Jeremy Siegel, Ph.D. The Future for Investors

Leaving Zurich's international airport on the way for the World Economic Forum, visitors confront a huge billboard declaring: "India: The Fastest Growing Free Market Democracy."

India was a key sponsor of the 2006 Davos Forum, and its direct jab at China, witnessed in prime time by the world's elite, signals just how fierce the competition for the world's investment capital has become.

India's bragging rights were inconceivable just a few years ago. As recently as June, 2003, The Economist magazine ran a cover story "India v China: A Tiger, Falling behind a Dragon." In that article, the magazine indicated that in 1980, India's GDP was greater than China's and its per capita income was some 60% higher. Yet by 2003 the situation reversed, as China's economy soared ahead of India and sported per capita income some 50% higher. But in recent years India's economy is rising again and the Tiger is making a run at the Dragon.

Investor Confidence

The sudden interest in India has boosted the country's self-confidence. Grant Thornton, a leading international audit and consulting firm, carries out a survey of business confidence of more than 7000 owners of medium-sized businesses from 30 countries. Surprisingly, India ranks number one, ahead of the G8 economies, China, and Europe's "Celtic Tiger," Ireland.

As I reported in my last column, India lags China in the hard infrastructure of roads, airports, and real estate, but it leads in the "soft" infrastructure of democratic institutions, free press, and an independent judiciary. What other factors favor India?

Banking and Finance

India's long experience with a free market enabled it to gain significant experience in lending and raising capital. This is not the case in China. Until recently China's banks were in business to funnel loans to woeful state-run enterprises. There were no incentives for these loans to be repaid, and now banks are crippled with an estimated $213 billion of non-performing loans.

In contrast, India's major banks are thriving and ICICI Bank, India's second largest, is considered one of the best run in Asia. More than 6,000 firms are listed on the Bombay Stock Exchange, far outnumbering the number in China and more than double the number on listed on our New York Exchange. Furthermore, investors in China's stock markets in Shanghai and Shenzhen have performed miserably over the past decade as overpriced stocks flooded the markets. In contrast, Bombay's stock market has been booming.

Business Relationships

Trust is certainly an important component of any business relationship. But one aspect of Chinese culture that disturbs me is called guanxi, a network of business and social relationships among various parties who are expected to exchange favors regularly and voluntarily.

Although it is wrong to interpret this practice as "bribery," since these exchanges need not involve money, I worry that these networks can be used to shut out those that don't "fit into" an approved Chinese social circle. Guanxi, when combined with the corruption that permeates the Chinese economy, make a truly competitive economy difficult, if not impossible to achieve.

For India, these social networks and corruption are less of a problem. To be sure, dishonesty still exists in government service, but high level corruption is being vigorously rooted out by a free press that is absent in China.

Perhaps the greatest strength of a free market economy is its openness to do business with anyone who has the qualifications and desire to do a job, regardless of ethnic or social backgrounds. America is so attractive to so many immigrants who have been shut out of opportunities in their own homelands because of our openness. Guanxi combined with the uncertain new laws defining private property and business contracts in a still-Communist China should be a source of concern to investors.

Demography

Perhaps the most positive aspect of India's future is its demography: India is a very young country, while China, because of its one-child policy, is rapidly aging. According to the UN demographic Commission, by the middle of this century the most densely populated age group in India will be those aged 40 to 50, while in China it will be those aged 55 to 65. This means China will soon start to suffer the same problems as Japan, Western Europe and the United States: an excessive number of retirees relative to the working population.

The young have the flexibility to adapt, absorb, conceptualize, and innovate. This is the key ingredient of technological and economic progress. China has a large supply of new workers for private enterprises, but these workers are leaving state-owned enterprises and are older and are not as adaptable as the young labor market in India. The late management guru, Peter Drucker, said that demography is the "future that happened." Population trends are not easily reversible, and here the advantage goes to India.

India or China?

With all these points favoring India, the answer to the question, "Where should your money go?" may seem like a forgone conclusion: India has the best prospects for investors.

But, as I explain in my book, The Future for Investors, there are two aspects to every investor decision. First you must size up the prospects for the firm, the sector, or the country. On this score, India scores some high marks.

But you must also evaluate the price that you are paying for these prospects. India's investment climate looks ripe for growth, but the markets have recognized this and have pushed stock prices upward. The Sensex 30, India's best-known stock market index and analogous to our Dow-Jones Industrial Index, was only 3300 in December 2002 but on February 6, 2006, the index broke through 10,000 for the first time.

A Question of Value

The price-to-earnings ratio on this index has reached 21, while Chinese stocks on the Hong Kong Stock Exchange are selling for only 15 times earnings. Goldman Sachs Asia Pacific Strategy recently indicated that it thinks valuation has turned the tide toward China. In a December review of the Asian markets Goldman stated, "We remain bullish long term [on India], but are market weight given the stretched valuations [and other factors]." In contrast Goldman's Asia team remains overweight in Chinese equities due to the cheaper valuations.

Both India and China have enormous promise and I would certainly own stocks from each of these countries in a long-run portfolio. But India's edge is no secret and future returns will not match the stellar gains of the last three years. And remember, all the developing markets, no matter how promising, contain considerable risk. In a later column I will advise readers on how to build a global portfolio that will balance growth prospects with these risks.