Global PerspectiveMarch 2015In this edition of Global Perspective, we analyse the key drivers for the Indian economy. After sweeping to power last year, there are great expectations that India’s government will deliver on badly needed reforms, which if successful could allow India to overtake China in terms of economic growth. With India on the cusp of its demographic dividend, Prime Minister Modi must build widespread support for structural change. If India’s politicians are unwilling to endure the social turmoil of liberalising land and labour, the country will struggle to realise its economic potential and create enough jobs to absorb the army of young people that are entering the workforce. This would have adverse implications for social stability and for global investors.

The document is intended for institutional investorsand investment professionals only and should not bedistributed to or relied upon by retail clients.

India requires a series of major structural reforms to realise its economic potential. If these are achieved then India could follow in China’s footsteps as the most dynamic emerging market economy. However, if India fails to reform its restrictive policies, the economic pressures, such as rising unemployment and social unrest, would be extremely damaging.

India: the new tiger?

Author Alex Wolf, Emerging Markets Economist

A decisive year for IndiaIndia faces a fork in the road, with important implications for the country and the region. After sweeping to power last year, there are great expectations that India’s Prime Minister Narendra Modi will deliver on badly needed reforms. He campaigned on a promise to bring a Gujarat-style of government to New Delhi, one where government works as a facilitator for business rather than a barricade. As the first prime minister to hail from the ranks of state government, Modi brings a unique perspective to governance and is attempting to upset the status quo. The pace of reforms may have disappointed those hoping for a rapid transformation, but the decisions taken so far have still been important: easier regulation, streamlined approval processes and improving the functioning of the executive government. This is helping to clear the supply and governance bottlenecks that have been holding back growth.

Although the new government has made a good start, much deeper structural reforms will be necessary if India is to raise its potential growth significantly and become a middle-income country over the coming decades. Indeed, there is the opportunity for India to overtake China as the fastest growing large emerging market. Modi will need to shift his focus though from improving bureaucracy to changing India’s growth model fundamentally. Due to the rapid growth in the country’s working age population, India will need to create an additional 10 million jobs per year to absorb the growing labour force. Since the economy began to liberalise in 1991, India has been excessively reliant on services-led growth. Manufacturing will now have to take up more of the slack. Modi’s campaign slogan, “Make in India”, will therefore need to be made a reality. In this Global Perspective, we set out the challenges in more detail, including the precise reforms that are necessary to turn India into Asia’s new tiger. The downsides if the government raises hopes but fails to press ahead are palpable, not only the threat of weaker growth and greater social unrest but also a turnaround in already high investor expectations about the prospects for Indian assets.

A policy-induced slowdownIndia is slowly emerging from a three-year period of policy paralysis and sluggish economic growth. Between 2012 and 2014, growth decelerated sharply from its 6.5% average over the previous decade, to below 5%1. Most indicators of macroeconomic health, including the fiscal deficit, the current

account deficit, the inflation gap, and investment growth deteriorated. After doubling its GDP over the course of the past decade, India’s potential growth decreased significantly.

Policy mistakes were largely responsible for the growth slowdown. According to the IMF, weaker investment was primarily driven by policy uncertainty and low business confidence. Corruption scandals and crony capitalism led to government paralysis and gridlock between ministries. The environment ministry delayed project approvals worth more than $100 billion, often stalling half-completed projects, leading to a rise in non-performing loans, bank stress, and ultimately decreased investment. The public-private-partnership (PPP) model has also fallen apart over the past three years, as the government asked the private sector to bear an inordinate amount of regulatory, operational, and financial risk. Sharply intensified regulatory risk reduced the value of planned investments, causing postponement or cancellation. Confidence deteriorated and many corporates are now over-leveraged, consequently Indian corporates have the highest debt-to-equity ratio among Asian emerging market countries (see Chart 1).

The loss of faith in the previous administration aided Modi’s rise to power. As the leader of Gujarat, he championed clean, efficient government, strengthening the business climate by reducing processing time for government approvals, increasing investment in infrastructure, improving public services, and improving operational capabilities of state-owned enterprises (SOEs). This success led to a landmark victory in May 2014, though it may also have saddled him with the curse of unrealistic expectations.

