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India Elections: Mind the Policy Gap

The largest-ever general elections are underway in India, and investors have never been so enthusiastic about India as they are today. We look at the drivers of this enthusiasm and whether it is justified.

As the fastest growing major economy in the world, India has attracted a lot of investor interest. In our earlier article on India, we highlighted the macroeconomic rationale behind the country’s prospects. In this piece, we focus on geopolitical and policy factors and the degree to which they support or hinder India on its journey. In short, we think Indian assets are well-supported in the short term. But beyond that, markets have expectations that will be hard for policymakers to deliver.

Markets’ View on the Elections

Markets are excited about India in general. They see several sources of promise – the country’s large working-age population, the geopolitical opportunity arising from US-China decoupling, a reformist government, and the promise offered by technology. Investors see these as coming together to deliver sustained and transformative economic growth in India for years to come. There is even talk of India catching up with China as China’s growth slows.

The election gives investors political cover for their enthusiasm. That Prime Minister Narendra Modi and the Bharatiya Janata Party (BJP) party will win is almost a given. The question is by how much. The markets, therefore, expect continuity in economic policy. Indeed, BJP is expected to do well at the provincial level as well. Thus, the prospect of a landslide win opens up the possibility that the new government will do even more to promote and develop the economy.

The Markets Are Right in the Short Term

Good policy is critical for economic development, and the government rightly deserves credit. Over its 10 years in power, Mr. Modi’s government has rolled out world-class digital infrastructure alongside a material expansion of the real kind. The current administration has cleaned up the banking sector and replaced several local taxes with a new national sales tax, among other reforms. On the World Bank’s Doing Business survey, India jumped from the 130th place to the 63rd between 2017 and 20201. In the roughly 20-year history of the index, only a couple of countries have managed such a feat.

What can we expect from the new government? In the short term, we think it can deliver. Mr. Modi and the BJP have campaigned on a promise to push ahead with reforms. Therefore, growth expectations of 7%+ per annum for the next three years are justified.

One factor that excites the market in particular is the government’s fiscal prudence. Government finances have been notably well-managed over the past few years, and we expect this to continue. Public investment in both real and digital infrastructure should remain at elevated levels even as fiscal deficit continues to narrow. That should support growth, while keeping in check concerns about inflation or fiscal sustainability. However, over the long term, we urge caution.

Mind the Gap Between Policy and Promise

India’s demographics are a key factor that underpins the positive outlook on the country. India has a large working age population with a decreasing number of dependents. However, too few people are in the workforce – the IMF estimates that there are about 100 million individuals without jobs2. And among the people who are employed, too many are engaged in agriculture and other low-value-added or even unpaid work. The aggregate potential of bringing people into the workforce and increasing their productivity is significant.

Indian policymakers believe that they can unlock this potential by developing the country’s services sector. Creating more jobs is sensible policy. But where such policy delivers on volume it falls short on productivity. If the point of comparison is China, this is a critical point. China developed by way of export-led manufacturing. Although both approaches can employ a lot of workers, the margins on services are far narrower. By extension, the activity contributes far less to overall economic growth in aggregate.

Indeed, a couple of indicators speak to the extent of the policy failure in this regard. Private sector investment is a critical input to job-rich growth. However, as a share of output, productive private investment (excluding investments in buildings) has fallen, even as public investment in infrastructure has increased (Figure 1).

And the investment in manufacturing that has materialized has been concentrated in industries that are capital intensive but job poor (Figure 2).

Geopolitics offers another widely cited source of potential. However, at the aggregate level, India is struggling to take advantage of the current geopolitical dynamics. The United States (US) and China have been drifting apart for nearly a decade. However, in terms of inbound foreign direct investments (FDI), India continues to lag economies with a similar geopolitical dividend, despite low labor costs, and FDI has actually fallen in recent years (Figure 3).

In simple terms, Mr. Modi’s government has not demonstrated its ability or willingness to deliver on the long-term policy path of the scale and scope that is required for a genuine transformation of the Indian economy.

Considering the above, the most likely long-term path will be a slowdown in India’s GDP closer to a growth rate of about 5.5%-6%. If this comes to pass, the government could very well step in with additional public investment. However, this may end up being short-lived. With a debt-to-GDP ratio of over 80%, India’s room for fiscal intervention is limited, particularly if the need for additional public investment comes against a backdrop of slowing growth.

Short- and Long-Term Investment Implications

Investors seem to be brushing aside these long-term concerns and are starting to believe the transformational story of India becoming the next China. In our view, this is wishful thinking.

In the short term, we see Indian assets being supported by its strong macroeconomic performance, a supportive policy mix, and strong demand from domestic and international investors. A soft landing in the United States (US), which would support normalization of the policy rate in the US and a gradual depreciation of the US dollar, should prove to be a tailwind, as it gives the Reserve Bank of India leeway to reduce real rates.

We are more skeptical about returns over a longer term, given high valuations and the long-term outlook outlined above. Our view could change if we see a change in government priorities – in particular, a shift in policy towards job-oriented growth. We would look favorably upon greater global integration, in terms of inbound FDI and trade, and greater success in invigorating private investment. We are also monitoring for signs of geopolitical headwinds on the global services trade, which so far has not been as affected as goods trade.

In a Nutshell

Governments play a critical role in economic development – policy can support or hinder growth. In our view, the policy backdrop in India is supportive in the short term. As far as the long term is concerned, we think that markets’ expectations have gotten ahead of evidence about what the government wants and can deliver.

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