6 March 2019

Following the BJP’s dramatic 2014 electoral victory, Prime Minister Narendra Modi enjoyed a mandate to implement economic reform. From the beginning, however,  the program faced criticism. On the one hand, Hindu nationalist believe the changes do not go far enough in promoting their interests, whereas non-Hindus charge the  benefits have not been widely enjoyed throughout India’s diverse population. Even supporters suggest banking reforms are inadequate, the implementation of the landmark General Sales Tax (GST) was poor, and the demonitization program was reckless. With elections upcoming, financial markets also have become nervous. Will PM Modi be able to resist a pre-election fiscal stimulus? And, especially following the recent violence in Kashmir, will he become more assertive to solidify his Hindu-nationalist political base? In addition, how will the reform agenda be impacted if the BJP loses its parliamentary majority in the Spring polls, as appears likely?

What is clear, however, is the reforms are bearing fruit. The Chart above illustrates that GDP growth has surged in recent years, and India has outperformed all G20 economies, including China! What is also evident is that there’s a long way to go. The Chart also indicates India’s per capita GDP remains roughly half that of other BRICS nations. The upcoming election presents a perfect opportunity to take stock of the implications of past reforms, and to outline what the priorities of the next government should be. If reforms continue following polling day, as I expect, India’s economy should continue to outperform other emerging markets, and the per capita GDP gap will narrow by 30% during the next 10 years. Perhaps most striking, I expect Indian GDP growth to exceed China’s by  up to 15% during the next decade! (I will produce lots of Charts to save on words, bear with me!).

Sharing the Benefits: Producing More Inclusive Growth

Especially in a diverse country as India, sustaining reform momentum will require that the gains are widely shared. The Chart above illustrates that income inequality is amongst the highest in the world (e.g. high Gini coefficients). What’s especially concerning, however, is that the gap has widened during the period of rapid growth. And, while India can celebrate that roughly 200 million people have been lifted out of poverty, the following Chart highlights that despite its recent achievements, much of India remains desperately poor and poverty very high.

Economists have a simple formula for assessing a country’s long-term growth potential: add up the growth in labour supply, productivity, and the capital stock (driven by growth in investment).  The IMF (and others) indicates that India has the opportunity to exploit a “demographic dividend”. As a start, India’s population (and potential labour supply) is growing nearly 1.5% annually — over 4 times the pace in China. Unfortunately, however, India has not succeeded in creating enough jobs to absorb the new entries to the labour force in recent years.

Moreover, a distinctive trait of India’s labour market is that nearly 50% of the population is employed in the agricultural sector. And, the productivity of India’s agrarian economy is very low.

Therefore, a key ingredient for reducing poverty and promoting inclusive growth is to improve productivity levels in rural areas. Not only will improved efficiency boost rural incomes directly, but it would free workers to transition to higher paying urban, industrial jobs. The following Chart illustrates how successfully this strategy played out in China. During China’s growth surge, the urban population expanded by 20 million per year,  nearly three times faster than in India. In India, the combination of population growth and internal migration has enormous potential to provide low-cost workers to fuel industrial growth in the next decade.

Furthermore, sustaining strong, inclusive growth and reducing poverty would be advanced by greater involvement of women in the labour force. The following Chart illustrates India’s poor record in utilising this neglected resource.

Boosting Productivity, Investment, and Jobs

Boosting productivity is the most important factor in raising living standards, reducing poverty and sustaining strong, inclusive growth. The following Chart illustrates that India is poor because productivity is low. Fortunately, progress is being made.  In particular, India’s recent growth performance has been driven by 7% annual gains in efficiency.

Strong business investment is final component of long-term GDP growth. Again, historically India’s business climate has not been favourable  for capital spending. However, after declining for much of the past decade, fixed investment has become an important driver of growth following recent reforms (next Chart).

The World Economic Forum’s (WEF) competitive index illustrates that reform has improved India’s business environment more dramatically than any other emerging market in recent years (Chart below). Nevertheless, the survey illustrates that competitiveness still lags other key countries (especially China), and underscores the need to sustain reform momentum.

In addition, the Modi government has also sought to improve the climate specifically for foreign direct investment.  While there remains much to be done, these efforts are bearing fruit too. FDI has roughly doubled in recent years — reaching $40 billion last year. As a share of GDP, FDI now rivals others large EM destinations, e.g. China, Brazil, Mexico, and Turkey.