A nascent recoveryFortunately, India now appears to be at the start of a cyclical recovery due to the confluence of three favourable factors: falling commodity prices, the start of an interest rate easing cycle, and the government prioritising economic reforms. Commodity prices have fallen dramatically since mid-2014, none more so than oil which has fallen over 50% since its 2014 peak. For India, a large net-importer, this has meant lower current account and budget deficits, as well as a halving of inflation. In particular, the collapse in oil prices allowed the government to cut diesel subsidies. The money saved from eliminating subsidies can be applied to increasing government expenditure on infrastructure, while continuing on its fiscal consolidation path.

1All national accounts data used in this paper are based on the government’s previous dataset prior to 30 January, 2015 revision.

Lower inflation has allowed the Reserve Bank of India to cut rates by 50 basis points, with the potential of more to come. Real interest rates are now positive for the first time in years (see Chart 2). If this were to persist, domestic savings, which have been falling since 2007 (see Chart 3), would receive a boost, in turn lifting the deposit base for the struggling banking sector. Increased domestic savings could then be deployed to support infrastructure investment, creating a virtuous growth cycle. Finally, the government’s reform drive is improving governance and lifting business sentiment. Modi has centralised decision making and accelerated the process for government approvals. In the past, most government approvals required multiple agreements across several non-cooperative government agencies. Project approval has accelerated under Modi, underpinned by fixed time limits and online government applications. As a result, the backlog of stalled projects, totalling over $200 billion, has begun to clear.

Changing the growth modelThe government’s current incremental approach to reform will modestly boost potential growth, but a larger and more sustained improvement will require deeper reforms. India’s economic growth model has developed differently from its East Asian neighbours. Japan, followed by the East Asian ‘tigers’ of Korea and Taiwan, and more recently China, have all followed a similar model of industrialisation and export-led growth. The East Asian model involved a transition from agriculture to industry. It was facilitated by labour moving from rural to urban areas and an expansion of low cost exports; eventually exports moved up the value chain and services started to grow as a share of output. Such a model was not just about manufacturing exports, but also involved a boost in domestic savings, investment, and employment. The approach in China was enhanced by increased foreign direct investment (FDI), which in turn supported the development of a strong manufacturing base, improved infrastructure, and the rapid growth in exports and job creation. It also helped to boost domestic savings, which were then channelled into investment by an expanding banking system.

India has failed to follow this successful path to industrialisation. The manufacturing sector has not grown sufficiently to absorb the increasing share of urban labour, as growth has been centred on services. India is distinctive among developing countries for the rapid growth of its service sector. Unusually for a developing country, high-tech information technology, communications and business services have been the most important drivers. The drawback

of this development model is that the economy has done a poor job of absorbing labour. The services sector employs 26% of the workforce, but makes up nearly 60% of output (see Chart 4). On the other hand, manufacturing accounts for only 15% of India’s GDP, well below countries like China, Korea and Indonesia at a similar stage of development. Agriculture, despite accounting for only 14% of GDP, employs nearly 50% of workers and has an extraordinarily high incidence of informal unemployment. With such a large proportion of the population unproductively employed in agriculture, it is vital for India to move people out of the primary sector. Given the low skill level of the existing agricultural workforce, the manufacturing sector is a more appropriate destination for migrating workers than services.

Manufacturing prospectsIndian economists and policymakers are divided as to whether India will need to develop a low-end manufacturing niche. Many, including some government officials, argue that India can skip the industrialisation phase and move directly to services and high-skill manufacturing. It is true that the development of information technology and business process services has led to significant job creation and poverty reduction, while improvements in communication technology have made financial and business services more tradable. However, we doubt that India can skip the low-skill industrialisation phase of growth altogether. The services-led growth model has disproportionately benefited the existing English-speaking middle class and has not generated enough jobs for the wider population. That is partly because the responsiveness of employment growth to output growth tends to be low in the services sector compared with the manufacturing sector. Indeed, the Reserve Bank of India has calculated that for every 10% increase in output, the formal manufacturing sector adds between 4% and 6% more jobs, compared to less than 3% in the services sector.

