 that

required all businesses to get licenses from the governmentbefore they could launch, expand or change their products.The licence raj reigned. The government imposedimport tariffs in the name of encouraging domesticproduction, and domestic firms were prohibited fromopening foreign offices. Foreign investment dried up understringent restrictions.

As a result, manufacturing never blossomed and theeconomy grew at what Indian officials accepted as theHindu rate of growth of 3% to 4% annually, distinctly

CHART10

India and China Dependency Ratios


ratio of children (age 0-14) and elderly (age 65+) to working-age population

1950196019701980199020002010202020302040205020602070

0

10

20

30

40

50

60

70

80

90

0

10

20

30

40

50

60

70

80

90

India

China

CHART11Indian Internet Users

Source: World Bank

Last Point 2010: 7.5

per 100 people

1992 1995 1998 2001 2004 2007 2010

0

1

2

3

4

5

6

7

8

0

1

2

3

4

5

6

7

8

2010 Internet Users/100

Iceland 95.6

USA 74.2

Russia 43.3

Brazil 40.7

China 34.4

India 7.5

subpar for a developing economy while other Asianeconomies leaped. Between 1950 and 1973, the Indianeconomy annually grew 3.7% (Chart 12, page 6), or 1.6%per capita, while Japans economy grew 10 times faster, andSouth Koreas five times faster. China grew at a sustained8% annual rate.

All that began to change dramatically in 1991 with the shifttowards capitalism. Nevertheless, India has historically hada much more free market orientation than some other largedeveloping countries, notably Russia and China. IndiasBollywood freely cranks out movies that range fromexcellent to awful while in China, films are propaganda toolsand their content is tightly controlled by the government.State-controlled enterprises in India account for only 14%of GDP compared to 50% in China.

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Free Trade

Fortunately for India, thepharmaceuticals and especiallytechnology sectors never suffered theburdensome regulations that visited thesteel and airline sectors. And doublyfortunate, Indians have a natural benttowards technology, as was pointed outto us by the American Ambassador toIndia when we visited with him one onone in his New Delhi office in 1986.The English language facility of Indiasmany engineers and scientists is also abig help. Furthermore, the boominginformation technology sector reliesmore on new technologies such assatellite transmission than Indian-

regulated utilities and inadequate basicinfrastructure.

Am er ic an an d Euro pe an fir msoutsource many back-office and evenlegal and medical services to India.Outsourcing revenues there are now$69 billion annually and account for aquarter of Indian exports. The lowerwage costs in India and English-speakingability of call center employees has bigadvantages for this industry.

Another advantage of India, as well asChina, is a rapidly-growing middle class.PriceWaterhouseCoopers estimates thatin 2010, 470 million Indians, or 38% ofthe population, had annual incomesbetween $1,000 and $4,000, big enoughto permit some discretionary spending.That number is expected to jump to 570million in a decade, with about $1 trillionin income. The household saving rate ishigh (Chart 13), but still last year 82% of

Indian households had phones, usuallymobile.

Of the 247 million Indian households,77% had TVs, 42% had bicycles, motorscooters or motorcycles but only 10%owned motor vehicles, according to the2011 Census of India. Furthermore,much of Indian household saving isinvested in gold and the trousseaus ofyet-to-be married daughters.

CHART14

Chinese Yuan and Indian Rupees per U.S. Dollar

Source: Federal Reserve and Thomson Reuters

Last Points 12/3/12: yuan/$ 6.23; rupee/$ 54.66

Jan-81 Nov-84 Sep-88 Jul-92 May-96 Mar-00 Jan-04 Nov-07 Sep-11

1

2

3

4

5

6

7

8

9

5

10

15

20

25

30

35

40

45

50

55

60

Chinese Yuan per Dollar - left axis

Indian Rupees per Dollar - right axis

CHART13Indian Household Saving Rate

Source: Ministry of Statistics and Programme Implementation

Last Point 2011: 29.4%

1951 1961 1971 1981 1991 2001 2011

5%

10%

15%

20%

25%

30%

35%

5%

10%

15%

20%

25%

30%

35%

CHART12

Indian Real GDP

Source: Reserve Bank of India

Last Point FY 2012: 6.9%

fiscal year/fiscal year % growth

1951 1961 1971 1981 1991 2001 2011

-6%

-4%

-2%

0%

2%

4%

6%

8%

10%

-6%

-4%

-2%

0%

2%

4%

6%

8%

10%

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Large Diaspora

As the World Bank stated in a 2005report, Indiahas a large and impressiveDiaspora, creating valuable knowledgelinkages and networks. This isincreasingly clear to us in our NewYork suburb as we greet more Indianfamilies as neighbors, see them in localrestaurants and note the highachievement of their children in school.

China is moving, but slowly, to open itsfinancial and currency markets toforeigners. The yuan, however, remainstightly controlled (Chart 14, opposite page),allowed to appreciate in good times butheld stable in the Great Recession andlater as the economy again weakened(Chart 3). This year, the yuan had risenabout 1% against the buck, no doubtChinas attempt to deflect politicalpressure from the U.S. during thepresidential campaign. But after aboutmid-October, Beijing kept the Chinesecurrency as flat as a pancake.

In contrast, and reflecting Indias morefree market bent, the rupee has beenrelatively free of governmentinterventions, despite its recentweakness (Chart 14). As the IMFstated in its April 2012 report on India,The flexibility of the exchange rateremains a useful buffer against externalshocks. Since the GFC [Global FinancialCrisis] and until August 2011, RBI [Reserve Bank of India,the central bank] intervention was minimal and recentinterventions have fallen within the RBI s stated policy ofintervening only to address severe market dislocations andforeign exchange liquidity shortages. Recent measures bythe RBI to restrict banks net foreign exchange (FX) open

positions and corporates

ability to trade in the onshoreforward market seem to have contributed to stabilizing therupee. The authorities have continued to gradually liberalizecapital flows, such as by freeing interest rates on nonresidentaccounts, facilitating the refinancing of external debt, andallowing foreign individuals to invest in equities.

RBI Independence

Furthermore, the RBI is relatively independent ofgovernment influence. In contrast, the Peoples Bank of

CHART16Indian Consumption, Exports and Investment

Source: World Bank

as a share of GDP

Last Points 2011: consumption 58.0%; exports 24.6%; investment 29.5%

1960 1970 1980 1990 2000 2010

0

10

20

30

40

50

60

70

80

90

0

10

20

30

40

50

60

70

80

90

Consumption

Exports

Investment

CHART15

Chinese Reserve Ratio and One-Year Lending Rates

Source: Bloomberg

Last Points 12/3/12: reserves 20.0%; loans 6.00%

Jan-07 May-08 Sep-09 Feb-11 Jun-124%

6%

8%

10%

12%

14%

16%

18%

20%

22%

4%

6%

8%

10%

12%

14%

16%

18%

20%

22%

Required Reserve Ratio (major banks) - left axis

One Year Lending Rate - right axis

China, the central bank, is completely controlled by thegovernment. With the recent regime change in China,PBOC Gov. Zhou Xiaochuan was dropped from the list of205 members of the Communist Partys Central Committeeas he apparently is being forced into retirement. Politicians,not central bankers, call the shots in China.

As weve noted in past Insights, interest rates are keptartificially low (Chart 15) to provide cheap loans to inefficientstate-owned enterprises that account for half of GDP andemploy a quarter of the workforce. Consequently, Chinesemonetary policy is run mainly by reserve requirements, acrude tool long ago shelved by the Fed and other majorcentral banks since it amounts to credit allocation. Incontrast, when interest rates are raised, borrowing for themost profitable investments still continues.

