India’s growth risks

Nicholas Spiro says that while China’s downturn is high on the list of investor concerns, less attention is paid to the economic difficulties New Delhi faces Pedestrians get into shape at a shopping mall in Wong Chuk Hang. Photo: Yik Yeung-man

Hardly a day goes by without comparisons being drawn between India and China. Such contrasts are invariably inapt and misleading. Not only is India’s economy one-fifth of China’s, the structure of the two economies and the nations’ development paths and political systems are vastly different.

Yet the diverging fortunes of India and China over the past several years raise important questions about the future drivers of global growth as well as the right investment strategies in emerging markets.

Nobody is suggesting India will catch up with China any time soon. However, even a cursory glance at India’s projected growth – annual economic output of more than 6 per cent for at least the next five years and a weighting in the benchmark MSCI emerging market equity index rising from the current 18 per cent to 23 per cent by 2033 – suggests it could supplant China as the largest contributor to global growth.

If this rosy scenario materialises, it will have a lot to do with China’s woes. While there are signs the Chinese economy has stabilised and sentiment in equity markets has improved markedly in the past two months, much could still go wrong.

The combination of cyclical and structural headwinds, the crisis in the housing market, the weakness of household consumption and the acute challenges in pivoting to a new growth model prioritising highend manufacturing is reason enough to be sceptical about policymakers’ ability to restore confidence.

Global investors remain bearish on China. In Bank of America’s latest Asia fund manager survey, published on March 19, a net 18 per cent of respondents had an underweight position in Chinese stocks, the biggest net underweight stance in the Asia-Pacific region. Last year, China accounted for just one-fifth of foreign institutional investment in Asia’s equity markets excluding Japan, data from HSBC shows. India, by contrast, comprised 55 per cent of the inflows. Granted, this is just one year’s worth of data, and a year when sentiment towards China was exceedingly bleak. But it also reflects the almost unbridled optimism about India, in particular the confluence of economic, policy and geopolitical tailwinds that have made the country a vital engine of global growth and, along with Japan, the linchpin of the “Asia ex-China” investment narrative.

According to a report by Barclays last September, India could overtake China as the biggest contributor to global growth by the end of the decade if it is able to raise its growth rate closer to 8 per cent. A lot hinges on whether the government “can encourage more rapid growth without compromising India’s hard-won macro stability”, Barclays said.

However, while China’s downturn is at the top of the list of risks in developing economies, less attention is paid to the difficulties in sustaining India’s boom.

Even the most prominent India bulls concede that the stakes have risen significantly in recent years. Morgan Stanley notes that “as the economy grows and investment picks up, policy support will become even more critical to expanding infrastructure, developing a skilled labour force, deepening capital markets and engaging with domestic and foreign investors”.

The biggest vulnerability – and the one that threatens to rob the country of its huge potential – is India’s extremely low labour force participation rate which, at just under 56 per cent, is one of the world’s lowest. For women, the rate drops to a deplorable 35 per cent, data from the International Labour Organization shows.

Just because India has a large and rapidly expanding working-age population does not mean that it will reap its much-touted demographic dividend. Worryingly, labour’s contribution to growth has fallen since the late 1990s, partly because India is not generating enough non-agricultural jobs. Moreover, sectors growing the fastest, such as finance and business process outsourcing, are not big creators of employment. Jobless growth risks undermining the investment-driven expansion India is banking on.

Furthermore, unlike China, India runs a current account deficit and a large fiscal deficit, increasing its reliance on inflows of foreign capital. JPMorgan believes India’s fiscal deficit is “overlooked” given the high rate of growth. Even if the economy powers ahead, which is likely, India’s fiscal governance will come under greater scrutiny.

In June, a portion of Indian government debt will be added to JPMorgan’s influential emerging market local currency bond indices, giving foreign investors greater exposure to India’s bond market. Index inclusion, while a victory for Indian technocrats, could lead to rapid and volatile inflows at a time when there are already concerns about financial stability and stretched valuations in the stock market.

While China is the world’s cheapest major equity market, India is the most expensive. Although strong corporate earnings have helped deliver eight straight years of gains, a trading frenzy among inexperienced retail investors has led to regulatory clampdowns. The actions have had a chilling effect on India’s once-booming market for initial public offerings and caused a brutal sell-off in smaller stocks.

Many investors take comfort from the fact that a third term for Prime Minister Narendra Modi is assured in a general election that gets under way this month. Yet Modi’s victory will only increase the risk of overheating. Some global fund managers, worried that Indian stocks are priced for perfection, are already rotating back to China because of cheap valuations and signs of economic stabilisation.

This may prove costly given China’s deep-seated problems. Yet managing and sustaining India’s boom is also fraught with risk.