In addition, the education level of the general population is too low for a high-skill growth model to be successful. Over the next decade, the working-age population will rise by 125 million, followed by an additional 103 million over the following decade. Based on current trends, a third of the growth will come from poorer and less literate states such as Bihar and Chhattisgarh (see Chart 5). The labour market will also need to absorb the aspirations of those that want or are forced to shift out of farming, many of whom have low literacy and numeracy skills.

Chart 1Highly indebted corporates

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India’s need to create more low-skilled jobs and bolster their underperforming manufacturing sector fuelled Modi’s “Make in India” movement, specifically targeted toward increasing manufacturing’s share of output, which has been stagnant at approximately 15% for many years (see Chart 6), to 25% by 2022. The campaign aims to increase manufacturing’s share of the economy by encouraging investment and removing regulatory barriers and other supply-side constraints. This is a herculean task. India’s share of manufacturing is well below most other large emerging economies at similar stages of development (see Chart 7). The drive to boost manufacturing has inevitably brought comparisons with China, sparking the debate both internally and externally as to whether India can, or even should, follow in China’s development footsteps. India’s ability to achieve success in the manufacturing sector will depend largely on Modi’s ability to transform the supply side of the economy.

Can “Make in India” become a reality?According to former Singaporean Prime Minister Lee Kew Yuan, no country has become an economic power without becoming an industrial power first. Indeed, there have been no instances of a ‘large’ country joining the middle income ranks without the emergence of a large industrial base. Why has Indian industrialisation been so sluggish? After all, it has an abundance of labour and a large domestic market that should have given it a comparative advantage in low-wage, low-skill manufacturing. The answers lie in its poor infrastructure, intrusive land and labour regulations, as well as the inadequacies of the education system.

Industry, particularly manufacturing, requires substantial physical infrastructure, something India has lacked compared to most successful developing countries. India ranks 85th in transport, communication, and energy infrastructure according to the World Economic Forum rankings. This has forced Indian entrepreneurs to focus on companies that can grow regardless of the low quality of the physical infrastructure. Transport in particular is a critical component for assembly and processing activities. The time taken to move goods around the country from ports to manufacturing sites is much longer and more variable than competitors such as China. This makes it more cost effective to import finished products from other nations. Power supply has also held back labour-intensive manufacturing, as firms in India pay a much higher price for energy than elsewhere in the world although the electricity supply is extremely unreliable.

While the condition of India’s infrastructure is poor, it is not the only binding constraint. Restrictive land acquisition and labour laws are arguably even more severe barriers to the growth of manufacturing. The Industrial Disputes Act means firms with 100 or more workers need government permission to fire workers, even in the face of bankruptcy. This inhibits labour productivity growth (see Chart 8) and raises unit labour costs. It has also favoured capital or skill-intensive industries at the expense of labour-intensive sectors. Moreover, labour laws are considered concurrent state and central laws, meaning states can pass their own regulations; as a result approximately 50 central laws overlap with 150 state regulations. Onerous restrictions have forced employers to remain small and off the books, which has resulted in about 93% of the Indian workforce to be employed in the informal sector. Modi has initiated modest reforms to some labour laws, such as making inspections less onerous, but to date unfortunately there has been no talk of substantial changes to Indian firms’ ability to hire and fire workers.

Restrictions on land acquisition also make it hard for manufacturing activity to grow. The Land Acquisition Act passed in 2013 requires the consent of 80% of landowners during acquisition. This has made it nearly impossible to acquire land for projects and has stymied the development of infrastructure. As a result, both foreign and domestic firms have cut back their capital spending, which has contributed to India’s declining investment rate (see Chart 9). FDI, a critical component during other countries’ industrial-led growth, has been anaemic in India. This is largely due to India’s restrictive land policies, poor infrastructure, and regulatory environment. In other emerging economies, FDI, particularly in manufacturing, improved productivity growth and export competitiveness. Following the global financial crisis, India’s share of FDI inflows decreased and restrictive foreign investment laws coupled with land acquisition challenges have pushed foreign investors to look elsewhere (see Chart 10). Fortunately, Modi has prioritised land reform and introduced an ordinance both to decrease the required consent from 80% to 50% and also exempt many government-sponsored projects. Nevertheless, senior Congress Party politicians have suggested that this ordinance will be subject to intense political opposition. Labour, land, and infrastructure constraints have rendered large-scale industries uncompetitive and forced entrepreneurial Indians to build businesses in service-related sectors. The constraints are so severe that Bangladesh now exports more merchandise than India.