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India has the advantage, at least in thecurrent world of slow growth andmeager import demand in the U.S. andEurope, of being much more inward-oriented than China and the other export-led countries in Asia. Afterindependence, Indian leaders advocatedself-sufficiency and used high tariffs tokeep out imports in order to encouragelocal production, as noted earlier. RajivGandhi, Prime Minister in the late1980s, believed that the U.K. haddiscouraged industrialization in India inorder to keep her as a supplier of rawmaterials for British factories and amarket for Englands manufacturedgoods.

In contrast to Chinas 37.7% consumerspending component of GDP in 2011(Charts 4 and 5), India had 58% (Chart5 and Chart 16, page 7) despite Indiansequally high saving rate (Chart 6a). Thisis a better balance in a world whereexports and the capital spending are nolonger the easy route to economic growthfor developing countries. Indian exportsare sizable, 24.6% of GDP in 2011, andthat percentage has risen despite theglobal recession and slow recovery.

In contrast, Chinese exports in 2011were a higher percentage of GDP,29.3%, but much more volatile anddown from about 40% in 2007 beforethe global recession commenced (Chart4). The merchandise component ofIndian exports in 2011 was 16%compared to 26% in China. And whileIndian service exports have a high techand high value-added content relativeto Brazil and China (Chart 17), goods

and manufacturing exports tend towardstextiles, leather and other low value-added products (Chart 18).Nevertheless, the sophistication ofIndias goods exports is rising and closingthe gap with Brazil and China (Chart18).

Services vs. Goods Exports

A key difference is that Indias exports

CHART 19

India Services, Industry and Agriculture

Source: World Bank

Last Points 2011: services 56.4%; industry 26.4%; agri. 17.2%

% of GDP

1960 1970 1980 1990 2000 2010

15%

20%

25%

30%

35%

40%

45%

50%

55%

60%

15%

20%

25%

30%

35%

40%

45%

50%

55%

60%

Services

Industry

Agriculture

CHART17

Sophistication of Services Exports

Source: International Monetary Fund

1990 1992 1994 1996 1998 2000 2002 2004 20068.8

8.9

9.0

9.1

9.2

9.3

9.4

9.5

9.6

9.7

9.8

8.8

8.9

9.0

9.1

9.2

9.3

9.4

9.5

9.6

9.7

9.8

India

China

Brazil

CHART18Sophistication of Goods Exports


1990 1992 1994 1996 1998 2000 2002 2004 20069.2

9.3

9.4

9.5

9.6

9.7

9.8

9.2

9.3

9.4

9.5

9.6

9.7

9.8

India

China

Brazil

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emphasize outsourcing and otherservices that tend to be much lesscyclical than the manufactured goodsthat dominate Chinas exports.Manufacturing and other industryremains a relatively small and onlyslowly growing component of IndianGDP that accounts for about the sameshare of total production it did in theearly 1980s (Chart 19, opposite page).Meanwhile, services gain at the expenseof falling but still significant agriculture,which amounted to 17% of GDP in2011 vs. 56% for services. In contrast,the industrial sector in China is muchlarger, 47% of GDP in 2011, whileagriculture is smaller than in India,10%, as were services at 43% of GDP(Chart 20).

Not only do exports account for asmaller percentage of Indian GDP as inChina, but also Indias chronic tradeand current account deficits are growingwh ile export -led China had hadconsistently large surpluses until theGreat Recession struck (Chart 21). Wellreturn to these troublesome Indiandeficits later.

India and Pakistan

Like many developing countries, Indiaspends heavily on her military (Chart22) to the detriment of productivity-enhancing and job-creating capitalspending. India lost a border war withChina in 1962 and still has boundarydisputes. But her primary concerns arewith Pakistan, which, of course, waspart of British India and split off as thepredominantly Muslim area and Hindu-

dominated regions parted ways.Pakistan and India have fought threewars since 1947 independence, and arestill at odds over ownership of Kashmir.Heavy military presence on both sidesof the border is expensive and impedescross-border trade.

Both India and Pakistan have nuclearweapons, which have altered the militarystrategies of both. Pakistan cant

CHART21China and India Current Account and Trade Balance

* 2010 data Source: World Bank

Last Points 2011: India CA -3.1%; India TB* -5.4%; China CA 2.8%; China TB 2.6%

as a share of GDP

1982 1987 1992 1997 2002 2007

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

10%

12%

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

10%

12%

India Current Account

India Trade Balance

China Current Account

China Trade Balance

CHART20

Share of Chinese GDP by Sector

Source: World Bank

Last Points 2011: agri. 10.0%; industry 46.6%; services 43.3%

1970 1975 1980 1985 1990 1995 2000 2005 2010

10%

15%

20%

25%

30%

35%

40%

45%

50%

10%

15%

20%

25%

30%

35%

40%

45%

50%

Agriculture

Industry

Services, etc.

CHART22

2011 Military Spending

Source: World Bank

Saudi ArabiaIsraelIraq

U.S.RussiaPakistanU.K.IndiaFranceChinaEgyptItalyBrazilCanadaGermanyJapan

as a % of GDP

8.4%6.8%5.1%

4.7%3.9%3.0%2.6%2.6%2.2%2.0%1.9%1.6%1.4%1.4%1.3%1.0%

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compete with larger and wealthier Indiain conventional weapons so she hasbeefed up her nuclear arsenal. Inreaction, India has deployed her non-nuclear forces in ways that anticipateand offset Pakistans nuclear capability,including detection and surveillancetechnologies that monitor Pakistansnuclear preponderance and revealsconventional vulnerabilities.

Better relations between Pakistan andIndia could curtail defense spending onboth sides and spur growth-promotingtrade. The two have been trying toimprove relations through talkscommenced in 2004, but suspendedafter Pakistani militants attackedMumbai in November 2008, killing160 people.Still, a year ago, Pakistan agreed togrant Indian most favored nationtrading privileges, meaning her importtariffs on Indian goods will be as low aswith any other country. India did thesame for Pakistan in the mid-1990s,but Pakistan didn t reciprocate,maintaining that India has manynontariff barriers to trade. Instead,Pakistan limited imports from India toa list of fewer than 2,000 items. Earlythis year, however, Pakistan switchedto a negative list that bans about 600imports from India of strategic itemssuch as defense equipment, but allowstrade in all other goods. And the negativelist is scheduled to be scrapped by theend of this year if India reduces nontariffbarriers such as complicated labelingrequirements. Indian exports toPakistan are already climbing (Chart

23). Still, with past animosity, India

strade with Pakistan is rising from a verylow base (Chart 24).Pressure To ChangeThe turn from social ism towardcapitalism in India in 1991 was notvoluntary but forced by concurrentsevere economic and financialproblems. In the 1980s, persistent

CHART23

Trade Between India and Pakistan

Data is as of 3/31, the end of India's fiscal year Source: India Department of Commerce

Last Points FY 2011-2012: imports 0.4; exports 1.5

$ billion

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

0.0

0.5

1.0

1.5

2.0

2.5

0.0

0.5

1.0

1.5

2.0

2.5

Imports

Exports

CHART24India Trade by Partner Country

Source: India Department of Commerce and The Wall Street Journal

$ billion

67.1

63.3

45.6

25.6

25.5

19.7

18.7

17.4

16.2

14.9

2.7

UAE

China

U.S.

