India is poised to achieve a rare economic feat over China

India’s new Prime Minister Narendra Modi had only been in power three months before he did an estimated $1 trillion worth of damage to the global economy. In Bali in August of this year, India’s 15^th prime minister sank the biggest deal the 160-member World Trade Organisation has ever nearly reached in its 19-year history. Modi reneged on a global agreement approved by his predecessor that would have reduced the cost of moving goods through the world’s ports. His motive was to indefinitely protect subsidies that lower food prices for about 800 million of India’s 1.25 billion citizens.

While the domestic political motive of India’s first prime minister born after independence in 1947 was stark, Modi’s sabotage of one of the least-contentious aims of the almost-dead Doha round of WTO negotiations was a surprise. For it clashed with the promises of free-market reforms Modi used to propel his Bharatiya Janata Party to victory in elections in May after 10 years in opposition. The BJP’s triumph was so sweeping the right-wing party gained India’s first lower-house majority in 30 years.

Thankfully for investors, the aberration is likely to be Modi’s anti-free-market stance in Bali. And by passing pro-business measures to revive India’s stalled industrialisation, the 64-year-old former chief minister of western Gujarat province could well repair some of the damage he has done to the world economy. The Hindu-favouring BJP’s rare majority in India’s lower house gives Modi the ability to compensate for China’s diminishing role as a driver of global growth. For with a little more government help, India’s economy can achieve a rate of growth that exceeds China’s – say, India’s could top 7% while China’s sinks below this level. Such an outcome would be a rare feat, for only once since New Delhi implemented market-based reforms in 1991 has India’s economy expanded at a faster annual pace than China’s. That was in 1999 when India outgrew China by 1.2 percentage points; 8.8% versus 7.6%. The average annual gap in growth over the past 23 years is 3.4% percentage points in China’s favour – 9.1% average annual growth for China against 5.7% for India.

Modi has taken control of India at a time when it has much catching up to do compared with China mainly because India gave China a 13-year start at reform. India, almost ironically, last had a higher GDP-per-capita than China in 1990, the year before the IMF helped India navigate a balance-of-payments and currency crisis on condition the country modernised. (US$395 output per person India versus US$341 for each Chinese). After more than two decades of better performance, China’s GDP-per-head is now more than four times that of India’s (US$6,747 for China versus US$1,505 to India in 2013), which means, as they have roughly the same population, that China’s economy is more than four times larger than India’s – China’s 1.36 billion people created US$9.2 trillion in output in 2013 versus US$1.9 trillion produced by Indians. (The size difference means India’s economy needs a rate of growth four times faster than China’s to contribute the same amount to global GDP growth.)

Much could disrupt a Modi-led rejuvenation of India, of course, for the country’s challenges are vast. The flipside to India’s ascent over its northern neighbour in terms of the pace of growth is China’s economic descent as it confronts the consequences of the lending boom that Beijing engineered to protect the country during the global financial crisis. So perhaps Modi won’t need to be too much of a star for India to outpace its neighbour. Much of the credit for any improved showing by India would be due to the Reserve Bank of India under Governor Raghuram Rajan, if the central bank were to win its battle against inflation, now down to a five-year low of 6.5%. But whoever Modi would deserve to share any acclaim with, the more pertinent fact for investors is that India’s policymakers are helping unleash, once again, the entrepreneurship of the world’s largest liberal democracy.

Modi’s mojo

India achieved praiseworthy economic growth after reforms were enacted from 1991, even if the pace of growth undershot China’s. But the economy has spluttered in recent years. Economic growth slowed from an average of 8.5% from 2009 to 2011 to less than 5% in 2012 and 2013 as corruption scandals tore at the minority government led by Manmohan Singh of the Indian National Congress party.

The resulting political paralysis and reform setbacks battered foreign and local confidence in a country where inflation is the highest among Asia’s major economies. India’s stock benchmark, the S&P BSE Sensex Index, only rose 3% over 2011, 2012 and 2013 as investors held back their money (compared with, say, the S&P 500 Index’s 47% gain over those three years). The rupee sagged to a record low of 62.62 to the US dollar on 30 September 2013 while foreign investment stagnated.[1] Amid all the economic inertia, widening current-account deficit and budget red ink, rating agencies threatened to slash India’s sovereign credit rating to “junk”.

