Don’t Bet Against India

India has stood out for its economic resilience during a time of global macroeconomic uncertainty and volatility. With seven percent GDP growth estimated for 2022 and only a slightly smaller figure expected for 2023, the Indian economy has defied the slowdown that has affected most of its major counterparts amid the war in Ukraine, trade disruption, and other pressures. In its most recent report on the Indian economy, the World Bank concluded that India is “better positioned to navigate global headwinds than other major emerging economies.”

Despite this impressive performance, Arvind Subramanian and Josh Felman argue in a December Foreign Affairs article that “India can’t replace China.” Expressing skepticism about India’s ability to attract the foreign capital that is likely to flow out of China, they assert that India’s growth has been lower than its potential over the last three years and features “high” investment risks and “strong” policy inwardness. Further, they maintain that India’s “large” macroeconomic imbalances impede the future flow of capital into the country. In short, they conclude, “For most [international] firms, the risks of doing business in India outweigh the potential rewards.”

But as India’s recent economic data suggest, most of Subramanian and Felman’s assertions do not stand up to empirical scrutiny. India’s widely noted rebound is undergirded by structural reforms that have significantly raised the country’s prospects for the coming decade. In its recent report on India, the International Monetary Fund (IMF) noted that India’s “successful implementation of wide-ranging reforms or greater than expected dividends from digitalization could increase India’s medium-term growth potential.”

EXTERNAL SHOCKS, INTERNAL PROGRESS

Subramanian and Felman are right to note India’s subpar growth performance in the last few years. But to ignore, in India's growth outcomes, the role of the financial crisis over the last decade is to ignore the elephant in the room. In the decade up to 2020, India faced severe financial system stress caused by an unsustainable lending boom that saw the private nonfinancial sector’s credit-to-GDP ratio rise from 58.8 percent in March 2000 to 113.6 percent by December 2010, according to data from the Bank for International Settlements. These loans could not be serviced as economic growth rates declined after the 2008 financial crisis, led by export growth. Bad debts in the banking system rose. Consequently, bank credit and overall credit growth in the economy were well below trend for the rest of the second decade of the millennium. The problem was compounded toward the end of the decade (in 2018 and 2019) by the collapse of some nonbanking finance companies, too. The debt-to-GDP ratio mentioned earlier went into reverse. It decreased from 113.6 percent in December 2010 to 83.8 percent in December 2018. As the private nonfinancial sector deleveraged, its investments in business equipment and other assets suffered.

India’s experience was typical for a financial sector crisis, as empirical evidence across developed and developing economies shows that financial system stress after a credit boom tends to have a longer and deeper impact on growth. The government and the central bank helped the financial sector recoup its balance sheets. India’s banking and nonfinancial corporate sectors had repaired their balance sheets and strengthened their credit discipline by the end of the decade. But a series of external shocks hit the country from 2020 onward. These shocks, which included global trade tensions, the pandemic, pandemic-induced supply chain disruptions, the war in Ukraine, commodity price increases, and synchronized monetary tightening across economies, delayed the return of the Indian economy to full health. Economic recovery is afoot, and India has commenced a new credit cycle. Demand for credit has also picked up for all sectors, and monthly bank credit growth has reached its highest level in over a decade while being in double digits since April 2022. A recent IMF paper noted that India’s efforts to clean up bank balance sheets and boost capitalization would be critical in boosting credit growth and, thus, GDP growth over the medium term.

Capital investments by the private corporate sector in India also show signs of revival. Based on research estimates by Axis Bank for a set of 3,023 Indian companies, total private capital expenditure has increased to the equivalent of $41.9 billion in the first six months of FY 2023 (April–September 2022), up from the equivalent of $35.3 billion over the same period one year ago. This is also substantially higher than the pre-pandemic levels. In the meantime, India has continued to make substantial progress in modernizing its infrastructure through large-scale public spending. The effective Capital Expenditure by the Union Government has risen from 2.8 percent of GDP in the fiscal year ending March 2013 to 3.5 percent in 2022. As the IMF has noted, this robust government investment has begun to encourage the private sector to invest more.