Saudi Arabia

Switzerland

Hong Kong

Germany

Singapore

Indonesia

Belgium

Pakistan

CHART 25

Indian Fiscal Deficit


Last Point 2012: 5.9%

share of GDP; for fiscal year

1981 1986 1991 1996 2001 2006 2011

2%

3%

4%

5%

6%

7%

8%

9%

10%

2%

3%

4%

5%

6%

7%

8%

9%

10%

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CHART 26

Foreign Direct Investment in India and China

Source: World Bank

Last Points 2010: India 1.4%; China 3.1%

net inflows; % of GDP

1975 1980 1985 1990 1995 2000 2005 2010

-1

0

1

2

3

4

5

6

7

-1

0

1

2

3

4

5

6

7

India

China

budget deficits forced austerity actions(Chart 25, opposite page). In 1991, aforeign exchange crisis pushed thegovernment to align spending withrevenues and move away from fixedexchange rates. The overvalued rupee,wh ic h had dis cour ag ed foreigninvestment, fell. Led by ManmohanSingh, then Finance Minister and nowPrime Minister, the government alsoopened the door to foreign investment(Chart 26) while Indian companies wereallowed to borrow in foreign capitalmarkets and invest abroad. Double-digit inflation (Chart 27) was tamed.These new policies initiated the boom ininformation technology.Life expectancy jumped to 64 years in2008 from 58 in 1991. Literacy hasrisen. GDP per capita grew from $925in 1991 to $3,270 in 2009. Airline andtelecommunications companies becameprivatized.Slow ProgressNevertheless, progress has been limitedas shown by the slower growth in Indianreal GDP compared to China (Chart28). Also, India recently announced anew five-year plan with probablyunrealistic goals for reducing thegovernment deficit from 5.3% in thecurrent fiscal year ending March 31,2013 to 3% in fiscal 2017, but providedfew details. Remind you of the Sovietsfive-year plans that were alwaysoptimistic but seldom met?Changes come slowly in India, with aculture thats been around for millennia

and heavily influenced by Hinduphilosophy that doesnt emphasizeurgency. Hindu belief is that afterdeath comes reincarnation in anotherform of life. The process of birth andrebirththe transmigration of soulsis endless until one achieves moksha, orsalvation, by realizing that the truthliberates, that the individual soul (Atman)and the absolute soul (Brahmin) areone. Hindus also believe in Karma, the

CHART27India Wholesale Price Index - All Commodities

Source: India Office of the Economic Advisor

Last Point 10/12: 7.5%

year/year % change

Apr-83 Jun-87 Aug-91 Oct-95 Dec-99 Feb-04 Apr-08 Jun-12

-2%

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

-2%

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

CHART28

Chinese and Indian Real GDP Growth

Source: IMF


year/year % change

1980 1985 1990 1995 2000 2005 2010

2%

4%

6%

8%

10%

12%

14%

16%

2%

4%

6%

8%

10%

12%

14%

16%

China

India

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law of cause and effect that states that what one does in thepresent life will have its effects on the next life. Nevertheless,a Hindu doesnt need to get everything accomplished in thislife since he can probably get it done in later lives. Also,belief in predestination gives Hindus a sense of fatalism.

Hinduism also incorporates all forms of belief and worship

without necessitating the selection or elimination of any.This results in a spirit of independence and lack ofacceptance of authority among Indians that makes itdifficult for the authorities to force family planning ormuch of anything else on the population. The chaos onIndian roads where cars, trucks, ox carts, bicycles, rickshaws,pedestrians and stray cows all compete for the right of wayin a random fashion is ample proof of this independentspirit. The contrast with the disciplined Chinese society,where family planning is reinforced throughout the structure,is marked.This approach is very different than in the Western world,dominated by Christian philosophy. Christians believethere is an afterlife, but you have only one trip through yourearthly, physical existence so you better make the most ofit. Think ofbucket lists, things people want to do and seebefore they die. Then there was the old ad for womens haircoloring with the tag line,If I have only one life, let me liveit as a blonde.

Tire Changing

As Westerners, my wife and I were struck by the muchmore casual attitude toward death by Indians while on a tripthere some years ago. We were being driven in a limo fromAgra, the location of the Taj Mahal, back to Delhi when thecar suffered a flat tire. It was a good road, only two lanes,but with wide berms on each side.Nevertheless, our driver, a well-spokenmiddle-class Indian, didnt pull overonto the shoulder but stopped right inthe middle of the lane to change thetire. Traffic was moving swiftly, andvehicles traveling in our direction hadto swing into the oncoming lane to passour stopped car. As the brakes squealedand the horns blared, I turned to mywifeand said, Peggy, were getting out ofthis car immediately and retreating tothat mustard field across the road untilthe driver is ready to move on.Still, the heat is now back on Indianleaders for reform due to economic-

CHART29

Chinese Imports and Exports

Source: China General Administration of Customs

Last Points 10/12: exports 11.6%; imports 2.4%

year/year % change

Jan-06 Nov-06 Sep-07 Jul-08 May-09 Mar-10 Jan-11 Nov-11 Sep-12

-60%

-40%

-20%

0%

20%

40%

60%

80%

100%

-60%

-40%

-20%

0%

20%

40%

60%

80%

100%

Exports

Imports

depressing external forces, bad policy decisions and theresulting declines in economic growth, the rupee andforeign direct investment while the trade and currentaccount deficits mount (Chart 21).External IssuesDespite her inward-looking nature, India has not beenimmune from the worldwide Great Recession and the morerecent slowing of global growth (Chart 28). As mentionedat the outset of this report, huge amounts of the globe smanufacturing shifted to China in recent decades. Still,China doesnt produce goods for domestic consumptionand exports from scratch, but imports raw materials,petroleum and other supplies and components. And weakChinese imports (Chart 29) are negative for suppliers suchas South Korea, Taiwan, Indonesia, Australia, Brazil andIndia. With the global glut in steel, iron ore prices are downabout 50% in the last year, and shipments to China fromAustralia, Brazil and India are expected to drop to about 25million metric tons this fiscal year from 60 million last year.Iron ore exports have been banned in the Indian states ofOrissa and Goa.Indias trade relations with China remain strained despitethe trade talks launched when Chinese Premier Wen Jiabaovisited India in late 2010. Her trade gap with China jumpedto $28 billion in fiscal 2010-2011, the largest for any ofIndias trading partners (Chart 30, opposite page). India wantsexports to China to shift away from raw materials likecopper and iron ore, which account for about half of thoseexports, to value-added products such as pharmaceuticals(Chart 31, opposite page). India also wants more access toChinese government procurement. But exports of drugsand fine chemicals to China have fallen 12% since 2007 toonly $108 million per year due to Chinese regulations. It

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CHART30

India's Top Trade Partners: FY 2010-2011

Source: Indian Department of Commerce

Total

EU (27 countries)EurozoneUnited Arab EmiratesU.S.ChinaHong KongSingaporeSaudi ArabiaSwitzerland

369.8

44.535.032.820.143.59.47.1

20.424.8

100.0%

12.0%9.5%8.9%5.4%

11.8%2.5%1.9%5.5%6.7%

$ billion % of total251.1

46.035.733.825.315.510.39.84.70.7

100.0%

18.3%14.2%13.5%10.1%6.2%4.1%3.9%1.9%0.3%

$ billion % of total-----Imports----- -----Exports-----

takes three or four years to register anew drug in China vs. 10 months inIndia.Rare Earths

Interestingly, India, the worlds secondlargest producer of rare earth, hasdecided to challenge China, whichaccounts for 95% of global production(Chart 32). She wants to force electronicsand green energy users of these mineralsto establish production in China in returnfor access to those commodities. State-owned Indian Rare Earths suspendedmining in 2004 due to inability to competewith Chinese low-cost mining techniques

but is planning to build a processingplant in the eastern state of Orissa.Even if successful, that plants 11,000metric ton annual output would hardlydent Chinas dominance with 130,000tons of production in 2010 compared

to India

s 2,700.Furthermore, China has about 55 milliontons of rare earth reserves, half theglobal total compared to 3.1 milliontons in India. And prices of averagerare earths have dropped from the$148 per kilogram peak in 2011 whenChina limited exports to $56 on worldmarkets and $33 in China. Until themid-20th century, rare earths came

