December 1, 2019

India’s promise

Despite its promise over the last decade, the Indian economy has slowed down sharply in recent years. That has led some to predict the decade ahead will be one of lower growth and frustration that India’s enormous potential will, yet again, go unfulfilled.

These fears are overblown. In fact, the Indian economy is likely to grow two and a half times to $7tn by 2030, from about $3tn today. That could make it the world’s third largest economy. That also means nominal GDP growth is likely to average just over ten per cent through the next decade. True, that is lower than the 13 per cent annual average recorded over the previous ten years, but it will still be an amazing feat in a growth-starved world.

First, let us consider some of the reasons for the current slowdown in growth. The sharp drop in GDP growth is primarily due to ongoing problems in the shadow-banking sector and large non-performing assets in the banking sector, which has reduced private consumption expenditure and domestic demand substantially. Furthermore, monetary transmission remains weak due to a variety of structural factors and given the weak demand, the outlook for private sector investment also remains muted. In addition, a significant reduction in the inflation level (and inflation expectations), thanks to the new inflation-targeting framework, has also contributed to lowering nominal GDP growth relative to past periods.

While Indian economic growth may remain below potential in the near term, ongoing reform measures have significantly boosted its future potential. For starters, to offset the demand slowdown, the government took the bold decision in September to meaningfully cut the corporate tax rate. This will likely incentivise greater foreign direct investment flow into the country and support private investment in the economy which has remained weak over the last eight years. In addition, the central bank also cut the policy rate by 135 basis points to revive growth.

Apart from these stimulus measures, reforms initiated in the last few years, should also improve the medium term outlook. As economies with significantly higher informal sector employment, such as India, typically have lower per capita income, policies which are aimed at the greater formalisation of the economy should help to accelerate per capita income levels. In India’s case, the Goods and Services Tax (GST) and demonetisation are likely to play a major role in the formalisation of the economy, a process which is already underway. Demonetisation, apart from reducing tax avoidance, has also resulted in incentivising a faster pace of digitisation, a dynamic which will gain further momentum in the next decade. Similarly, GST by the very nature of its design will incentivise a faster pace of formalization of the economy, which will consequently improve the fiscal and growth dynamics of the country. Add to this, the increased focus on urbanization, should also help improve India’s prosperity over the next decade and beyond.

The prospects for boosting prosperity for the average Indian are strong. A study by the Brookings Institution1 found that India is slated to become one of the leading sources of middle-class demand in the coming decades (that is, people who spend $11 to $110 a day). India’s per capita income is expected to double to $4,500 by 2030 which, in real per capita income terms, will constitute close to 5.5 per cent average annual growth through the next decade. This means India should account for 17 per cent of global middle-class consumption, just behind China on 22 per cent and ahead of US on seven per cent. This level of consumption growth has tremendous implications for investment opportunities in different sectors of the economy, particularly infrastructure, banking, utilities, and industrials.

There are two other factors that will help drive growth over the coming decade. The first is a proper bankruptcy law which only came into force in 2017. This will help to reduce crony capitalism and incentivise proper risk assessment. It will also make the banking sector more credible and boost transparency and resiliency in the financial system over the next decade. The banking sector itself will likely be very different by the end of the next decade as the public sector banks consolidate. Already, the government has announced merging ten public sector banks into four entities. This should reduce their share in the banking system from the current level of 70 per cent, while private sector banks commensurately grow their market share.
The second factor that will drive growth is the Reserve Bank of India’s move a few years ago to adopt inflation targeting and establish positive real interest rates in the economy. This, coupled with the government’s focus on bringing more transparency into the real estate sector, have started a seemingly irreversible structural shift of household savings from physical to financial assets. This trend will likely accelerate in the decade ahead. Our preliminary calculations suggest the share of financial savings in total household savings is likely to touch 55 per cent by 2030, up from 40 per cent currently. Most of these incremental household savings are likely to find their way into India’s capital markets which will boost its prospects in the medium term.

While the long term structural story remains positive, there are a few challenges India must deal with over the coming decade. From a macro standpoint, fiscal consolidation remains the need of the hour, as without a credible plan to reduce India’s debt from the current level of 70 per cent of GDP to 60 per cent or below, there are potential risks of crowding out, once the cycle begins to turn. Also, without debt and deficit reduction, it will be difficult for India to win a ratings upgrade in the coming years. Given competing considerations of supporting growth, providing subsidies to farmers and poor people, and a large interest payment obligation each year (which accounts for a quarter of total expenditure), it is difficult to aim for meaningful fiscal consolidation, unless revenues pick up. While the GST and the cut in corporate tax rate will be beneficial for the economy in the medium term, currently tax revenues remain below potential, thereby raising risks of fiscal slippage and resulting in a widening of term premium, which is inhibiting monetary transmission in the economy.

Given this fiscal backdrop, we expect the authorities to open India’s bond market more liberally to foreign investors. This will be a welcome source of incremental demand for local currency government bonds which are used to finance the fiscal deficit and will help drive longer-tenor yields to decline and aid in the transmission process. An idea which has often been under discussion is to consider including India in global bond indices. These potentially see large inflows from a diverse investor base which tracks a particular index.

Inclusion in bond indices may become a reality and gain traction over the next decade. This will lead to a fundamental shift in India’s fixed income markets, with commercial banks’ holding of local currency bonds (currently 39 per cent of outstanding bonds) likely to see a steady decline, while that of foreign investors’ holding (currently just over three per cent of outstanding government bonds) growing materially over the next decade.

The second big challenge India faces are its population dynamics. While India as a whole is slated to enjoy a demographic dividend of increasing working age population (and a lower dependency ratio), 60 per cent of the rise in India’s population by 2030 will come from some of the poorest and fiscally weak states – Uttar Pradesh, Bihar, Rajasthan, Madhya Pradesh and West Bengal.

As the working-age population increases sharply in these states over the next decade and beyond, the pressure on their respective state governments will mount. They will need to generate new employment and attract higher investment. Failing this, the incidence of poverty and human development conditions (which are already poor) could worsen further. Fiscal support to prop up growth and development may be minimal given these states already remain severely challenged.
If the incidence of migration gathers pace, as people move elsewhere for employment opportunities, the fiscal position of these states could deteriorate further. The state government’s own-tax revenues will fall and thereby raise deficits and debt. Therefore, it is essential that rapid progress toward fiscal consolidation continues. This should occur alongside factor market reforms – land, labour and capital. It is essential for these poor states, and for India in general, to leverage its economies of scale in a productive manner. In this backdrop, the present government’s approach to foster a culture of competition among states is a step in the right direction.

The structural changes undertaken in recent years will help transform the Indian economy over the next decade and maintain growth at strong levels. Despite a challenging global environment, India benefits from demography, an aspirational middle-class, and recent economic reforms that give it a constructive outlook over the coming decade.