Finally, India needs to upgrade its education system substantially. Although low-wage manufacturing firms do not need as highly skilled workers as services firms, or producers of complex manufactured goods, they still need workers that are literate and have solid numeracy skills. However, as of the last census, literacy rates in India were below China’s in 1990 (see Chart 11) and they varied widely between states. Despite an increase in government expenditure on education and improvements in school infrastructure, learning outcomes in rural primary schools remain low – for example only 25% of class III students can solve simple arithmetic (see Chart 12). According to the World Economic Forum, India ranks 80th in primary education enrolment and 110th in secondary education enrolment; comparatively Vietnam ranks 15th and China ranks 4th.

This is a substantial problem. High rates of literacy and a strong primary education system in China allowed farmers to transition easily from the countryside to coastal factories. As India develops, it will have to increase investment in education, make schools more accountable, and improve public-private partnerships.

Budgeting for growthThe Indian budget released on 28 February 2015 sent a positive signal that the government is prioritising infrastructure investment. Although absent of any big-bang structural reforms, the budget maintained the government’s push towards incremental change and sent clear signals that the government is prioritising the removal of infrastructure bottlenecks. Public capital expenditure on infrastructure is set to increase 25% with the majority of spending going to much-needed improvements of railways, highways, ports, and power plants. Additionally, the budget established a National Investment and Infrastructure Fund which will further boost off-balance sheet sources of infrastructure financing. While the budget did not address any significant structural changes, it laid out changes that should boost financial savings and improve the regulatory environment – corporate tax rates will be reduced and simplified, a bankruptcy code will be introduced, and the much-awaited goods and services tax (GST) is earmarked for April 2016.

Conclusion – actions not wordsIndia faces a once in a generation fork in the road. If a series of structural reforms are put into place, there is the prospect of the country taking advantage of its demographic dividend in the coming decade and overtaking China as the fastest growing large Asian economy. Conversely, if internal opposition and intransigence at all levels of government cause the reform movement to slow and stall, then India will fail to meet its potential, with serious implications for social stability, the region, and also for global investors, who have started to buy into the growth story.

One important risk is that while India’s unique growth model has underpinned solid improvements in living standards over the past two decades, it will not generate enough formal jobs over the coming decades to absorb its rapidly growing working age population, nor drive productivity growth substantially higher. Prime Minister Modi campaigned on a commitment to lift growth and create more jobs, and has made good early progress on improving governance and removing some of the approval bottlenecks that have been constraining investment growth. His next challenge is to tackle the serious job of accelerating structural reforms in order to realise fully the benefits of India’s demographic dividend. This will require the government to improve the education system, reduce labour and land restrictions, improve infrastructure, and encourage greater FDI.

To make this strategy politically viable, Modi will also need to build a consensus around prioritising growth by convincing voters that a rising tide lifts all boats. Until now, India has lacked the dedication to boosting growth seen by China, Korea and Taiwan during their periods of rapid development. Modi has used speeches to introduce and address issues popular to voters, but has yet to build an informed consensus around the importance of economic growth and the depth of the reforms that are necessary to achieve it. Actions are needed, not words. Until India’s politicians are willing to endure the social turmoil of liberalising land and labour, the country will struggle to realise its vast economic potential.

Chart 5Growing need for jobs

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House ViewThe following asset allocation is based upon a global investor with access to all the major asset classes. For regional versions of the House View, please contact your Standard Life Investments representative.

March 2015 House View

Risk The Global Investment Group emphasises moderate levels of risk, focusing on assets either with sustainable yield or those able to provide sustainable earnings expansion in a moderate growth environment.