CHART31Selected Items Traded by India and China ($ billion)

Source: Indian Commerce Ministry

CHART32

2011 Rare-Earth Mineral Reserves and Production

U.S. and Australia plan to boost productionSource: U.S. Geological Survey and The Wall Street Journal

millions of metric tons

55.0

13.0

3.11.6

0.130

0.000.003

0.00

China United States India Australia

0

10

20

30

40

50

60

0.00

0.02

0.04

0.06

0.08

0.10

0.12

0.14

Reserves - left axis

Production - right axis

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CHART 34

Share of Indian Electric Power Generation by Source

Source: India Ministry of Power and The Wall Street Journal

total capacity = 205,340 mw.

from the sands of Indias coast line,then shifted to the U.S. from the 1960suntil Chinas low-cost productiondominated, starting in the 1980s.Meanwhile, the quantity of Indianmanufactured goods is no match forChinas, and Chinese goods pour intoIndia. In about a decade, China hasadvanced from Indias seventh largestsource of imports to Number 1, evenexceeding the U.S. and the entireeurozone (Chart 30). In typical Indianreaction, the cabinet in July approved a21% tariff on imports of equipmentfor electric power projects in order toprotect local manufacturers fromadvanced Chinese producers thatalready supply 40% of Indias power equipment and whosesophisticated gear is desperately needed to boost powergeneration.Monsoons

Another external problem, or at least one out of the controlof policymakers, was the weak monsoon this year. TheSouthwest monsoon comes to India via winds from theArabian Sea, and arrives in the southern state of Kerala inlate May or early June. It gradually moves north and coversthe entire subcontinent by mid-July. About 60% offarmland depends on monsoon rainfall. This year, rainfallwas well below normal in June and July. There was somecatch-up in August and more in September, but the four-month average was 7% below long-run averages (Chart 33).

The reaction of farmers was to plant less summer cropsincluding staples such as pulses, oilseed,rice and cereals. They also pumpedmore water from wells since reservoirsthat feed irrigation canals were low.But that required more spending ondiesel fuel, and those added costs plus

the anticipated poor harvests aresqueezing farmers discretionaryspending. Also, drawing more electricityfrom the power grid to run pumps mayhave contributed to the widespreadsummer blackouts in India. Over halfof electricity generation is from coal,which is in short supply (Chart 34).About 19% comes from hydroelectric.

CHART 33

Rainfall During the 2012 Southwest Monsoon

Source: India Meteorological Department

4-month mean - long-run average: 221.9; actual 206.2

millimeters

June July August September 4-Month Mean

0

50

100

150

200

250

300

0

50

100

150

200

250

300

Long-Run Average

Actual

Policy Problems

Adding to externally-imposed detriments to economicgrowth, Indian leaders recently have introduced a numberof policy measures that may be necessary politically but stilldiscourage domestic and foreign investment and economicgrowth. Early this year, the government proposed taxes ontransactions back to 1962 in which Indian assets weretransferred between foreign entities. That would overridean Indian Supreme Court decision in January that U.K.mobile phone company Vodaphone isnt liable for over $2billion in taxes on a 2007 deal it made to enter India.

Another proposal would establish an anti-tax avoidancepolicy that investors worried would allow the governmentto tax investments in India from offshore tax havens suchas Mauritius. It put the responsibility on investors, many ofthem foreigners, to prove that they didnt structure corporate

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deals to avoid taxes. In reaction, $692 million in foreigncapital left the Indian stock market in the three days afterthat proposal was announced.Then there was the budget provision to increase taxes on oilproduction by 80% that would only hit Cairn India, whosemajor shareholders are British companies. Cairn Indiaresponded to the expected $2.5 billion tax hike by saying itwould jeopardize its plans to invest $6 billion in India.Another deterrent to foreign direct investment is the recentgovernment proposal to extend price controls on

pharmaceuticals from 20% of drugs to 60% of the 348 thatthe government considers essential. Price restrictionswould extend beyond generics to patented drugs for thefirst time, and are in response to the governments concernsfor the two-thirds of Indians who lack health insurance andthe fact that Indians pay 70% of their health care costs outof pocket. In addition, Indias patentauthority is trying to force Bayer tolicense an Indian generic drug companyto sell a cheap version of its patentedcancer drug Nexavar.

And don

t forget the 21% tariffs onimported power generation equipmentaimed at sophisticated Chinese geareven though the chronic lack ofgenerating capacity spawned majorblackouts in India this past summer.CorruptionThen there is the recent rash of scandalsinvolving government officials,

CHART 35

Selected Indian Scams

* Maximum estimated by the Comptroller and Auditor General and others, as lost revenue or as stolen goods Source: The Economist

2G

Coalgate

Adarsh

CWG

Karnataka

2008

2004-2009

2010

2010

2006-2010

Dodgy sale of mobile-phone licenses

Shady allocation of coal blocks

Mumbai home for war widows taken by the powerful

Crooked contracts for Delhi Commonwealth games

Illegal mineral pillage

$39 bn.

$34 bn.

$ millions

$ millions

$3.6 bn.

Name Date Description Notional Loss*

especiallyCoalgate in which 57 companies, between 2008and 2011, illegally acquired coal blocks, some of thosefirms controlled at the time by senior members of the rulingCongress Party. Indias Federal Auditor reports that thegovernment lost as much as $33 billion by allocatinglicenses without transparent auctions. Losses from 2004 to2009 were more than $200 billion.Corruption in issuing mobile-telephone licenses in 2008could result in the potential loss of $39 billion in governmentrevenue, according to federal auditors (Chart 35). Seniorgovernment officials, including a former telecom minister

in the Congress-led government, are facing criminal trialsfor conspiracy. The government now promises to auctioncoal blocks rather than allocate them in private. But whenthe Congress-led coalition came to power in 2004, itdiscussed starting public auctions but nevertheless has yetto act. Transparency International ranks India 95th among

CHART36

Transparency International Corruption Perception Index

Source: Transparency International

Last Points 2011: India 3.1; China 3.6; US 7.1; UK 7.8; Germany 8.0

0 (highly corrupt)....10 (least corrupt)

2000 2002 2004 2006 2008 2010

0

1

2

3

4

5

6

7

8

9

0

1

2

3

4

5

6

7

8

9

India

China

USA

UK

Germany

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182 nations in 2011 in terms of perceived corruption (Chart36, page 15).India is not alone in suffering a lack of transparency andmajor corruption, with China close behind (Chart 36).Premier Hu Jintao in his last major speech before retiringrecently acknowledged that corruption among Chineseofficials is a major concern of the Chinese people. If wefail to handle this issue well, he said, it could prove fatalto the Party.

With Prime Minister Singhs fragile coalition governmentunder fire and losing public support while the oppositioncalls for blood, almost nothing is being done in Parliament.In the session that ended in early September, Parliament didno business during 13 days of the 20-day session and passedonly four bills out of 30 the government hoped to enact.Furthermore, bureaucrats throughout the government arefrozen into inaction, fearing that in a new era of activewatchdogs, anything they do may boomerang on them.

Nevertheless, one of the three commissioners of theCentral Vigilance Commission that investigates corruptionin effect told government officials to relax. He said thatonly a minusculenumber of the CVC investigations leadto administrative punishment or prosecution. So its graftand corruption as usual!

