Is India the next China?

India is now the world’s fifth largest economy, climbing from 10th place in 2009. The country’s growth has been resilient over the past few decades due to its scale and diversity. Is this the next China?

Investors frequently compare the two countries given India’s similar attributes to China’s economy at the turn of the century. Traits such as low gross domestic product (GDP) per capita, a large and relatively young population, and a strong government intent on bold reforms. It begs the question – will big bang reforms see India replicate China’s long period of double-digit growth? We believe India has great economic potential and is capable of sustaining healthy growth around 7% per year based on our estimates; see the analysis that follows. Emulating an East Asian miracle, however, will be challenging given the domestic and external growth impediments that the country faces. India’s growth and path to prosperity should be exciting to witness, but in our view, it is too simplistic to rely on China’s story. Its path will be its own.

India’s per capita GDP is equivalent to China’s in 2002

India's per capita GDP equivalent to China in 2002

Source: World Bank, as of 2018.

Resilience in India’s growth

India’s demographic dividend and rising middle class represent its biggest opportunity. India commands approximately 20% of the world’s working population. Based on United Nations data, the working age population over the next two decades, is expected to grow by almost 200 million to more than 1 billion. Economies such as Japan experienced this demographic dividend between 1964 and 2004, as China did since 1994 and is projected to until 2031. Now India is expected to benefit over the next 35 years. (Source: World Population Prospects 2019, United Nations Population Division.) With more of the population entering the workforce, generating income, and ultimately spending more, the young population will likely be a multidecade blessing to the country. However, this blessing could turn into a curse if India is unable to train its workforce and create productive jobs to match its skills.

India’s demographic dividend – % of population at working age

India's demographic dividend graph

Source: United Nations Population Division, World Urbanization Prospectus 2018.

Note: Working age is defined as the age bracket of 15 to 64 years.

India’s domestic consumption contributes 60% of the GDP today, and we expect it to grow from $US1.5 trillion to nearly $US6 trillion by 2035. This is more conservative than the World Economic Forum forecasts of $US6 trillion by 2030 which appear too optimistic to us. This strong reliance on domestic consumption has made the economy resilient to external shocks. India’s wealth is rising but is yet to reach middle income status according to the World Bank classification. We expect incomes to continue to rise in India with the key challenge of reducing income inequality; this is set to drive consumption growth and support sustainable economic growth of about 7% per annum for years to come. Growth in income will be the catalyst, in our view, to transform India into a true middleclass economy from its current low-middle-class status, but India needs to address certain structural deficiencies.

Is India the next China? It’s different this time

China’s rise was led by exports due to the strength of their manufacturing sector and during a time of relatively favourable geopolitics, reducing trade barriers, and sustaining global growth. While India has huge scale to be globally relevant, we don’t believe the world can accommodate another China. Exports will likely naturally grow with the economy and India could be a beneficiary of trade tensions. But the real growth story for India is more domestic than exports.

India’s exports versus China: A long way to go

India's exports versus China graph

Sources: Government of India Central Statistics Office (CSO), CEIC, Citi Research, and World Bank.

It is not uncommon for developing countries to transition away from agriculture to services, such as the path China continues to walk, but what’s different for India is the “missing middle.” India has transitioned to a services economy, growing this sector by approximately 9% per year for two decades to now representing 55% of GDP, all without the help of manufacturing in between. India accounts for approximately 25% of global information technology (IT) service exports, but only 2% of the world’s goods trade. (Sources: CEIC, World Bank, and HSBC.) In our view, India should benefit significantly from an improving services sector, but it will have to address the problem of premature deindustrialisation of the manufacturing sector if it wants exports to contribute meaningfully to future growth.

The missing middle, from agriculture to services

The missing middle, from agriculture to services graph

Sources: CSO, CEIC and Citi Research.

In the absence of strong export-led growth, we believe that domestic demand within India can sustain real GDP growth of about 7% a year, but not the double-digit growth achieved by China. Regardless, we expect a sustainably high growth rate from India even as many economies, including China, are slowing.

Unlocking future growth: India has some work to do

We believe India has the building blocks to develop and significantly expand the country; the journey may be exciting, but it won’t be smooth. Where will the pain and stumbles be felt as some of these policies find their way in the real economy?