NEUTRAL

Government Bonds

US Treasuries The end of QE and the economy’s strength should enable the Federal Reserve to start raising interest rates in the middle of 2015, although it will use forward guidance to control the pace of yield movements.

VERY LIGHT

European Bonds Bonds are supported by an environment of low inflation and modest economic growth. ECB QE can cause peripheral spreads to tighten further, but the Greek situation requires careful monitoring.

HEAVY

UK Gilts The asset class is vulnerable to interest rate increases as economic growth remains firm while valuations are expensive. Manageable inflation pressures and central bank guidance can anchor rising bond yields.

LIGHT

Japanese Bonds The long-term inflation outlook is deteriorating as the government aims for reflation, although the Bank of Japan’s sizeable bond-buying programme should prevent yields rising significantly.

LIGHT

Global Inflation- Linked Debt

Inflationary conditions are subdued in many developed economies, although valuations require careful examination. Investor worries remain about future inflation due to ultra-easy monetary policies.

NEUTRAL

Global Emerging Market Debt

Dollar-denominated bonds are Heavy, as spreads show better value, while local currency bonds are Neutral as careful examination is required of individual currency and spread factors.

HEAVY/NEUTRAL

Corporate Bonds

Investment Grade Attractions such as positive corporate cash flows are increasingly priced in, while upward pressures from government bond markets will periodically affect total returns.

NEUTRAL

High-Yield Debt Spreads have widened, creating a more supportive valuations environment, especially for US bonds over European debt. The bond default outlook is favourable but market liquidity remains a concern.

NEUTRAL

Equities

US Equities Economic growth and investor sentiment are supportive, but valuations are expensive and profits margins are likely to compress due to higher wages as well as the impact of a stronger dollar on overseas earnings.

NEUTRAL

European Equities Valuations are supportive and corporate competitiveness improving, while earnings look to benefit from further euro depreciation as well as the impact of lower energy costs on consumers and many businesses.

HEAVY

Japanese Equities Many structural reforms remain outstanding but management focus on return on equity and plans to cut corporation tax are supportive. Meanwhile, the Bank of Japan is taking action to reach the inflation target.

HEAVY

UK Equities Economic data is a positive driver, but profit margins are coming under pressure from a mixture of currency strength and commodity price weakness, while political uncertainty could become an issue.

NEUTRAL

Developed Asian Equities

Slowing commodity demand, particularly from China, is affecting some countries, such as Australia. The lower oil price is leading to noticeable winners and losers among exporters and consumers.

LIGHT

Emerging Market Equities

Commodity export dependent markets have deteriorated while those with strong domestic fundamentals are improving. Politics, current account positions and central bank actions are other drivers of divergence.

NEUTRAL

Real Estate

UK The robust growth environment continues to bolster prices in the near term, and yields remain attractive compared to other assets, suggesting reasonable returns over a three-year holding period.

HEAVY

Europe Prime assets in core markets offer attractive relative value given QE and the low interest rate environment, while parts of the periphery are starting to show consistent value growth.

NEUTRAL

North America Canadian property faces headwinds from an interest-rate sensitive consumer and significant office construction. The US should benefit from continued economic growth but pricing is quite aggressive.

NEUTRAL

Asia Pacific Yields are broadly stable, while the attractive yield margin and recovering rents are driving pricing. Japan remains ahead in the property cycle, followed by Australia.

NEUTRAL

Other Assets

Foreign Exchange The US dollar will benefit from eventual monetary policy tightening. ECB and BoJ actions have weakened their respective currencies, while the pound will be held down by political uncertainty.

HEAVY $, NEUTRAL £ , € & ¥

Global Commodities

Different drivers, such as US dollar appreciation, Chinese demand, Middle East tensions and climatic conditions, influence the outlook for different commodities. Supply issues and OPEC inaction will keep prices constrained in 2015.

NEUTRAL

CashUnconventional monetary policy is ending in the US and UK; some emerging markets are also tightening. QE in Europe and Japan will keep interest rates there low.

NEUTRAL

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