An additional black eye for the Singh government is therecently leaping fiscal deficit in relation to GDP after athree-decade declining trend (Chart 25), suggesting that thegovernment has lost control of its finances. As well discusslater, transfers to rural residents and energy subsidiesincreasingly outrun government revenues.

Housing

Housing bubbles and busts have notbeen confined to the U.S., Europe andnow Canada (see "U.S. Semi-AnnualEconomic Outlook," page 40). Propertyprices in India soared in recent years,

but slowing economic growth, highconsumer inflation and elevated interestrates have pressed home owners andaffordability. Financing from banksand private-equity investors hasatrophied and foreign direct investmentin real estate has declined. Funding isscarce.

Developers are trying to prevent pricedrops, but new home sales fell 50% to

CHART 37

India House Price Index

Source: India National Housing Bank

Last Point 2Q 2012: 164.3

15-city average; 2007=100

Jun-08 Dec-08 Jun-09 Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 Jun-12

100

110

120

130

140

150

160

170

100

110

120

130

140

150

160

170

60% in the six major Indian cities that comprise 80% of theresidential market in the first half of 2012 from a yearearlier. Record inventories will take two years to clear, andas weve noted continually, excess inventories are themortal enemies of prices. Nevertheless, house prices in15major Indian cities continued to rise as of the secondquarter, and were up 64% since 2007 (Chart 37).

The condition of Indian houses is something else, however,at least by Western standards. Some 71% of householdshave tap water but 62% have water from treated sources,73% have toilets and 93% have electricity for lighting.According to the 2011 Census of India, of the 247 millionhouseholds, 95% in rural areas own their own abodes and69% in urban locations. In rural areas, 39% of householdslive in one room and 32% in two rooms while 32% of urbanhouseholds occupy one room and 31% live in two rooms.And 46% of the abodes of rural households were rankedas good while 48% were only livable and 7% weredilapidated. From urban households, 68% lived in goodhouses, 29% in livable homes and 3% in livable structures.

The materials used in roofs, walls and floors of Indianhouseholds are interesting (Chart 38, opposite page). Notethat 30.5% of walls in rural houses are mud/unburnt brickand 62.6% of floors are mud.

Rural Subsidies

Indian politicians are obviously sensitive to the rural areaswhere two-thirds of the population, 833 million, live in640,000 villages. Government subsidies for rural residentsare huge. Major subsidies total about $57 billion per year,and crowd out government spending on job-creating capitalspending (Chart 39, page 18). Welfare spending has leapedfrom 1.6% of GDP when Singh became Prime Minister in

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2004 to 2.5%. Farmers get subsidizedfertilizer and diesel fuel to run waterpumps. The government pays abovemarket prices for wheat and rice andthen sells it back to villages at discounts.The governments National RuralEmployment Guarantee Act promiseseach rural poor Indian 100 days ofwork per year.

These actions keep people on the land,but distort labor markets, delayurbanization (Chart 40, page 18) andencourage corruption. Its estimatedthat 44% of state-managed foodvanishes as leakage. In contrast tothe two-thirds of Indians living in ruralareas, in China, its around 50%. Thecombination of high demand and supplyconstraints in food, energy andelsewhere due to corruption, inadequateinfrastructure, government regulationand inefficient land distribution keepinflation rates in India artificially highcompared to China and other developinglands (Chart 41, page 18) and difficult tomanage through fiscal and monetarypolicies. Subsidized rural food costsincreased demand for food and shifts ittowards proteins and away from grains,adding further to food price pressures,according to the IMF.

The Indian government has alsomishandled food distribution. Thecountry has produced enough food tofeed its 1.2 billion people since theGreen Revolution decades agointroduced better seeds and fertilizers.Also, the government buys a lot of grainfrom farmers at high prices toredistribute in its subsidy programs, as noted earlier. But

corruption and bureaucratic inefficiencies prevent foodfrom always reaching the needy, so 200 million are under-nourished. The International Food Policy ResearchInstitutes 2011 Global Hunger Index put India 67th out of81 countries. Some 42% of Indias children are underweight.Meanwhile, food shortages keep prices high, with year-over-year increases in wholesale food prices of 7.9% inSeptember and 6.6% in October (Chart 42, page 19).

Recently, a government advisory panel recommended thatIndia ease controls on sugar by stopping purchases of 10%

CHART38

Building Materials In Indian Homes

Source: Census of India 2011

Households by Predominant Material of Roof

Total No. of Households

grass/thatch/bamboo/wood/mud, etc.plastic/polythenehand-made tiles

machine-made tilesburnt brick

stone/slateG.I./metal/asbestos sheetsconcreteany other material

Households by Predominant Material of Wall

Total No. of Households

grass/thatch/bamboo, etc.plastic/polythenemud/unburnt brick

woodstone not packed with mortar

stone packed with mortarG.I./metal/asbestos sheets

burnt brickconcreteany other material

Households by Predominant Material of Floor

Total No. of Householdsmudwood/bambooburnt brickstone

cementmosaic/floor tiles

any other material

rural and urban; % of total

100.0

15.00.6

14.59.3

6.68.6

15.929.0

0.4

100.0

9.00.3

23.70.7

3.410.8

0.647.53.50.6

100.04.650.62.3

8.131.1

10.80.5

100.0

20.00.6

18.310.4

7.28.9

15.918.3

0.4

100.0

1.90.3

30.50.8

3.610.0

0.540.0

1.70.6

100.062.6

0.72.3

6.224.2

3.70.2

100.0

4.60.6

6.27.0

5.47.9

15.951.9

0.4

100.0

2.70.39.30.5

2.712.3

0.963.5

7.20.6

100.012.2

0.42.4

12.245.8

25.91.0

Total Rural Urban

of sugar mills output at a big discount and then selling it to

the poor at even lower prices. The panel also wants to endthe premium price that sugar mills are forced to payfarmers to please voters, and to stop fixing the quantitymills sell on the open market. These market distortionsresult in India flipping between sugar importing and exporting.She is the worlds top sugar consumer and biggest producerafter Brazil.

Inadequate Warehouses

The government, as of mid-2012, had 63 million metric

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CHART39

Composition of Indian Government Expenditures


% of GDP

2000/01 2003/04 2006/07 2009/10

0%

5%

10%

15%

20%

0%

5%

10%

15%

20%

Other current expenditures

Interest, Pensions, Subsidies, and Wages

Capital Expenditure & net lending

CHART40India Population Projections


billions

1960 1970 1980 1990 2000 2010 2020 2030 2040 20500.0

0.3

0.6

0.9

1.2

1.5

1.8

0.0

0.3

0.6

0.9

1.2

1.5

1.8

Rural

Urban

CHART41

India and China CPI

Source: IMF


year/year

1980 1985 1990 1995 2000 2005 2010

-5%

0%

5%

10%

15%

20%

25%

-5%

0%

5%

10%

15%

20%

25%

China

India

tons of grain warehouse capacity tostore but 75 million tons of grain. Intotal, the government is storing about20 million tons in makeshift storagespaces, vulnerable to weather androdents. About 7% of annual Indiangrain output is lost due to insufficientstorage space and inadequatetransportation and distribution. A fifthof storage warehouses are in non-grain-producing areas and rely on overloadedand delayed railroads for transport.Over a million tons of wheat in state-run warehouses from previous bumpercrops will probably go bad because thegovernment failed to distribute it overthe past two to three years.

