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Duncan Robertson

Papers White Paper

On the dragon’s tail: will India become the next China?

White Paper
21 April 2015

By

Portfolio Manager, TT Asia Equity Strategy

TT considers whether the reform-minded government of Narendra Modi will be the catalyst for the world’s largest democracy to become a major engine of global economic growth.

Amid all the enthusiasm about China’s booming economy over the past decade, it has been easy to overlook India. With a population of nearly 1.3 billion, the country is running a close second to China in terms of people and, according to Worldbank data, is the world’s third largest economy on a Purchasing Power Parity basis.

GDP by PPP (US$ trillion)

GDP by PPP (US$ trillion)

Source: Worldbank, 2013

Yet in per capita terms, India remains well behind China. This year Indian GDP is expected to be $1,760 per head – only 1/5 of that in China and worlds apart from the $57,000 predicted in the US.

GDP per capita (US$)

GDP per capita (US$)

Source: IMF

To understand this divergence, we must first understand how both countries achieved economic expansion in the past. Much of China’s stellar growth has been investment led, with the substantial tailwind of huge government spending on infrastructure and urbanisation.  Future growth is likely to depend on the extent to which its growing middle class can be encouraged to consume.  India, on the other hand, has relied on its consumers for economic growth and, in the process, has grossly neglected its infrastructure.  It is estimated that India’s capital stock per worker is just 12% of the world average and a shocking 3% of that in the US.  It desperately requires renewed investment in infrastructure and manufacturing in order to re-accelerate growth.

In addition to a lack of infrastructure investment, India has suffered for many years with excessive levels of bureaucracy, inefficient labour markets and a culture of over-subsidisation. All have conspired to discourage vital foreign investment.  This downward spiral has caused a gradual slowing in the rate of economic growth, as well as deteriorating current account and fiscal deficits.  As the charts below show, if India is to prise the growth mantle from China, it is starting from a disadvantaged financial position.

Budget balance as % of GDP

Budget balance as % of GDP

Source: TT International, Bloomberg

Current account as % of GDP

Current account of % of GDP

Source: TT International, Bloomberg

Despite these handicaps, there are signs that the tables are turning. Given the sheer size of China’s economy, and the fact that it has grown by an average of over 10% per annum for the last 30 years, a slowdown was inevitable.  In 2014, China’s economy expanded at the slowest rate in 24 years and fell marginally below the government’s official target for the first time since 1998. Premier Li Keqiang recently announced a new target for 2015, indicating a further slowdown in the rate of growth to “around 7%.”  This is overstated as a concern in the financial press, in our view, and is perfectly normal in an economy reaching middle income levels.

India, on the other hand, may well be seeing the tide turn in its favour.  On recently revised calculations of GDP, India exceeded China’s rate of growth in both of the last two quarters of 2014. Over the last 10 years, there have only been three quarters where this has been the case. Perhaps a new economic power is emerging.

What’s changed in India: Modi magic

One major catalyst for this turnaround in fortunes has been the election of reform-minded Prime Minister Narendra Modi in May 2014. If his enthusiastic rhetoric is anything to go by, India could emerge as a true economic powerhouse in the coming years. Following his election, Modi quickly began the task of reinvigorating India’s stalling economy. 

He acted almost immediately to reduce fuel subsidies, which cost the country $34bn a year, or over 1% of GDP. This was a vital decision as these subsidies have severely reduced government revenue, leaving it well below that of other emerging countries, and curtailing India’s ability to invest for growth.

Indian fiscal position versus emerging economies (% of GDP)

Indian fiscal position versus emerging economies (% of GDP)

Source: CLSA, IMF

Of course, the Prime Minister’s decision was made materially easier by the collapse in the oil price since his inauguration.  The sharply reduced cost of imported fuel is feeding through to a marked improvement in the current account deficit.  Indeed, a $10 annualised fall in the oil price improves India’s current account position by $8bn, or 0.4% of GDP.  As a result, the country’s current account balance may turn positive as early as the first quarter of 2015.

As the current account slowly recovers, India’s fiscal position should also benefit from tax reforms. The country suffers from a complex taxation system with multiple exceptions and loopholes. This has caused revenue to languish and the cost of bureaucratic administration to soar.  Again, the new government has plans to make substantial changes and simplifications. It has started by abolishing the wealth tax and plans to replace it with a 2% surcharge on the “super-rich”.  This is expected to provide an eight-fold increase in the aggregate revenue extracted from this source. The corporate tax rate is also to be cut by 5% over four years, beginning in 2017, in order to attract crucial business investment.  In conjunction with a reduction in business exemptions, the average corporate tax rate will fall significantly to around 23%.  At the consumer level, the introduction of a Goods and Services Tax from April 2016 will replace a cumbersome patchwork of taxes, currently imposed at state level.  The net effect of all this will be considerably more investment and a simplification of the taxation system, particularly in favour of businesses, alongside a moderation in the rate of fiscal consolidation in favour of more growth-friendly policies. Such tax reforms will play an important role in re-establishing India as a substantial driver of future emerging economic growth.  

