NRI: Investing in India or in USA???

Everyday we came across hundreds of Non-Resident Indians (NRIs) who are debating whether or not to shift all or a part of their savings to India. In many instances the thought is triggered by the recent run up in Indian stock and property prices and not by a 'real need' i.e. the intention is usually to speculate and make some quick money. For such NRIs, we have little to offer other than guidance on what probably could be better reasons to consider investing in India.
We also come across NRIs who are looking at India from a 'real need' perspective. This note will help them take several steps forward in planning their India exposure.

What is a 'real need'?

Take for instance you have parents in India for whom you wish to provide a monthly income. Or say you are planning to relocate to India in the future and therefore want to accumulate some local currency (i.e. Rupee) denominated assets. Or maybe you wish to diversify your portfolio of assets by taking exposure to India. These are just a few examples of a real need.
Before you, an NRI, get down to actually investing in India, there are three critical questions that you need to answer or get answered; all questions are broadly linked to each other and answers to them will form the basis of your investment planning.

1. What is the objective for investing.
2. How much of your savings that are abroad should be in India.
3. what are the likely prospects of the Indian Rupee and how will it influence the answer to the second question.

Clear on the objective
Before making any investment, it is imperative that you be clear on the objective/s for investing your money. Unless you are clear on what your goal/objective is, no one can help you. The objective/need, some of which have been mentioned above, needs to be well-defined both in terms of the desired result and the tenure.
So if you are planning for retirement, one critical question that must be answered is 'where are you likely to settle down post-retirement'?

Once you are clear on your objectives, which by no means is an easy task, you should look at your asset allocation and ascertain whether the same is geared to meeting your objectives. In all probability you will need the help of an expert to reach a conclusion. It is here that you will have to decide in which asset class to invest, in what proportion and in which country (as you have options apart from India).

Let's take an example to understand how you should go about allocating money to India. Suppose your objective is to plan for your retirement ten years from now; you plan to settle down in India. Presently, you reside in say the USA and most of your monies are invested in US Dollar-denominated assets.

There are two ways you can go about allocating your assets for this need.

1. One, you can take a neutral view on the currency and deploy the required sum of money in India that will help you take care of your retirement. This will ensure that in case there are some adverse currency movements between now and the time of your retirement, you need not worry much about the same; your assets, and thereby the income they generate, and your expenditures are in the same currency i.e. Indian Rupee.

2. The other option is that you allocate your assets depending on where you believe the risk-adjusted return will be maximum i.e. you take a view on the currency and basically bet that when you approach retirement, your investments would have generated a better return, after factoring in the appreciation/depreciation in the Indian Rupee.
In our view it is best that you take a neutral view on the currency for that portion of your assets which you ultimately wish to transfer to India to meet your needs.

Let's take another objective that NRIs often have - to provide a regular income to their parents and/or other dependents in India. Usually the methodology adopted by NRIs is to set aside a lumpsum, the income generated from which takes care of the need of the parents/dependents. Here again you need to decide whether to invest the lump sum in India or to invest in assets denominated in other currencies as well.
Given that the money is 'sacred' for the parents/dependents, it is probably best you take measures to reduce the volatility in the income generated i.e. take less risk. One way to reduce the overall risk is to avoid taking on the risk that any adverse currency movement may have on returns. Ideally, in such circumstances one should opt for Rupee-denominated assets which generate steady tax-efficient returns.

Where the Rupee headed?

And this brings us to the third question - Where is the Indian Rupee headed? A cautious view would be a gradual decline, in the range of 3.0% - 5.0% every year. However, if India were to get its act right as far as attracting foreign investment is concerned, the foreign currency inflows could support the Rupee. We would recommend that you opt for the cautious view
(India still runs a hefty fiscal deficit and relies on imported crude oil).
But then if the currency is likely to persistently depreciate by 3.0% - 5.0% p.a., is it not better to invest in assets that are denominated in currencies which are likely to strengthens (as this would add to overall returns)? This may not necessarily be true.

Stock Market

Take for example the prospects that the Indian stock markets hold out for the next 3 - 5 years. In our view, the returns from a well diversified carefully selected basket of stocks should be about 15.0% compounded annual growth rate (CAGR). Warren Buffett, arguably the most successful investor ever, estimates the long-term return from US equities to be about 6.0%. Well, that is quite a spread; it takes care of currency depreciation and more.
Even if you compare debt instruments, the 10-Year government bond in the US yields 4.6% while the comparable Indian bond yields 7.6% (as on the 28th of September 2006); a spread of 3.0%.
Of course the spread would vary from time to time; but as any economist will tell you, the interest rate differential between comparable bonds denominated in different currencies tends to reflect the expected change in the exchange rate of the currencies over a period of time i.e. you are probably getting a higher rate of interest in India via-a-vis the US because over a period of time, one expects the Indian currency to depreciate against the US Dollar to the extent of the differential (ofcourse there are many other factors that impact interest rates and exchange rates and therefore the result may turn out to be different).

To conclude, in our view, it is best to avoid taking a call on the currency when it comes to "deploying assets" to take care of 'real needs'.