Part of the food distribution problemstems from the 1980s law that requiresthat 100% of the wheat and rice cropsmust be packed in jute bags. That lawwas designed to protect 250,000 jutefactory workers and 5 million farmerswho grow jute from the mushroomingof cheaper plastic sacks. But boomingwheat harvests, up 82% from 1990,antiquated jute industry machinery leftover from the British era and frequentlabor strikes have kept jute bag output

well below demand. In Madhya Pradash,a major wheat-growing state in centralIndia, the government was forced toallow 20% of the wheat harvest to beplaced in plastic bags if jute sacks werentavailable.

The Indian government has belatedlybegun to deal with the crisis inmicrolending. Mohammed Yunus ofGrameen Bank in Bangladeshdeveloped the system and for it received

the Nobel Peace Prize in 2006. It hasspread across emerging Asia, Africaand South America and involves loansof less than $200 to entrepreneurs,often women, who start or expandsmall businesses such as vegetable standsor bicycle repair shops.

Microlending has surged in India (Chart43, opposite page) and repayment ratestend to be extremely high. But the cost

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of administering small loans in remoteareas requires annual interest rates of25% to 100%. So, in the Indian stateof Andhra Pradesh, local governmentofficials and politicians urged borrowersto stop paying even if they had themoney. After dozens of suicides blamedon microlenders, the government finallyimposed restrictions and arrested somelending agents for allegedly harassingdebtors.

Furthermore, Indias Sahara Group,which sold small denomination bondswith promised payouts between 1.25and three times the investment amount,is coming under intense public scrutiny.Regulators worry that it is growing toorapidly without government oversight.

Sad Effects

The sad effects of Indias recent externalproblems and uneconomic policydecisions are many and substantial. Themushrooming foreign trade and currentaccount deficits (Chart 44) are seriousconcerns because the foreign funds tofinance them have largely dried up.The trade deficit jumped to $185 billionin fiscal 2011-2012, up 56% from fiscal2010-2011 as oil and gold import pricesjumped. The trade as well as currentaccount deficits, about 4% of GDP, issignificantly driven by oil imports, butbarring a collapse in global crude oilprices, will remain high. India importsabout three-fourths of her petroleumusage.

Retroactive Taxes

The proposal to tax asse t sa le sretroactively to 1962 and other adversemeasures have especially put the brakeson foreign direct investment inflows(Chart 26). Furthermore, Europeanbanks that have traditionally financedIndian debt have cut lending amidst theeurozone debt crisis. And there isrelatively little foreign participation inIndias government bond market. Thisis in part due to the foreign investment

CHART43Microfinance Loans in India

Source: Intellecap and The Wall Street Journal

FY 2007 FY 2008 FY 2009 FY 20100

5

10

15

20

25

30

20

40

60

80

100

120

140

160

180

200

220

240

Number of Borrowers (mil.) - left axis

Value of Loans (bil. Rupees) -right axis

CHART 44

India Current Account and Trade Balances

Source: Directorate General of Commercial Intelligence and Statistics and Reserve Bank of India

Last Points: current acct. 2Q 2012 -21.8; trade bal. 1Q 2012 -40.2

$ billion; 4-quarter total

Jun-90 Dec-92 Jun-95 Dec-97 Jun-00 Dec-02 Jun-05 Dec-07 Jun-10

-200

-150

-100

-50

0

50

-200

-150

-100

-50

0

50

Trade Balance

Current Account

CHART 42

India Wholesale Price Index - Food Articles

Source: Bloomberg

Last Point 10/12: 6.6%

year/year % change

Apr-95 Jun-99 Aug-03 Oct-07 Dec-11

-5%

0%

5%

10%

15%

20%

25%

-5%

0%

5%

10%

15%

20%

25%

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CHART46Indian Rupees per U.S. Dollar

Source: Federal Reserve and Thomson Reuters

Last Point 12/3/12: 54.66

Jan-11 Mar-11May-11Aug-11Oct-11Dec-11Feb-12May-12Jul-12 Sep-12

44

46

48

50

52

54

56

58

44

46

48

50

52

54

56

58

CHART47

Indian 10-Year Sovereign Bond Yield

Source: Thomson Reuters

Last Point 12/3/12: 8.17%

Jan-07 Sep-07 May-08 Jan-09 Sep-09 May-10 Jan-11 Sep-11 May-12

5.0

5.5

6.0

6.5

7.0

7.5

8.0

8.5

9.0

9.5

5.0

5.5

6.0

6.5

7.0

7.5

8.0

8.5

9.0

9.5

cap on government bonds, which wasraised by $5 billion to $20 billion by theRBI last June 25, shortly after the rupeehit an all-time low against the dollar.The government also reduced theminimum holding period on some bondsfrom five years to three years.

On the bright side of the foreign directinvestment picture, liquor giant Diageajust announced plans to buy up to53.4% of India United Spirits for asmuch as $2 billion. United Spirits is theworld s largest liquor company byvolume with an extensive distributionnetwork in India and a major share ofthe market for affordable local boozesuch as Indian whiskey. High alcoholimport taxes have impeded sales ofhigher priced Diagea brands such asJohnnie Walker scotch and Smirnoffvodka.

Private Equity Retreat

Private equity firms charged into Indiawith India-oriented funds in 2005-2007when the Indian stock market wasbooming (Chart 45). Now theyre havingtrouble raising money for India funds inview of Indias fiscal and current accountdeficits, slowing growth and uncertainoutlook for stocks. Returns on Indian-oriented private equity funds have beenpoor in recent years, and a decline inIPOs makes it difficult for investors torealize gains and exit. In 2011, privateequity firms sold $3 billion via IndianIPOs or through mergers andacquisitions, down from $7 billion in2010.

With the trade and current accountdeficits high in recent years and foreignmoney abandoning India, the rupee,not surprisingly, has been falling onbalance (Chart 46). The weak currencycreates woes for Indian companies withforeign currency bonds as well as foreigninvestors in Indian debt. In the booming2005-2007 years, when Indian real GDPwas growing at 8% annually and thestock market jumped (Chart 45), the

CHART45

BSE 500 Index

Source: Bloomberg

Last Point 12/3/12: 7,489

Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12

0

1000

2000

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9000

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rupee was strong, reaching a record 40rupees per dollar. So Indian companiessold huge quantities of bonds toforeigners.

Many of these bonds were convertibleto stock, and their issuers assumed theywould be converted as their stockscontinued to rise. But now with theirstocks down, conversion is unlikely andthe rupee has fallen 40%, making thecost of retiring foreign bonds very high.

Rupee Support Attempts

As noted earlier, the RBI has attemptedto support the rupee by encouragingforeign purchases of Indian

government bonds, hoping thatinvestors will be attracted by yields(Chart 47, opposite page) that exceedeven those in troubled Spain and Italy(Chart 48). Foreign investors are oftenonly interested in India bonds, however,if they can hedge their currencyexposure, but the RBI has also made itmore difficult for traders to bet againstthe rupee with futures contracts. TheRBI has attempted to attract moneyfrom offshore Indians by offering them

higher interest rates on bank deposits inIndia. It also in May forced foreignexchange earners to convert 50% oftheir foreign currency holdings torupees. None of these actions haveproduced lasting support for thebeleaguered rupee.

The central bank also spent $22 billion in foreign exchangereserves between September 2011 and April of this year tosupport the rupee. But the RBI has limited ability to repeatthis exercise. Foreign currency reserves of $295 billion

(Chart 49), equal to about six months of imports, comparedwith $3.3 trillion in China, which built them through yearsof chronic trade and current account surpluses, the reverseof in India (Chart 21). Standard Chartered Bank believesthe RBIs foreign-exchange reserve adequacy is at a decadelow, after subtracting a buffer for five months of importsand short-term external debt.