Since 2016, the Indian economy has also undergone many structural reforms that have strengthened the macroeconomic fundamentals of the economy. But balance sheet stress in financial and corporate sectors, followed by one-off external shocks, has delayed their effect on economic growth. Among these reforms are the introduction of the Goods and Services Tax (GST), the Insolvency and Bankruptcy Code, the enactment of the Real Estate Regulation Act, a new privatization policy, the reduction of direct taxes for businesses and individuals, large-scale digitalization, the ramping up of public investment, a new national logistics policy, and the creation of production linked incentives for businesses. It is worth considering the actual effects of each of these carefully.

A NEW DIGITAL ECONOMY

There is evidence that small businesses in India have been growing rapidly. Contrary to what Subramanian and Felman suggest, the GST—a consumption tax on the supply of goods and services—has not hurt small enterprises. Rather, it is nudging them to become part of India’s formal economic system by giving them access to loans and other financing. The number of GST taxpayers increased from 6.6 million in mid-2017, at the time of its introduction, to 14 million in November 2022. The government is making efforts to ensure that GST invoices can be used to provide working capital loans to small enterprises or to enable the automatic discounting of receivables. Out of the total GST collections in 2021–22, taxpayers who migrated from the old tax system have contributed about 80.2 percent, while the remainder came from new taxpayers. Moreover, the average GST collected per migrated GST Identification Number (GSTIN) has been the equivalent of $5,933 and that for new GSTIN is the equivalent of $1,517. This indicates not only the increased formalization of the economy but also that newer entrants to the GST regime are businesses that are classified as micro, small, and medium enterprises—MSMEs. V. S. Krishnan, a retired member of the Central Board of Indirect Taxes and Customs in India, wrote, “at the end of five years, what has come out clearly is the robust design of the GST system—the integration of the entire value chain from raw material to retail for the purpose of dual taxation by the Centre and the states . . . . GST is more than just a tax reform. It has unleashed triggers in the economy that have not been appreciated because of inadequate analysis of its economic impact.”

Meanwhile, India’s build-out of digital infrastructure is doing much to bring economic opportunities to a large swath of the population. Among its achievements are the creation of digital identities, improved access to finance, access to markets, reduction in transaction costs, digitally backed transparent transactions, improved tax collection, and better-targeted welfare spending, which even some developed nations have struggled with during COVID times. As an illustration, since July 2020, more than 12 million small and medium-sized businesses have registered on the government’s Udyam portal, a central online system for registering small businesses. Notably, about 93,000 microenterprises registered on the portal have grown to become small enterprises, and about 10,000 small enterprises have become medium enterprises over the last two years.

Small businesses in India have been growing rapidly.

In another major digital transformation, more than a billion Indian bank accounts are now enabled to work with the country’s Account Aggregator system. This financial data-sharing system currently encompasses more than 90 Indian financial institutions. In addition to allowing consumers to consolidate all their financial data in one place, it provides rapid access to new financial products, including loans from other financial institutions. The exchange of information that this system facilitates will open the doors for cash-flow-based lending across the economy. In addition, the government’s recently launched initiative to democratize e-commerce, Open Network Digital Commerce, has the potential to open global markets for even the smallest of businesses. It will transform the e-commerce landscape in India by enabling transactions between buyers and sellers on different e-commerce platforms. These leaps in the public digital infrastructure are likely to significantly enhance India’s growth prospects in the coming years. It is too early to conclude that they are unlikely to generate sufficient economy-wide benefits, as Subramanian and Felman have done.

The government has also made significant progress in simplifying regulatory frameworks, eliminating unnecessary compliances, and removing policy uncertainty. For example, the Insolvency and Bankruptcy Protection Code, enacted in 2016, has adopted leading international standards and asset resolution mechanisms. More important, the code is changing India’s credit culture, and assets are being put to their economic use without languishing while creditors recover their claims. Until September 30, 2022, 23,417 applications for initiating the Corporate Insolvency Resolution Process (CIRP) of corporate debtors having underlying default of 7.3 trillion rupees were disposed of even before their admission into CIRP. This transparent resolution mechanism instills confidence in the financial system and attracts investors to Indian businesses.

THE BOOM TO COME

India’s current economic situation is analogous to what it was in the years leading up to its last great economic boom, in the first decade of this century. Between 1998 and 2002, the government undertook several economic reforms, such as the deregulation of interest rates, the privatization of government entities, the reform of the telecom sector, and a new prioritization of infrastructure spending. Then, as now, the Indian financial system was undergoing balance sheet repair, as was the country’s corporate sector. At the time, growth proved elusive, as various global and domestic crises limited the immediate impact of the reforms. Yet strong growth began as soon as the shocks worked their way through the system, and India contributed to the global boom that followed and benefited from it, with an average annual growth rate of eight to nine percent from 2003 to 2008. Similarly, when the current global shocks start dissipating, India will realize its potential growth rate even as that potential growth rate itself increases.

Subramanian and Felman’s concerns about India’s macroeconomic imbalances and trade policy should also be put to rest. Consider inflation. When inflation across the world reached multidecade highs in 2022, India exceeded its inflation target range of two to six percent by a maximum of 1.8 percentage points. Consumer price inflation peaked at 7.8 percent in 2022 and did not reach double digits, as it did in several countries in the developed world. This was due to India’s measured and calibrated fiscal and monetary stimulus during COVID. Moreover, India’s budget deficit would have been much less without the pandemic-induced growth shock, even with the same expenditures. The increase in India’s government debt-to-GDP ratio has been quite modest in the last 15 years relative to other countries.

Of course, India is not exempt from global trade disruptions. The country’s current account deficit grew in 2022. Still, the available foreign exchange reserves covering nine months of imports and a relatively low dollar-denominated external debt (debt owed to foreigners) have created adequate buffers to withstand future volatility from international markets. Moreover, India has signed 13 free trade agreements in the last five years and has brought down average tariff rates for all products from 7.3 percent in 2015 to 6.2 percent in 2020.

India has made democracy a springboard for shared prosperity.

As a result of India’s strong macro-fundamentals, there has been a visible structural shift in foreign direct investment flows to India. The net FDI-to-GDP ratio increased from an average of 1.2 percent of GDP from 2007 to 2013 to an average of 1.5 percent from 2014 to 2020. That ratio has crossed the 1.5 percent mark only once in the previous ten years, from 2004 to 2013. Apple’s export of iPhones from India crossed $2.5 billion in April–December 2022, nearly twice the amount as during the same period a year earlier. Recently, India approved several of Apple’s suppliers from China to commence operations in India to create the supply chain ecosystem for producing iPhones in India. Correctly, the recently published Chief Economists Outlook 2023 (World Economic Forum) highlights India’s opportunity to gain from the global trends of supply chain diversification.

The returns on portfolio investment in India can be seen from the returns of the MSCI India (USD) Index, which measures the performance of large and midcap stocks on the Indian exchange. Net of fees, in 2022, Indian equities outperformed their emerging market counterparts by nearly 15 percent and global equities by about 11 percent. Over the long term, MSCI India (USD) has given an annualized net return of 7.1 percent since May 1994, compared with just 4.2 percent for MSCI Emerging Markets Index and 6.8 percent for MSCI All-Country World Index. India has rewarded its direct and portfolio investors durably to the regret and embarrassment of naysayers.

Even as India has made its economic framework much more transparent and easier to do business in, policymakers know that they have more work to do on many fronts. For instance, however, the government has done away with 25,000 unnecessary compliances and repealed more than 1,400 archaic laws in the last eight years; it should systematically dismantle the requirements of licensing, inspections, and compliances for the private sector. The state needs to do more to eliminate bureaucratic mindsets and train India’s workforce in the skills required for advanced industries and the service sector. Though much has been done in recent years to address the structural challenges that small businesses face, reforms must continue to eliminate the systemic barriers, such as delayed payments, that prevent small businesses from growing into large enterprises. These ongoing reform goals will require the collaboration of India’s state and local governments.

India has not made democracy a scapegoat for economic underperformance but a springboard for shared prosperity. The economist Sudipto Mundle recently returned to the village of Palamu, in a remote region of Jharkhand, one of India’s poorest states, which he had visited 45 years earlier. As he wrote, he discovered not only that there had been a “complete transformation” of the town’s physical infrastructure but also that the visible hand of the state and the invisible hand of the market had “radically transformed the lives of the villagers.” For an unbiased view of India’s potential, investors should experience firsthand what promises to be a remarkable economic and social transformation of the country over the next 25 years.