In contrast, the BJP victory in May this year that ended a decade of rule by Singh’s Congress party drove the Sensex to an immediate record high, the benchmark having already risen 15% since the start of the year to the election day as polls predicted a Modi triumph. (The rally can almost be said to have started with Rajan’s appointment to head the Reserve Bank of India on August 6 last year. The Sensex rose 13% from that day to year end.) Investors saw that the electorate was largely voting for capable and clean administration and for higher economic growth, thus making the politics of reform easier, all accomplishments Modi achieved in his near-13-year stretch as chief minister in Gujarat. Investors became upbeat that the (sometimes disputed) pro-business and corruption-free reputation that Modi brought to the country’s top office could overcome India’s political paralysis and spark a wave of investment.

If Modi is successful, it may well prove because India has so much potential rather than any genius that resides within the leader from India’s lower caste who started out selling tea. India’s economy has potential because the country’s population is young (800 million people are aged under 35) and fast-growing. It is the world’s largest liberal democracy, which means, for all its faults, that the country is blessed with a free media, an independent judiciary, enshrined property rights, a bias towards transparency, an apolitical public service and moderate politics. Its people are industrious and risk-takers. Many of them are highly educated and speak English. Past growth has created a situation where development is self-perpetuating for it’s fashioned a middle class whose consumption can drive the economy. There is much Modi needs to overcome, of course; poor infrastructure, bureaucracy squared – India is ranked 134 out of 189 economies in the World Bank’s “Ease of doing business index”[2], a lame export performance that leads to a chronic current-account deficit, tangled land laws, an energy shortfall, a stubborn budget deficit, benchmark interest rates at 8% as a result of high inflation, a weak banking industry, debt-heavy companies, poor public services and hundreds of millions of Indians who lack basic education and the means to meet everyday needs. Politically, Modi needs to engage about 175 million Muslim Indians who are wary of a Hindu-chauvinistic government.

Modi’s is enjoying a boost from the fact that world economic events are helping his cause. The drop in oil prices helps oil-importing India’s trade performance. It eases pressure on the central government’s budget by reducing subsidy payments. Most of all, it helps reduce inflationary pressures, hopefully allowing the Reserve Bank of India to ease monetary policy to spur the economy.

On top soon

Modi is up against excessive, perhaps even unrealistic, expectations. He faces cynicism that his promises to remove supply-side bottlenecks, attack the fiscal deficit, stimulate investment in infrastructure, encourage labour-intensive manufacturing and improve governance will largely prove talk. Some wonder that he might care too much about his approval rating to take unpopular reform. His first 100 days were a good reply to these critics for he took some risky steps. His boldest moves included boosting railway passenger fares by 14%, reducing the subsidy on diesel and announcing an assortment of changes to encourage more foreign investment in restricted industries, such as introducing a bill to allow 49% foreign ownership of insurance companies. He is trying to impose a national sales tax, a policy he has opposed in the past, and has laid out plans to streamline the country’s rigid labour laws, even if he seems reluctant to privatise state-owned companies or curb many of the subsidies that help India’s poor while cruelling the government’s finances.

The budget brought down in July was viewed by some as a missed opportunity, even though it included steps to reduce the deficit. Critics say it failed to take tougher action against subsidies to mend government finances. More to Modi’s reform credentials, his Independence Day address on August 15 contained a promise to abolish the Planning Commission that recalls India’s pre-1990 socialist ways and the announcement of a goal to boost India’s share of world exports from 1.6% to 2.4% in coming years. (China’s exports comprise 11.1% of the world’s total.) In September, Modi launched a “Made in India campaign” to boost manufacturing from 15% of GDP to 25%, to create jobs for the 12 million young entering the labour market each year. In October, he took steps to shift to make energy prices more market-based.

Perhaps Modi’s biggest economic accomplishment so far could well be that the optimism he generated during his election campaign and by his victory helped India’s economy grow 5.7% in the June quarter from a year earlier. While this is still slower than China’s 7.3% achievement for the September quarter, it was India’s quickest expansion in two years.

It will be a while yet before Modi can be judged. But the Sensex’s 32% surge to record-setting highs over the first 10 months of 2014 shows that stock investors think Modi is as credible a reformer as any country has. They are inadvertently saying that within a couple of years the fastest growing of Asia’s superpowers on an annual basis will be India. The IMF forecasts India to be ahead by 2018;[3] others predict 2017. On a quarterly basis, India’s leap ahead of China could occur even sooner.

Information on Indian and Chinese economic growth rates comes from the IMF World Economic Outlook Database http://www.imf.org/external/pubs/ft/weo/2014/01/weodata/index.aspx. India and China’s share in world trade comes from the WTO trade profiles. http://www.wto.org/english/thewto_e/whatis_e/tif_e/org6_e.htm

Other financial information comes from Bloomberg unless stated otherwise.

by Michael Collins, Investment Commentator at Fidelity

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