The weak rupee does make Indian goods cheaper abroad,but the effect is limited because unlike export-drivendeveloping countries, goods exports are a small part of the

CHART49India and China Foreign Reserves

Source: Bloomberg and Reserve Bank of India

Last Points: India 10/12 295; China 9/12 3,285

$ billion

Apr-01 Mar-03 Feb-05 Jan-07 Dec-08 Nov-10 Oct-12

0

500

1000

1500

2000

2500

3000

3500

0

50

100

150

200

250

300

350

China - left axis

India - right axis

economy, only 16% of GDP compared to 26% in China,as mentioned earlier. Furthermore, the costs of exportinggoods in India are more than twice as high as in China andexceed even those in the U.S. and U.K. (Chart 50, page 22).Once again, lack of infrastructure, normal bribes, etc. hypecosts and impede trade.

Rating Warning

In April, as the Indian economy and financial marketdeteriorated, Standard & Poors reduced its outlook onIndias long-term debt to negative and warned of a possiblecredit downgrade. S&P pointed to political gridlock andsaid there was a one in three chance of a downgrade fromtriple-B-minus, the lowest investment grade, to junk overthe next two years if the external position continues to

CHART48

Spanish and Italian 10-Year Government Bond Yields

Source: Thomson Reuters

Last Points 12/3/12: Spain 5.28%; Italy 4.45%

Jan-07 Oct-07 Jul-08 Apr-09 Jan-10 Nov-10 Aug-11 May-123.5

4.0

4.5

5.0

5.5

6.0

6.5

7.0

7.5

8.0

3.5

4.0

4.5

5.0

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6.5

7.0

7.5

8.0

Spain

Italy

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CHART51Indian Government Deficit

Source: India Central Statistics Office

Last Point FY 2012: -5.8%

% of GDP

2004 2005 2006 2007 2008 2009 2010 2011 2012

0%

1%

2%

3%

4%

5%

6%

7%

0%

1%

2%

3%

4%

5%

6%

7%

CHART52

Gross Fixed Capital Formation by Sector


Last Points: FY 2011

as a share of GDP

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

0%

5%

10%

15%

20%

25%

30%

35%

0%

5%

10%

15%

20%

25%

30%

35%

Household

Public

Private Corporate

deteriorate, growth prospects diminish,or progress in fiscal reforms remainslow in a weakened political setting.Moodys and Fitch, the other majorrating agencies, did not join S&P in itsnegative outlook but rated India at theirlowest investment grade, just abovejunk. S&P worries that Indias budgetdeficit (Chart 25) hit 5.8% of GDP infiscal 2012 compared with thegovernments 4.6% target (Chart 51).

In contrast to S&Ps view of India,Indonesian debt was raised toinvestment grade by two rating firmsand S&P raised its outlook on thePhilippines to positive last December.In early November, Fitch raisedTurkeys credit rating to investment-grade, the first such rating since 1994.Fitch cited a moderating debt burden,healthy banking system and soundeconomic management.

Capital Spending Weak

With a subdued global economy,investment-depressing governmentpolicy and dropping foreign directinvestment, private corporate capitalspending in India has been on the declinesince the Great Global Recession (Chart52). It has fallen from 14% of GDPbefore the crisis to 10% in fiscal 2011,and even more in recent quarters. Inthe past, growth in capital formation inIndia correlated well with global GDPgrowth, but recently has dropped belowzero while global GDP growth is runningabout 4.5% year-over-year (Chart 53,opposite page).

This suggests structural problems suchas inhospitable government policy, andthe World Banks Doing BusinessRankings put India consistently belowBrazil, China and Russia (Chart 54,opposite page). According to the WorldEconomic Forum, Indias globalcompetitiveness fell to 56th place in2011 from 49th in 2009. Among otherproblems, this reflected deterioratingtransparency in government decision-

CHART50

Cost to Export 20-Ft. Container by Country

Source: World Bank

Last Points 2012: India 1,095; US 1,050; UK 950; Germany 872; China 500

$ per container

2006 2008 2010 2012

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making and the relative slow growth ininfrastructure.

Indian real GDP grew 8.4% in bothfiscal 2010 and 2011, but slipped to6.9% in fiscal 2012 ending last March31. In the second calendar quarter of

2012, it grew only 5.5% from a yearearlier (Chart 55), a low rate in adeveloping country that needs at leastthat much growth to accommodate the13 million new labor force entrantseach year. The IMF predicts 4.9% realeconomic growth in calendar 2012,lower than its July forecast of 6.1% andthe lowest in a decade.

Productivity

In the last two decades, real GDP-to-working age population (those 15 to64), a measure of productivity, grew anaverage 4.6% per year. If this rate ofproductivity growth persists, adding inthe 0.9% projected rise in the working-age population implies 5.5% annualGDP growth in coming years, justenough to accommodate new jobentrants. This real GDP growth ratealso implies a 4.6% annual rise in realGDP per capita. That compares withthe low 1.8% from 1960 to 1991 and5.0% since then (Chart 56, page 26).

The slowdown in population growthfrom 2.2% per year from 1960 to 1991to 1.8% since then and 0.9% projectedfor future years obviously boosts theper capita economic growth rates. Also,future growth depends on productivitygains, and whether the 4.6% annual risein the GDP /working-age populationratio of the last 20 years persists.

Industrial production is falling (Chart57, page 26) and the HSBC IndiaManufacturing Purchasing ManagersIndex (Chart 58, page 26) is still above50, indicating expansion, but dropping.Compared to the other BRICs in 2011,India had the highest inflation rate, the

(continued on page 26)

CHART53

Real Global GDP and Indian Fixed Capital Formation

Source: World Bank and Reserve Bank of India

Last Points: global GDP 2011 2.7%; India GFCF 2Q 2012 0.7%

year/year % change

1997 1999 2001 2003 2005 2007 2009 2011

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

India Real Gross Fixed Capital Formation - left axis

Global Real GDP - right axis

CHART54Headline Doing Business Rankings

Source: World Bank

Last Points 2012: Brazil 126; Russia 120; India 132; China 91

composite rank amongst all countries

2006 2007 2008 2009 2010 2011 2012

80

90

100

110

120

130

140

80

90

100

110

120

130

140

Brazil

Russia

India

China

CHART55

India Real GDP

Source: India Ministry of Statistics and Programme Implementation

Last Point 3Q 2012: 2.9%

year/year % change

2007 2008 2009 2010 2011 2012

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INVESTMENT THEMESOur Investment Themes section reflects the positions that are in or being considered for our managed portfolios. We may addor delete portfolio positions in the course of the month, but those changes will not be shown in Insightuntil the following report.

Treasury bonds (favorable) The rally in Treasurysresumed in March as a safe haven in a sea of trouble andin response to slowing economic growth and looming globalrecession. The likelihood that inflation fears will turn soonto deflation worries also may help. The yield on 30-year

Treasurys actually reached our 2.5% target, the 2008 post-Lehman low, in early June. A 2.0% yield is possible aseconomic and financial conditions deteriorate.

Income-producing securities (favorable) As manyinvestors favor income over problematic capital gains,included are stocks of utilities, drugs and telecoms with high,safe and rising dividends. But all stocks are vulnerable toa likely bear market. Also, investment-grade corporate andmunicipal bonds and some Master Limited Partnerships areattractive. Income-producing securities, however, are subjectto the fiscal cliff.

The dollar vs. the euro, Australian dollar and yen. Alsothe Dollar Index (favorable) The buck is the world's safehaven. The eurozone financial crisis remains unresolvedand the recession there deepens. Australia has become acaptive mineral supplier to faltering China. We're reinstatingour negative stance on the yen with further massivemonetary ease in Japan in prospect (see page 40).

