The Hindu Business Line : `The reality is nobody has made money in China'

The advantage in being viewed as an `option' is that more uncertainty feeds into its value. In conventional budgeting, more uncertainty reduces value. — PROF ASWATH DAMODARAN

Professor Aswath Damodaran did his B.A in Accounting from Madras University in 1977, earned a Masters in Management from IIM before going on to do a MBA and a PhD in Finance from University of California, Los Angeles. He was profiled in Business Week in 1994 as one of the top twelve Business School professors in the United States.

The 21st century is widely touted as the one in which China and India will emerge and dominate as global economic powerhouses. Business Line spoke to Professor Aswath Damodaran about this aspect of the global economy.

Excepts from the interview

How does India compare with China?

We are in is a period in which India and China are poised to become dominant markets; whether they will become the dominant financial markets is open to question. This century you are going to see a race between the two from a financial markets perspective. India has an advantage with its financial markets right now and part of it comes from what China thinks is its advantage — stable government and predictable policies. That strength is going to become a weakness for China from a financial markets perspective.

What makes China strong from an economic standpoint — its predictable policies — will also make it impossible for its financial markets to be trustworthy. As an investor you are worried about a system where there is no legal protection. You see extreme examples of this in Russia with Yukos. China has a host of little Yukos that don't quite make it to the surface where the rules of the game are getting changed after you get into the game.

India has an advantage in that it has a legal system, which with all its weakness still has some teeth to it. That is going to be a big factor going forward.

The Chinese too have their Lenovos, Lifans... Will they make a difference?

They have made their reputation primarily as low-cost manufacturers, which will not be a long-standing competitive advantage. Your success ruins you. If you are successful as an economy, then the costs have to go up and there is also some one else who has lower costs than you.

Do you think their investments in manufacturing and infrastructure can help?

The question is whether they will make the next leap like Japan did and make the transition. The difference between Japan and China is Japan was able to do that in a much less competitive world market. They had more protection from competition. China, on the other hand, is in a market that is unforgiving of mistakes. It is possible that China could make that second leap. By investing in infrastructure they are potentially giving themselves the chance to do that.

Despite the higher costs of doing business in India, research has indicated that return on investment in India has been higher than that of China. What's your take?

To begin with, you have to be careful about return on capital. These are accounting returns and very dependent on management discretion. I always take them with a grain of salt. Let us face it — nobody has made money in China.

That is the reality. People are investing in China on promise that there will be returns in future.

In a sense, there are two sets of rules. They viewed India as a conventional investment. They decided that they would invest more in India only if the original investment made money. For China they set aside those rules. They invest in China because of the potential. To put it differently, investing in China is viewed as an Option. The advantage in being viewed as an `option' is that more uncertainty feeds into its value. In conventional budgeting, more uncertainty reduces value. There again we have to see if there is a transition and companies can start thinking that we can no longer afford to view China as an Option.

With the increase in the size of the Indian economy, is there a chance that investors will also start viewing India as an option?

It is difficult to view something that you are already familiar with as an option. India has to compete as a conventional investment choice. It is a little dangerous to view any emerging market as an `option.' I have always felt that about China.

It is like the dotcom business. People invested in these businesses as if they were an option. The problem was success attracted hundreds of competitors and drove out the excess returns.

Viewing any investment as an option is dangerous and sooner or later blows up in your face. It might happen in China in any investment sense. China could be a strong economy but a bad investment.

Can this line of thought be extended to sectors? For instance, the retail sector is viewed as an option.

That is exactly the danger in each of these sectors. We think of the retail sector as an option because we think there is going to be a huge retail market. If I want to get into retail what I will do is let you go into the market now, lose money, I will see what you do, learn from your markets and then get into it when the market succeeds.

What do you think of the edge India has in services and its latest efforts to grow their manufacturing base?

India's competitive edge was in specific area of services where they can draw on the fact that English is much more widely spoken. I am not sure manufacturing business is as great as it is made out to be. Ultimately, you are manufacturing commodities. Anybody can build factories and cut their costs down.

Manufacturing business is a much tougher business to maintain an edge on than services.

Even in services, we are beginning to find that there is no difference between the Infosys' and TCS' of the world.

Again, you have to move up the value chain. As long as stay at the bottom there will of course be somebody else who will do it cheaper. In a sense, the key for countries is to stay out of pure commodities business. This is because you get squeezed in terms of margins.

Does that mean it is only the multinationals with diverse work force and operations across the world that will run away with the high margin business?

Human capital is what you compete for. It is tough to lock in human capital. Unlike capital on which you can claim ownership, human capital goes to the highest bidder.

Do you think the financial markets will get divided into sets of risk managers and risk hedgers?

Ultimately it is not so much you can divide risk. It is almost like people have split personalities. One part of the personality is saying that I hate risk and am going to hedge against risk. But the other part of the personality is seeking out risk. As long as we do not reconcile the two personalities, then we are going to have all the risks of a split personality.