Another key problem requiring attention is India’s land and labour laws, some of which date back to 1926, and are amongst the most rigid on the world.  This has created a straightjacket for companies and made workforce restructuring and physical expansion very difficult to achieve.  The result has been a sharp rise in contract labourers, to the detriment of the broader labour force.  Rajasthan – India’s largest state by area – has become a talisman for labour reform.  Its trade unions now need larger membership before being perceived as representative of the workforce, and the definition of “factory” has increased from 10 workers to 20, reducing the regulatory burden for many small businesses.  The senior minister in Rajasthan is now targeting 12% economic growth for the region, which is clearly being held up as a model for others.  Unsurprisingly, many foreign multinationals are thriving in Rajasthan.

Foreign firms are clearly beginning to find life easier in certain parts of India. But people visiting from overseas will still encounter the country’s hopelessly overburdened transportation system.  Decades of underinvestment in roads and railways have left them unable to cope with the sheer volume of passenger and freight traffic that use them.  Since independence in 1947, India has added just 12,000 km of rail track to the 53,000 km it inherited from the British. Thankfully, the Indian government has promised to invest $137bn over the next five years in its railway infrastructure, with a 52% increase scheduled for 2016 alone. This is one of the crucial arteries of Indian industry, with 21m passengers carried each day and 1bn tonnes of freight transported annually.  In five years’ time, and after a 20% increase in track length, the target is 30m passengers and 1.5bn tonnes of freight, including a dedicated freight corridor.  Better infrastructure will enable greater speed and reliability, thereby boosting the domestic economy and, crucially, encouraging more foreign investment.

The reforms under way in India are long overdue and would seem to sow the seeds of sensible structural change and capital investment, which have been woefully overlooked in recent years.  Economic reform, by definition, is long term in nature and, as such, quantifying material improvement will be a multi-year task.  However, incremental steps in the right direction will continue to be rewarded by the stock market as greater investment and efficiency lead to higher investment returns and prosperity. 

Aside from making progress on reforms, India boasts the considerable long term advantage of attractive demographics, with a vibrant young population.  The country’s median age is 26.6 years, compared to 35.7 in China1. What’s more, 220 million Indians – equivalent to the entire population of Brazil – will enter the workforce between 2010 and 2030, while China will lose 10m people over the same period2.  India’s younger population and its favourable dependency ratio should enable growth rates to exceed those in China. 

Indian 2014 population

Indian 2014 population

Chinese 2014 population

Chinese 2014 population

Source: United Nations/Citigroup

Such divergent demographic trends will have major ramifications for equity investors in the long run. In China, a dependency ratio expected to rise above 60% by 2050 will be a significant headwind to economic growth as a whole, but it will create opportunities for investors in sectors such as healthcare, asset management, insurance, and tourism. Meanwhile in India, the sectors that stand to benefit are those most closely associated with growth and youth. These include infrastructure, banking/credit, and education.

Prospects for equity investors in India are equally positive in the short term. Modi’s reforms coincide with a collapsing oil price, strengthening economic data, moderating inflation, and a new cycle of monetary easing, all of which are supportive of the stock market.  In March, the Reserve Bank of India cut interest rates by 25 basis points. The decision was made outside the central bank’s normal cycle of meetings, due to an unexpected fall in inflationary pressure.  With a long-awaited formal inflation target now in place, we expect further rate cuts ahead, boosting investment and helping the government to drive through additional reforms. 

Of course, restructuring and reforms are neither easy nor quick, and Modi will undoubtedly encounter resistance from vested interests. However, as the winner of India’s biggest election mandate in three decades, he certainly has the people on his side and is known to want to remain as Prime Minister for at least two terms. With Modi at the wheel, India has huge potential to become a major growth engine in Asia and the wider world. We are watching with excitement to see if he can maintain the drive and the electoral mandate to fulfil this potential.


Footnotes:   

1. Worldometers

2. Bank of America Merrill Lynch


Important Information:

Nothing in this document constitutes or should be treated as investment advice or an offer to buy or sell any security or other investment. TT is authorised and regulated in the United Kingdom by the Financial Conduct Authority (FCA).

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