Is India in a sweet spot, near term?
The answer seems to be yes for global investors, given all the favorable factors, including: (1) the Modi effect; (2) the delayed and/or mini steps of a Fed rate hike; (3) low oil prices; (4) a global disinflation environment; and (5) room for the RBI to ease. Indian equity markets rewarded the Modi effect along with other factors with 50% gain (Nifty index) within one year from May 2014 after Mr. Modi assumed power. Since May this year, the market’s performance has been a bit disappointing. Doubts are rising in investors’ minds on whether India can stay in this sweet spot.
Is India the next China?
The straightforward question we would ask ourselves is this: Is India the next China? This seems to be the consensus long-term view, given (1) potential growth, especially from the favorable demographic picture; (2) the stage of development of China around 10 to 15 years ago, where a gap needs to be closed; (3) institutional reform, which is both similar to and different from China and which will fundamentally aid growth; and (4) market potential, on the back of long-term growth potential.
What have been the institutional differences between India and China?
China and India had near equal status for the 400 years prior to and including 1980. India and China had a habit of copying each other’s policies, sometimes by circumstance, at other times by a parallel ideology, for example in both having five-year plans. China started to reform in early 1980s. Since then, authoritarian China has grown at a much faster rate than democratic India, and even faster than any other country in recorded history, including democratic Japan, semidemocratic Singapore, and authoritarian Korea prior to its move towards democracy. Is China replicable or that is just a singular occurrence?
What has been severely lacking in Indian democracy is the other freedom – economic freedom. Sustaining growth in a noisy democracy is hard, and even when democracy becomes stable, economic change could create distributional conflicts and stresses on democratic institutions. The redistribution of wealth in India is an issue of considerable and continuing concern.
What are the economic differences between India and China?
1. Different development stages: The two economies are different in composition, and at different stages of development: based on PPP-adjusted per capita GDP, China was at India's current level nearly a decade back, having grown significantly faster than India over the past three decades. As per the IMF forecasts, the coming five years should see sustained outperformance of India's growth over China's.
2. Different economic structure: The two economies also have very different structures, though there should be greater convergence on this front going forward, with the Chinese rebalancing focusing on heavier consumption and less investments, and India trying to kick-start the investment cycle. The same can be said of India's industry, which should take some share of GDP away from agriculture in the coming years, and with China's services sector growing.
3. Different economic challenges: China's heavy debt levels are considered one of the key risks to its growth outlook. The low-inflation environment in China intensifies these concerns. In India, overall indebtedness is significantly lower, and its higher-than-global inflation further offsets this, but low financial penetration is a problem. The bad loan problem in India, too, is under-reported and growing, and in the coming years could be a drag on the banking system, particularly given banks’ heavy corporate lending.
4. Different demographics: Economic growth and the one-child policy have sharply slowed China's population growth (1.36bn people with a fertility rate at 1.5). Many believe China could grow old (with the number of people older than 80 nine times greater in 2015 than in 1970) before it becomes rich. India’s rapid growth in population (1.25bn people with a fertility rate at 2.5) has so far slowed its improvement in prosperity, but with the dependency ratio expected to continue to fall over the coming decade, it is better placed than China. While China opened up its economy to trade much earlier than India, its trade-to-GDP ratio is now similar to India's (50% for India vs. 44% for China). Hence, at a gross level, dependency on global growth seems similar.
5. Different infrastructure setup: It's well known that on several measures of "hard" infrastructure penetration, India significantly lags behind China, but even in tele-density (telephone connections per 100 people) China is nearly a decade ahead of India, but the lead is narrowing. This affects productivity with a lag. In particular, broadband penetration in China is 36%, vs. just 6% in India (on reduced standards).
6. Different market profiles: Chinese stock market performance has been volatile in the past. Volatility-adjusted returns have been poor, with likely reasons being a large number of SOEs on the market, and dependency on government policy. Private companies dominate the Indian market. In terms of sector composition, too, the Chinese and Indian equity markets are different, with the Indian market much more diversified than the Chinese.
What are the essential factors for success in India’s next stage of development?
China’s rapid economic growth in the past three decades is unprecedented in human history. Is India the next to achieve similar miracles, or it will never do so?
The general success factors for a country to move up to the next level of development stage, generally lies in: (1) Favorable demographics providing surplus labor for the economy to mobilize; (2) Globalization-enabled external demand and financing for the economy to utilize; (3) Economic reforms that provide incentives for the corporate sector to invest, by utilizing surplus labor and financing (FDI) to improve productivity.
As investors, we have always asked why, given that India is not lacking surplus labor and trade openness, is there no sticky FDI (the most important financing source)? Why have declining funding costs not provided a boost? Fundamentally we think this is due to: (1) Very low labor productivity (in terms of value-added per worker, China is around nine times higher than India in the industry sector, and five times higher in services); (2) Very backward infrastructure, which raises logistics costs; and (3) Very strict labor law (only companies with more than 40 employees are not allowed to lay off staff).
1. How to improve low labor productivity then? While some think China’s literacy rate may be overstated, there is no doubt it has reached a remarkable level, especially given that people must learn characters rather than an alphabet. Over 96% of the population is literate – compared to just over 71% in India. Sustaining current real GDP growth rate at around 7% for the next 5-10 years is crucial to doubling real GDP in absolute terms from current US$2tn.
While a gap has remained with China’s per capita GDP growth, India’s per capita GDP growth has accelerated quite sharply since 1980. Per capita GDP growth in the first 30 years (1950-1979) was only 1.3% per annum; after 1980, per capita GDP growth accelerated to 4.2% per annum; and since 1993 it has been 5.1% per annum. The two countries’ capita GDP growth is converging, and it wouldn’t take long for India to surpass China on this front.
With rising individual disposable income and government spending on education, labor productivity is positioned to rise. Conservatively speaking, at least another 5 to 10 years are needed to reach the labor productivity level where China is at now.
2. Does India have to be an investment-driven economy first? We think this is the path India is missing in its development and one that it must pick up and develop fast. Given Indian’s past legacy from the British Raj, India is rather more an exporter of services than goods, hence, we would rather call India the “world office” and China the “world factory”.
3. Is total factor productivity the key to India’s development breakout? We think this is crucial. Total factor productivity is often seen as the real driver of growth within an economy and studies show that whilst labor and investment are important contributors, total factor productivity may account for up to 60% of growth within economies. Total factor productivity includes technology growth and greater efficiency. With technology growth, especially in the manufacturing sector, this will absorb surplus labor as well. The Modi government is trying hard to improve efficiency by streamlining policy processes such as project approvals.
To conclude, we don’t think that India, given its different institutional setup, will be able to adopt a model similar to China’s, and it would be hard-pressed to repeat the miracle that China has achieved in the past three decades. However, amidst the persistently sluggish global recovery, we expect India to stand out with potential high economic growth from to-be-improved labor productivitycapital productivity and total factor productivity.
Is China model applicable to India?
Backwardness offers India potential
Low labor productivity hinders FDI inflow
Investment driven growth absorbs surplus labor