You will have manic swings in your investments. You would want to sell everything or buy everything. I think I am trying to reconcile the two sets. It is ok to both love risk and hate risk, hedge risk and seek out risk. Your tact as an investor is to go through your risks and decide which ones you want to seek out and which one you want to avoid.

It is almost like a risk inventory. These are the risks that I am going to take, avoid or protect against. These are the risks I am going to transfer to my investors and let them worry about hedging it through insurance or derivatives. Other than that, these are the risks that I have a competitive edge. I think it has got to be built in a much orderly way into corporate strategy.

How should companies and investors handle such risks?

The problem is that if you let investment bankers define risk, they are going to define it in terms of what products they are selling to you and those products tend to be risk-hedging products. If you let management consultants define risk, they are going to be in terms of the products they can sell to you and those tend to be risk-taking products.

So you cannot let vendors tell you what risks you should worry about, because they have their own agenda. This process has to start from within. After all, who knows more about the risks you take than the company itself.

Every company, at least once a year has to sit down and create an inventory of every possible risk- legal, financial, physical risks. Then you have to systematically go down and say that these are the risk that is not our job to protect against and investors will take care of them.

Could you give us an example?

You might be a gold mining company and gold prices may be a big risk. You are going to say, I am not going to hedge against that risk, because the reason investors buy my company's shares is because they want to be exposed to that kind of risk and I will let this pass through. No derivatives, no hedging.

You might down a little further. One of the apprehensions in my mind is that my mines are in the most dangerous spots in the world. If there is a revolution in that country, my mines are going to shut down. That is the kind of risk I am got to insure against, because it is the kind of risk that I do not want to pass through to my investor and it could cause me to go into defaults.

You might have sub-choices: am I going to insure using options, futures, derivatives or plain insurance contracts? As you go further down, there might be other risks where you say that is where my competitive edge is. I can go into dangerous areas and find out where the gold is and I am going to exploit those risks. I am not going to hedge against them or pass them on, but actively seek out those risks.

Are companies consciously looking at risks in this manner?

Right now the way we deal with risk is almost perhaps wait till something bad happens and then we realise that we need to insure against terrorist attacks. Or wait for prices to shoot up and then hedge against. It is very ad hoc, the way we manage risks.

What is your view on global imbalances?

Global imbalances have always been a fact of life. It may be now that US has a huge trade deficit, but twenty years from now who knows what imbalance it would be. So much of the global economy is now linked what individual countries are doing now matters less than it used to.

There are those prophesying that the housing bubble in the US will burst and the dollar will be in a free fall dragging the global economy with it. How do you view these perceived threats?

When you have an economy that is the 30 per cent of the global economy, what happens to it will affect others. Is it possible?

Sure. Is it probable? I don't think so. The US economy is so diverse that you can have segments of the economy that is doing well, the overall economy still seems to be muddling through.

There are a few who are saying that some pieces in the jigsaw puzzle are not right, be it the current account deficit or the housing bubble...

The pieces of the puzzle have never fallen in place. There are always some pieces that won't fit. The nature of the economy is that if all the pieces fit, you will be in a steady state. The problem with steady state is that is not the way economies work. Economies work because of friction. What you should worry about is something like a terrorist attack that will shake the whole puzzle. These imbalances are not unique. There is always something that could be off kilter.

What role has productivity gains linked to technology played in keeping inflation down at these levels?

Ultimately inflation comes from monetary policy. Everything else is a side trip. That was always Milton Friedman's point. The central banks have blamed everybody else but themselves on the one thing that causes inflation, which is central banks keep printing more money.

If you do not print money, there can be no inflation, by definition. All you have is relative prices changing. The absolute price level cannot change, if the central banks control the money supply. I think that is what has changed over the last twenty-five years.

Has the role and clout of central banks changed?

In the last twenty five years, if you were a government in an emerging market and an election was coming up, you turned to the central bank and say juggle your money or currency out there. Now it is unlikely that the central bank will listen to you. Even if they did listen to you, there will be so much external pressure from the IMF, World Bank and the institutional investors that it is almost impossible for a country to take off and do that now without facing the consequences.

One thing that has changed that the central bank is no longer is at the beck and call for pumping money. If you do not have that, it is not that inflation is going to go away. But you are not going to have that 30,40 or 50 per cent impact or the hyperinflation that you often saw bouts of.

The bouts might not last long, but all you need is one bout every ten years for people to become gun shy. If you issue long-term bonds, nobody will buy your bonds.

Has India handled these issues in a satisfactory manner?

Twenty years ago, if the Indian government had issued bonds, nobody would have bought them; people would not trust currency long term. One of the amazing things that has happened in the last few years is that you issue ten-year bonds, people are saying 5.50 per cent.

That is the ultimate vote of confidence you are getting from the investors, because you are saying, we trust you not to do something incredibly stupid in the next ten years. It takes a while to get there. This is the big difference between Asia and Latin America.

In Asia, the Asian governments took their medicine and kept issuing long-term bonds until investors got the trust. In Latin America, they never tried. Look at Brazil, the money that they raised long term is issued in US dollars.