  • Demographic dividend or curse?A young population is a key tailwind for the economy, but the poor quality of India’s education system is impacting the quality of its labour pool and overall employability. At the same time, India also suffers from underemployment as overqualified youth cannot find suitable jobs. The impact? Every year millions of semi-employable and often unqualified youth seek entry into the workforce, threatening to turn India’s demographic dividend into a demographic curse. To complicate the situation, labour force participation rates for women were at an abysmally low level of 23.7% in 2016, second only to Saudi Arabia (sources: World Bank, Citi Research). India will need substantial investment to train its workforce, increase women’s workforce participation, and, more importantly, create productive jobs to match those skills.
  • India’s informal economy is huge but unproductive. Representing 90% of employment and 50% of GDP, India’s informal sector usually evades the tax net, has low productivity and low access to formal credit, is largely unregulated, and its workers don’t come under the purview of labour protection laws. (Sources: Report of the Committee on Unorganised Sector Statistics, National Statistical Commission, 2012.) While India has reduced its reliance on agriculture, it has had less success in absorbing the excess agricultural labour into formal, organised enterprises. The 2017 implementation of tax reform, the Goods and Services Tax (GST), and the 2019 reduction in the corporate tax were good steps to increase the competitiveness of the formal sector and improve tax collection, but further work is needed to unlock future, productive growth by addressing areas such as simplifying complex land and labour laws.
  • Harnessing technology to leapfrog dated infrastructure and limited resources provides an opportunity to spur faster growth. Advances in technology are key to driving change and can unlock growth and new markets in India in ways beyond current imagination. While lagging the world on many fronts, smartphone adoption makes it the largest Internet market in the world, a good base to start from. India has already made progress using technology to increase financial inclusion via a universal biometric identification system (Aadhaar), measures to boost the number of bank accounts (Jan Dhan), and real-time payments systems (Unified Payments Interface and Bharat QR). Examples of progress, but more is needed.
  • Future growth requires investment, which the country has struggled to sustain in recent years. As investments and savings as a proportion of GDP fall, India will need to create a supportive environment for business, spur an innovative financial sector, and clean up the nonperforming assets within its public banks that are preventing credit growth. The government is trying to attract private and foreign capital with recent reforms contributing to India’s jump of 30 places in the World Bank’s 2018 global ease of doing business ranking. A good start, but the country needs significant investments in both physical and social infrastructure to sustain growth.
  • Sustainable urbanisation will be key to unlocking India’s demographic dividend. Between 1950 and 2015, the proportion of Indians living in urban areas doubled but remains comparatively low at 33% (China stood at 56% in the same year), according to the United Nations. Continued urbanisation is key for India to increase productivity and GDP per capita over the long term, but it also causes significant pressure in those urban centres. As India’s urbanisation rate improves to 40%, around 250 million people will be added to India’s cities taking the total urban population to 600 million. (Source: United Nations) These cities need to plan to accommodate the growing population in terms of public infrastructure, living space and jobs. India needs new planned urban centres rather than overcrowding existing metro cities. Unplanned urbanisation has costs, can lead to the creation of large slums, and may ultimately jeopardise the expected 7% growth rate.
  • Cooperative federalism is key to implementing all the major reforms announced by the central government. India has 22 official languages, 29 states, and 7 territories, each as unique and culturally diverse as the nations of Europe. Issues pertaining to land, labour, and education are the concurrent responsibility of the central government and the states and if India is to scale up its fragmented agricultural and industrial production, states need to embrace policy changes made by the federal government. India’s leadership, reduced red tape, and organisation surrounding nationwide reform will be key to unlocking faster growth.

Believe in the opportunity, beware of the hype

With the structural tailwinds of a rising middle class and young population, we believe India has great economic potential and will sustain healthy growth around 7% per year; yet we see inefficiencies likely resulting in stumbles along the way. With a limited manufacturing sector and domestic focused economy, we do not believe India will follow China’s export-led path to growth. We do, however, believe the country will grow sustainably for a long time to come as incomes continue to rise. In our view, the opportunity in India is real.

Despite the long runway of growth, we observe key areas of inefficiency that will require attention from the government to support India’s growth, and attention from investors when assessing the investment landscape. An exposure to Indian equities is necessary in our view for the longevity and resilience of growth, but we caution those hoping for rapid, quick gains.

For all the good, we believe investors can overlook some of India’s challenges and this hype creates bubbles at times – this explains the common thought that “India is too expensive.” While successfully timing an entry to this market is incredibly difficult, history has shown us that periods of stretched valuations on the back of high growth expectations have been followed by material market selloffs. We conversely believe that the best buying opportunities occur when growth expectations are modest.

We believe India provides an attractive investment opportunity for those who are aware of the shape of growth and who have the horizon and awareness to invest through its ups and downs.

Important risk considerations

Investing involves risk, including the possible loss of principal.

Past performance does not guarantee future results.

Diversification may not protect against market risk.

International investments entail risks including fluctuation in currency values, differences in accounting principles, or economic or political instability in other nations.

Investing in emerging markets can be riskier than investing in established foreign markets due to increased volatility and lower trading volume.

The views expressed represent the investment team’s assessment of the market environment as of October 2019, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice.

All charts are for illustrative purposes only. Charts have been prepared by Macquarie unless otherwise noted.

All third-party marks cited are the property of their respective owners.

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