Rental apartments (favorable) have gained favor by thosewho can't afford home ownership and are discouraged byfalling house prices. Their stock prices seem overblown, butdirect ownership of rental apartments may still be attractive.

Medical Office Buildings (favorable). The aging postwarbabies, the 2010 health care law and the migration ofphysicians from private practice to hospital employmentwill promote robust, steady growth in this real estate sector.But government regulations can be disruptive.

North American energy (favorable) Americans havedecided to reduce dependence on imported energy fromhigh-risk foreign areas. We like conventional energyinvestments including natural gas, on- and off-shore drillingand Canadian oil sands. Natural gas prices appear to have

bottomed, and pipelines are attractive. New nuclear facilitiesmay be postponed in the wake of the earthquake andtsunami in Japan. Renewable energy is problematic since itdepends heavily on unpredictable government subsidiesamidst federal cost-cutting.

Developed country stocks (unfavorable) With a hardlanding in China and the resulting negative effects oncommodity exporters, a major recession in Europe and astrong dollar, earnings of U.S. multinationals are being hurt.A moderate recession in the U.S. will also damage corporateprofits despite more cost-cutting in response. We look for$80 per share in S&P 500 operating earnings in 2013 anda bottom P/E of 10 (see page 40).

Homebuilders are unattractive if house prices tumble aswe forecast (see page 40).

Your house, second home or investment single-familyhouses aren't attractive. Excess inventories are likely topush prices down another 20% over the next several years.

U.S. major and regional banks (unfavorable) Majorbanks are being bereaved of proprietary trading and otherprofitable activities and are being busted back to less-lucrative spread lending. Regional banks suffer from weakloan demand and bad real estate loans.

Junk securities (unfavorable) Despite recent pre-borrowingfrom yield-hungry investors, default rates are likely to leap

in the global recession we foresee while junk prices drop.

Developing country stocks (unfavorable) China willprobably suffer a hard landing. She and other emergingexporters are vulnerable to economic weakness in the U.S.and Europe.

Commodities (unfavorable) The commodity bubble startedto break in early 2011 due to a prospective hard landing inChina and the global recession. Copper is already downsubstantially and excess inventories in China loom.

Unresolved eurozone financial woes have spilled into economies there, and a European-wide recession is well underway.With falling exports, the hard landing we forecast in China still seems likely despite monetary and fiscal stimuli and strongerdata of late. Huge deficits and gridlock in Washington have curbed sizable U.S. fiscal stimuli but the fiscal cliff willprobably be avoided (see page 40). The euphoria over the Fed's QE3 will probably end with a shock that will benefitour quartet of investment strategies: long Treasury bonds, short stocks, short commodities and long the dollar.

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Summing Up

In the wake of Novembers elections in the U.S., stocksstagnated as investors focused their attentionand theirfearsto the looming fiscal cliff and prospects for afavorable resolution. Tax rates will rise and governmentspending will be cut sharply come January if Congress andthe re-elected Obama Administration dont reach anagreement to avoid a situation that could cut consumerspending and real GDP and put the U.S. economy into arecession. The Dow Jones Industrials finished Novemberdown slightly while the S&P 500 was up slightly and theNasdaq gained 1.1%. Overseas markets, however, werestronger.

The dollar moved sideways against the euro last month andrallied vs. the yen. Treasury rates gained slightly.

The Federal Reserves policymaking committee meets next

on Dec. 11-12. The approaching fiscal cliff and prospectsfor a peaceful resolution were on the mind of Fed ChairmanBernanke, who said in a Nov. 20 speech that uncertaintyabout the fiscal cliff, federal debt limits and challenges ofbalancing the U.S. budget were alreadyaffecting privatespending and investment decisions and may be contributingto an increased sense of caution in financial markets, withadverse effects on the economy.

Consumer prices rose 0.1% in October and were up 2.2%year-over-year. Core CPI was up 0.2% in October and rose2% over the year. Producer prices declined 0.2% in

October as declining energy prices outweighed rising foodcosts. Core PPI fell 0.2% in October and is up 2.1% year-over-year. The core personal consumption deflator, theFeds favorite inflation barometer, has risen 1.6% fromOctober 2011 through October 2012, safely below theFeds 2.0% target.

Ample global supplies kept crude oil prices stable in themid-$80 range throughout November despite renewedMid-East tensions and the lateOctober East Coast SuperstormSandy that led to local supplyshortages and rationing for several

days. Oil and gasoline prices havestayed put for the most part sinceearly October.

The first revision of third quarterGDP showed a gain of 2.7% vs.the original +2.0% estimate, thanksto increased inventories, morefederal spending and strongexports. Personal income barelyrose in October while consumer

spending, in part due to the East Coast hurricane in the finaldays of October, fell 0.2%. The personal saving rate edgedup to 3.4% in October from 3.3%.

Retail sales fell 0.3% in October after three straight monthsof gains, including an upwardly revised 1.3% rise inSeptember. Auto sales fell 1.5%. The Christmas shopping

season seemed to get off to a solid start, with spending instores and online over the four-day Thanksgiving weekendrising 13% over last year, according to the National RetailFederation. Online shopping on Black Friday rose 26% toexceed $1 billion for the first time ever, according toComScore Inc., and Cyber Monday online sales rose 20%over last year. The retail group predicts holiday sales to rise4.1% this year vs. last years 5.6% gain. Early Thanksgivingweekend sales may have pul led spending forward.

The jobs picture has revived in recent months, withnonfarm payrolls increasing by 171,000 in October while

September

s figures were revised upward from a gain of114,000 to 148,000.. The national unemployment rate,which declined to 7.8% in September, rose to 7.9% inOctober.

Housing starts rose 3.6% in October to a four-year high.New home sales fell 0.3% in October vs. September duein some part to the East Coast hurricane in the final daysof October. Still, sales year-over-year were up 17.2%. Themedian price of $237,700 was 5.7% higher than a yearearlier while unsold inventories stood at a 4.8-monthssupply. Existing home sales rose 2.1% in October. Themedian price of $178,600 was 11.1% higher than a year

earlier. Unsold inventories stood at 5.4 months supply, thelowest level since early 2006.

The S&P/Case-Shiller index of property values in 20 citiesrose 3% in September vs. a year earlier and 0.4% fromAugust. Eighteen of the 20 cities surveyed showed gains,led by Phoenixs 20.4% year-over-year advance. TheNational Association of Home Builders confidence indexrose five points to 46 in Novemberthe highest level since

May 2006.

Consumer sentiment rose to 82.7

in November from 82.6 inOctober, the University ofMichigan reported. TheConference Boards index ofconsumer confidence rose to 73.7in Novemberits highest levelsince February 2008from 73.1in October.

Fred T. Rossi

Editor

INSIDE THE NUMBERS

Dow Jones IndustrialsS&P 500Nasdaq CompositeNikkei AverageFTSE 100

Hang Seng

*through Nov. 30

Nov. 2012

% Change*

Year-to-Date

% Change-0.5%

+0.3%

+1.1%+5.6%

+1.5%+1.8%

+6.6%+12.6%+15.5%+11.7%+5.3%

+19.5%

10-yr. Treasury note$=

=$

Oct. 31Nov. 301.62%82.44

1.30

1.69%79.78

1.30

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CHART56

Indian Real GDP per Capita

Source: World Bank

Last Points 2011: level 837.7; yr./yr. 5.4%

1960 1970 1980 1990 2000 2010

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

10%

100

1000

Year/year percent change - left axis

Level (constant 2000 US$) - right axis (log scale)

CHART 57India Industrial Production

Source: India M

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