It is a much less healthy way to deal with it, because ultimately for the economy to sustain itself, it will have to trust its own currency. And I think that trust comes from an extended period in which you observe your currency retaining its value without bouts of very high inflation.

Your article on Value and Risk: Beyond betas, published in November 2003, talks extensively about a comprehensive strategy of dealing with risk. Are you working currently on new measures of risk?

It is not so much new measures of risk, but a fuller dimension of risk. We have considered risk to be a bad thing and we discount rates and put it away. But risk is a very strange thing. It is both opportunity and threat, boon and bane and an up and a down. It is not something you protect yourself against, but something you seek out. Great companies become so not by being risk hedgers, but by seeking out particular types of risk and exploiting them. So, what I want to do is put out a much fuller picture of both the upside and downside of risk.

Infosys says that it already has high operational risks on the balance sheet, so they are not going to take any financial risks. They are not going to leverage at all.

It is a part of both. In a sense, it is a good thing to be thinking about, but they are thinking purely in terms of debt ratios. But these might also have consequences in terms of what types of contracts they should sign with their employees. As you have operational risks, do you want to tie these long-term consulting contracts while something is fixed price for the next ten years. Everything is tied into everything else. And the only way to do this in a comprehensive way is to bring it all together in one place.

Have you found a way to circumvent the ad hoc discounts that you have been talking about?

There are fairly straightforward ways of dealing with all these issues. But we have to think about risk more comprehensively. We have been thinking about them in a piece meal basis.

What are your views on market inefficiencies and what really creates them?

I am not sure you can call them inefficiencies in the first place. These are anomalies that you cannot explain. Human beings are at work in the markets. They behave in ways that are often quirky. So we might not be able to explain why people like low price-to-book stocks or why people like large-cap companies more than small-cap companies. That is an anomaly.

The reason why I am a little reluctant to call it inefficiency is because it suggests something to make money on. So there seems to be a gap between what we cannot explain and our taking advantage of what we cannot explain. In the area of behavioural finance, it is largely about what we cannot explain. So, behavioural finance does not give us any tools about how we can go out and take advantage of what we cannot explain.

In India, we find that mutual fund managers have been able to do consistently better than the markets. Your view on this.

The emerging market portfolio managers seemed to consistently beat the Morgan Stanley Capital Index because of the way it was constructed. All you had to do to beat the index for four to five years was to underweight your portfolio in Japan and you could beat the index.

In the US, in the 1960s and the 1970s, the way to beat the index was to load up on small-cap stocks, until evaluators caught on and built the small-cap stocks into the measurement mechanism and, all of a sudden, such returns went away. So I am a little wary about whether the market is adjusting for all these differences.

The Reserve Bank of India is paranoid about hedge funds.

I don't blame it.

Is it possible and preferable to have a hierarchy based on type of investors that could help in regulating fund flows?

I do not think it is possible to do that. For one, no banker is going to have the tools to monitor whether they are hedge funds or not. They are going to create loopholes that can help drive them in. The reason I think hedge funds are scary is that historically when you give mutual fund managers more freedom, they have always hung themselves. The more room you give them the higher they seem to hang themselves.

Hedge funds have more freedom than mutual funds, because they can go long or short, and that freedom is what destroys them. Since their leverage is so high, even a small mistake can prove catastrophic. So I do not blame the Reserve Bank of India. To be honest, though, it cannot stop them.

It can try to regulate them, but there will be disguised hedge funds and these must already be operating in India. No fund will call itself a hedge fund, but there will be 15 acronyms for hedge funds and they will all be in the market anyway. The only way to prevent it probably is to prevent short-selling completely or put options completely.

But SEBI is thinking of introducing short-selling for institutional investors.

Not allowing it to happen just pushes it into a different arena. So, by bringing it to the surface, you can both monitor how much is happening and bring down the cost of doing it much lower. For a long time, many markets have outlawed put options under the misguided view that allowing people to buy puts was a way to speculate prices down.

It actually had the reverse impact, which is that people could not bring bad news to the market. That led to the bubbles getting bigger rather than smaller. And when the markets did collapse, the collapse was much more catastrophic. It is better to give people outlets to get their news into the market. I think selling short is not a bad thing.

For hedge funds it is not selling short that is wrong, but sometimes the hubris of what they are doing to the market by being smarter than the market catches up, and they end up doing stupid things. You can almost guarantee it will happen and hope that, when it happens, only a small number of people get burnt.

The RBI has forced public sector banks in India to be risk-hedgers, while the private sector banks are managing risks and walking away with the market share. What's your view?

You cannot think of risk as a bad thing. You are in so much of a "defensive crouch" that you are not going to bring up your eyes up and see the opportunity that the exact same risk gives. So by focussing so much on the downside, you ignore the upside.

Regulatory agencies cannot be the ones to determine how people invest. But your risk management cannot stop with merely meeting the regulatory criteria. That may take care of the downside, but somebody in the bank has to say, given that lever of restrictions, how can I go out and exploit risks among the things I do best?

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