The WEF Competitiveness report helps identify key policy issues to boost investment and productivity in the next stage of reform. In addition to rampant corruption, the most often cited impediments to growth are high tax rates, poor access to finance, labour force rigidities, and poor infrastructure. Indeed, India’s corporate tax rate is amongst the world’s highest. The following Chart illustrates that only Indonesia has stricter labour market controls.

New banking (including bank recapitalisation) and bankruptcy reforms aim to improve access to capital, but this is only in the early stages. State banks account for 70% of lending, and NPLs stand at 18% of outstanding loans — compared to 3% at private and foreign institutions. Likewise, return on assets has been negative for 4 years, while ROA in the private banking sector is about 2%. To be sure, high levels of Indian corporate debt is considered an impediment to economic growth. However, compared to other EM countries, especially China, the situation appears manageable (especially as foreign debt is low) — a key reason the next decade favours India over China (where an extended period of corporate deleveraging is inevitable)!

Public Finances: Still the Achilles Heel?

Large deficits and high levels of government debt have been identified correctly as posing risks  to India’s economic prospects for a long time.  Indeed, the public sector’s deficit will approach 7% this year, and debt could hit 70% of GDP. Such results put India alongside Brazil — a country in which fiscal credibility is often a huge concern. However, India differs importantly from Brazil. Indeed, strong GDP growth will lead to a decline in India’s debt ratio even if large deficits persist. In Brazil, on the other hand, tepid GDP growth will produce an unsustainable rise in its debt ratio unless the new goverment takes urgent action. At first glance, India’s public finances appear more precarious than China’s: where the deficit and debt stand at 4% and 38% of GDP respectively. However, the situation changes dramatically using the IMF’s “augmented” definitions of China’s public sector: deficit and debt results expand to 11% and 72% of GDP respectively. That is, worse than India’s.

To be sure, therefore, India confronts fiscal challenges, especially controlling shortfalls at the state level. Strong GDP growth, however, suggests that these issues can be addressed over the medium term. Therefore, priority should be given to redirecting spending to boosting productivity and inclusive growth. As the Chart above illustrates, poor infrastructure, especially in the provision of electricity and water are important impediments to growth and living standards, especially in rural areas. Likewise, spending on health care at 5% of GDP is half OECD levels — and government spending of 1% of GDP in this area is shockingly deficient  compared to the OECD’s 7%. Also, education outlays of 4% of GDP lag most other EM nations.

Many pundits believe India’s deficits prevent it from increasing public sector spending. I am more optimistic. India has considerable scope to raise revenues in line with other BRICS. The recently implemented GST is a step in this direction, and signals an intent to  expand the formal sector of the economy, which can be taxed more effectively.

International Risks: Trade Wars and External Financing Risks

Concerns about trade wars and rising US interest rates created volatility in Emerging Markets last year. How vulnerable is India? To be sure, trade worries are already adversely impacting exports and economic activity throughout Asia. India has not been immune: GDP slowed to 6.6% in Q4 2018 (compared to 8% in Q2 2018).  The following Chart, however, illustrates that so far the impact on Indian exporters has been less severe than in other regional economies.

Nevertheless, India is the USA’s 9th largest trading partner, and its bilateral deficit is the 7th biggest ($22 billion). As a low-income nation, India’s restrictive trade practices have not drawn much attention yet. It is plausible, however, that India could become a focus of the Trump Administration’s trade policy at some stage. US steel tariffs did have a small impact on India.

The US Federal Reserve’s recent decision to postpone further interest rate hikes has taken pressure off Emerging Markets. However, India’s relatively small external financing requirement limits the nation’s vulnerability to this risk  (Chart above). India’s external debt is low (25% of GDP), foreign participation in the local bond market is quite minimal, and international reserves of $400 billion provide a cushion. India’s rising current account deficit (approaching 3% of GDP), however, bears watching. Roughly 50% of the shortfall is financed by FDI, and the rest by potentially skittish portfolio and banking inflows. As in 2018, this combination is more likely to contribute to periods of FX volatility, rather than to create a crisis that could derail the reform program.

Strategic Implications

• If reforms continue and the global economy avoids recession, India could enjoy another decade of 7% GDP growth. India’s economy will outperform other EM nations. In particular, India will outpace China by a meaningful margin.
• Prior to the Spring elections, Indian equities may underperform until the next government displays its intention to continue economic reforms.
• The India rupee is roughly in line with fundamentals. I expect the INR to depreciate roughly in line with inflation differentials in the next few years in order to maintain competitiveness.