The government likes to point to the booming stock market as evidence of Shining India. But the boom has been driven overwhelmingly by foreign institutional investors (FIIs). They poured in a record $7.6 billion in 2003 and another $4.12 billion to date in 2004, of which $1.26 billion came in just nine trading days in April. Despite this, the stock market has slipped slightly since the start of 2004. But for foreign inflows, it might have crashed.
Does this mean that the doubling of the Bombay Sensex over the last year is unsustainable, and will be reversed when global winds turn from fair to stormy? If rising interest rates make US securities more attractive, or if global terrorist attacks create panic, will money flood back from developing countries to the US ?
Maybe. Yet, in the longer run, emerging markets like India appear irresistible for western investors. For starters, successful developing countries grow much faster than mature ones like the US . More important, demographic change will drive billions of dollars from West to East.
The population in several rich countries is shrinking or is about to shrink because women in-creasingly have stopped having children. When the fertility rate (births per woman) drops below 2.0, there are not enough kids to replace oldies. In several rich countries, the fertility rate has dipped to 1.3 or less. The resulting population implosion is sometimes but not always offset by immigration.
Besides, with improving medicine, old people are living longer and longer. The net result: the proportion of oldies is rising and that of youngsters of working age is falling. Traditionally, old people have been supported by workers. What happens when the proportion of workers keeps shrinking and that of retirees keeps rising?
Western countries have traditionally taxed their workers to pay pensions and medical benefits to the aged. But this will increasingly become difficult as workers shrink and retirees expand. An enormous pensions crisis looms over rich countries. America ‘s unfunded pension liabilities are estimated by experts at $10.5 trillion, more than its entire GDP. In some European countries, unfunded pension liabilities are 250% of GDP.
What is the way out? Western countries know the days are gone when they could tax an increasing workforce to support a small number of retirees. So they are shifting from fixed pensions to funded pensions. In funded pensions, workers and employers contribute to a pension fund, which invests the money. The better the returns from investment, the higher are the retirement benefits of the aged. The shift from fixed state pensions to funded pensions will shift trillions of dollars into pension funds, a shift of tectonic proportions.
Yet, this will not entirely solve the problem. Traditionally, pension funds have invested in their home country, something regarded as safe. But in future, extracting returns from domestic investment will mean, one way or another, extracting more and more from a shrinking workforce to support the aged. Funded pensions are better than unfunded ones, but the underlying demographic problem remains.
Rising productivity is unlikely to offset demography totally. Investing at home in ever-rising amounts will typically lead to diminishing returns. This will mean a steady reduction in retiree benefits. And this will not be politically sustainable in countries where the aged constitute a rising (and very vocal) share of voters.
Solution? Invest abroad. Traditionally, most rich countries have invested in one another, not in developing countries (which have been regarded as risky). But no country with a ageing problem can find a solution by investing in other countries which also have an ageing problem. Willy-nilly, they will have to invest in countries with growing populations, backed by productive policies. That means countries like China and India . These countries are on a strong growth path, unlike African ones. Their populations are expected to rise to 1.5 billion each by 2050, up from 1.2 billion in China and 1.0 billion in India today. Their expanding workforces exhibit rising productivity. A recent article in The Economist summed up the matter succinctly. To pay pensions, ageing countries can no longer depend on taxing their own people. Nor can they tax people in developing countries. But they can invest in efficient developing-country industries. There lies a solution.
A distant prospect? No, the process has begun. A huge US pension fund like Calpers is already investing in some emerging markets, though not India (which it still views as too risky). Sooner rather than later, India will cease to look risky. At that point, the inflow of foreign funds will explode, and so will the Indian stock market.
The bottom line: I have no idea whether the stock market will go up or down in the next eight months. But looking at an eight-year horizon, I would predict a runaway boom.