The Indian economy is at a critical inflection point in its modern history. India’s GDP growth has accelerated to become the fastest of all major economies in the world, with income levels today at China’s c.10 years ago, it is expected that India is now the next big story. Given its favourable demographics and other resources, India has the inherent drivers to sustain 7-8% growth over the medium to long term and the potential to achieve 10%. An India that can sustainably harness its core assets and create new ones has the potential to emerge as one of the key drivers of growth and stability in a world faced with increasing global economic and geopolitical uncertainty. In order to attain this position, however, India will need to do what China has historically excelled at, creating significant population-wide savings and channelling these into (reasonably) efficient assets to deliver competitive returns. Doing this requires a robust financial machine ready to finance the nation’s growth. Despite the significant growth and evolution of its financial services industry, India’s financial sector continues to be hamstrung by major structural inefficiencies, including an old fashioned state-dominated banking system and, despite increasingly aggressive changes, a lack of financial inclusion for large parts of the population. It is a sector in need of a new vision as the basis of a restructuring so it can play its part in India’s new growth story. Recent years have seen a concerted effort by both the Reserve Bank of India (RBI) and the Modi-led government to rapidly grow financial inclusion and bring more and more of India’s poor into the formal banking system. The country’s technology sector has also made a significant contribution by developing delivery systems that reduce transaction costs and spread access by leveraging growing smartphone penetration. However, as various factors including the large pile-up of stressed assets in the banking system, the sharp slowdown in industrial credit growth and other measures of inefficiency of the financial system indicate, India still faces significant challenges in creating an effective financial system if it is to stride more aggressively towards its potential. While addressing these challenges will undoubtedly be a painful process and require the expenditure of political capital, the prize is significant: potential incremental growth of 2-3% p.a. would set India’s growth on the path to achieve the double digit levels necessary to replicate China’s economic miracle.
The Role of the Financial System in Wealth Creation in our Turbulent Times
India stands as a stable and growing zone in a world that seems to be facing ever greater political risk and turbulence. The Modi government has been a beneficiary of the relative unattractiveness of other emerging markets, the collapse of China’s growth, currency stability and political issues and a growing series of political and security risks world over.
Stable growth but higher savings rate needed to grow faster
In 2015, India attracted an unprecedented US$55m of foreign direct investment (FDI), making it the number one foreign investment destination globally. The Modi government’s focus on FDI makes complete sense: India’s saving rate generates 82% of the US$820bn it needs to sustain a GDP growth rate of 8% but for a 10% GDP growth rate, India would need an additional US$950m to US$1,000bn. The current savings rate is inadequate for financing this growth and FDI alone cannot be adequate for filling this gap at this point in time. Indeed, the rise of global macro political risk has come unexpectedly to make FDI less reliable for India than it was ten years ago for China. With the world facing an array of destabilising factors including the recent ‘Brexit’ vote, the potential election of a nationalist-isolationist in Donald Trump, destabilisation in the South China Sea, the continuing battles with ISIS in civilian and military arenas and Russian adventurism, India cannot rely on foreign investments alone to propel its growth. India’s domestic financial savings are unquestionably an essential part of the answer and indeed these savings need to become the stable core underpinning its long-term financing if it wishes to control its own destiny. The question for India therefore is how it can restructure its financial sector and augment it with the agents that allocate capital well so that it can create a flow of domestic financial savings that can play a critical role in propelling the economy towards sustainable double-digit growth.
Investment rate increase of 5% would set it on the path to match China’s rise
China’s savings and investment rate demonstrate how this needs to work to be effective. China’s success in generating over 10% growth over three decades (from 1982 to 2011) offers some clues as to the level of savings and capital efficiency required to achieve sustained double-digit growth. Firstly, in terms of generating financial savings, during these 30 years, China saved on average 41% of GDP. Given that it was able to exert a very high level of government control over its economy and financial system, it is unsurprising that India has been unable to match this and achieve a savings rate of ‘only’ 33%. More relevant to GDP growth though is the rate at which capital (including savings) are reinvested into the economy: China during its boom invested 39% of GDP, effectively nearly all of its savings. India on the other hand has actually been able to invest more than it saves, (mainly by running a current account deficit financed by FDI) achieving an investment rate of 34% over the past three years. Therefore, despite saving significantly less, India’s investment rate is only c.5% lower than China’s was, a gap that could potentially be bridged by a combination of more FDI and an increase in domestic financial savings.
Inefficient use of capital costing nearly 3% to GDP growth rate
The efficient use of capital is even more important and here India’s performance under the final years of the Congress government, prior to the Modi government, was a major setback, when a decline in capital efficiency reduced India’s annual GDP growth in by 2.5-3.0%. Capital efficiency is best measured by the incremental-capital-output-ratio (ICOR) , which effectively captures not only real-economy productivity metrics, but also the relative sectoral balance that results in a particular growth profile (see charts). During its high-growth phase, China was able to deploy its savings relatively effectively generating an average capital efficiency of 27% over a thirty-year period. Importantly, India’s capital efficiency has declined significantly with economic expansion, dropping from an average of 26% in the 2003-2007 period to 19% over the last five years. The impact on growth has been significant: if India had allocated its investment as efficiently in the last five years as it did from 2003-2007, GDP could have grown at 9.4% instead of 6.7%, an annual growth penalty of 2.7%.
India does not need to copy China to succeed, but will need to drive savings and capital efficiency
China provides an example of one solution to the problem of generating savings and investments. In the absence of a guiding government hand, the financial sector is the key determinant of how efficiently a country’s investment is deployed given it holds the deposits, issues debt and manages equity portfolios. China changed this by having the government play the key role in the savings and investment process. The government exerted significant control over the financial sector through a combination of capital controls, state ownership of banks, and the control of domestic capital markets to force a high degree of savings on the one hand and channel them towards investment in state-owned infrastructure, construction and manufacturing enterprises– on the other hand. With this formula, some of the fastest growing provinces in China achieved investment rates of 60-80% (compared to the national average of 39%). Clearly, the Indian government today does not have the level of control over all the pieces of value creation that China did to achieve this.
However, India’s model may not need to become more like China to succeed. As the analysis below demonstrates, its past peak investment rates and capital efficiency levels imply an ability for its economy to grow at c.10% based on changes that are not in the revolutionary end of the spectrum, namely a 4-5% increase in the savings rate and a 3-5% improvement in capital efficiency (see our analysis below on what level of investment and capital efficiency is required for various levels of GDP growth). The implication for India’s government and regulators is clear, drive both of these metrics and India can hit the magic 10% GDP growth rate. China was able to centrally direct the transfer of massive wealth from households to industry, with the aim that this would pay off because the trickle down and back to households through wage employment would be adequate and there would be only a minor leakage through corruption (the former did work well but is now faltering but the latter did not and has become the number one agenda item for the Xi government). India as a democracy clearly has fewer levers to pull and will need to pull those it does have more softly than China did, and in hindsight this may create a better and more sustainable system.
Key Conclusions from Analysis
Based on the analysis of two key drivers of a given rate of GDP growth, namely the level of investment and the accompanying capital efficiency, some of the key conclusions for driving growth in India are:
- India was able to accelerate GDP growth from under 6% to c.9% in the 2003-2007 period on the back of a combined increase in both investment and capital efficiency
- The last few years of the previous government saw capital efficiency drop significantly, therefore even though investment increased, growth slowed down to c.6%
- Under the new government, capital efficiency has rebounded allowing growth to increase to over 7%, which could have been faster were it not for a slight drop in the investment rate
- To get back to the 10% growth it achieved in 2007, India needs to drive investment higher by 4-5% and capital efficiency higher by 3-5%
As an aside, China has been gradually increased its investment rate from the early 1980s from 36% to 43% of GDP which has been the primary driver of the acceleration in GDP growth. China was able to maintain high levels of capital efficiency from 1982-2011, however, this has declined significantly as the chart and table above show, helping to drive down GDP growth to its current level of c.7%.
The Key Elements of Transforming India’s Financing Machine
While macroeconomic variables such as inflation and productivity are clearly key drivers of both savings and capital efficiency, the quality of the country’s financial system is the major long-term determinant of these metrics. Creating a robust and productive financial system, which aggregates capital and allocates it effectively will require India’s leaders to focus on restructuring a few key critical areas. These include: