India Is NOT the Next China
But there is an abundance of investment opportunity there, nonetheless.
Comparisons to China are plentiful when considering the Indian economy and its growth potential. While we share a lot of optimism about India, it faces challenges that demand a more circumspect approach. We have been students of India for the last two decades, and recently had the great privilege of inviting Professor Vijay Joshi, an Emeritus fellow at Oxford University, and the author of India’s Long Road – The Search for Prosperity to address the Emerging Markets Team. The thoughts below are inspired in part by what we learned.
The Rise of India and Its Challenges
India is clearly one of the most important countries in the emerging world. With a market capitalization of $2.2 trillion,1 India is the second largest equity market in our universe. It is also significant in a global economic context, with a GDP of $2.6 trillion in 2017,2 reflecting its continental-sized population of 1.3 billion as of 2016. However, as Professor Joshi points out, India is a “premature superpower.” Despite its tremendous growth potential, it still faces considerable challenges in its journey to becoming an industrialized, modern economy – many of which are self-inflicted.
One of the most debilitating issues in India today concerns labor laws dating back to 1947. These laws inhibit employer flexibility and create barriers to labor absorption in the productive, organized sectors of India’s manufacturing and service industries, leaving a plurality of the labor population in low paying jobs with limited security. As a result, India’s rapid economic growth has not translated into broad-based social mobility. In fact, India has the unfortunate distinction of being one of the world’s poorest countries on a per capita income basis. Its GDP per capita of $1,940 in 2017 is not only low on an absolute basis, it is merely a quarter of China’s, a country with similar population size.2
The situation is compounded by the difficulty the Indian government faces in delivering services to its population. Despite a consolidated public-sector deficit of 6.6% of GDP in 2018 and outstanding consolidated government debt of 68% of GDP, healthcare, education, and infrastructure programs are woefully inadequate.3 For example, India is still substantially behind China in terms of literacy rates and secondary and tertiary school enrollments.
The election of Prime Minister Narendra Modi a few years ago was accompanied by high hopes that reform would address these and other challenges. However, those hopes have given way to the cold, hard reality that unwinding the government’s excessive, and often obstructive, involvement in large swathes of the economy – banks, transportation, energy – will be a herculean task.
It’s Not the Next China, but India Does Have Significant Growth Potential
For these and many other reasons, declarations that India is poised to become the next China are inappropriate. India aside, we’re unlikely to see a “next China” growth story out of any emerging market given the profound depth and size of China’s economic expansion, unleashed over the past three decades through a combination of powerful reforms, urbanization, massive expansion of trade, property market development, and significant capital formation.
India, however, does have enormous potential to grow into a significant regional economic power over the next 10-20 years. We see three main drivers of total factor productivity gains and overall economic growth: capital investment, urbanization, and the potential for significant labor absorption into the formal sector. On capital investment specifically, India has relatively high levels of domestic savings, averaging 31.9% of GDP over the past five years, with which to fund much needed investments in infrastructure and capital stock.4 Second, urbanization has a long potential runway given that nearly 70% of the population still lives in rural India. A shift into urban areas is likely to result in significant productivity gains, a phenomenon we continue to witness in China.EMERGING MARKETS EQUITY
Developing Markets FundView Fund PerformanceRegarding the movement of labor, both challenges and opportunities lie ahead for India as it shifts large swathes of the economy into the organized sector, which currently employs only one-fifth of the population.5 India has a pronounced dual economy, with a relatively small, but highly productive, formal sector complimented by a huge, but insufficiently productive, unorganized sector in agriculture and domestic services. According to Joshi, despite a 63 million person increase in India’s total workforce during the first decade of the century, there was a net three million decline in the number of formal workers in the organized sector. The sheer size of the unorganized sector represents a huge opportunity for India if they can pull off the transition.
For India to grow faster than the 6%-7% rate (4%-5% per capita GDP) of the past 30 years, a new wave of reforms to boost capital accumulation and productivity is much needed. Unfortunately, the near-term economic backdrop is working against it. The external environment is clearly becoming less accommodating, with rate normalization in the United States, a weaker rupee, and higher energy prices. Additionally, fiscal pressures appear to be building up in an important election year. Meanwhile, credit growth has not picked up as desired, with private capital formation still cautious.
Opportunities Still Abound
We believe that navigating the long-term complexity and short-term volatility of the Indian equity market requires a nuanced, active investment approach. A propensity to look for compelling analogues without understanding the underlying economic drivers and risks – e.g., likening India to China – can lead to dangerous conclusions and inappropriate portfolio exposures. Our approach in India, and elsewhere in our universe, looks beyond seductive narratives to appreciate structural drivers and real options, both of which are often unique to individual companies.
India’s economic realities have given birth to some extraordinary companies that have been able to turn the country’s longstanding challenges into long-term opportunities. A good illustration of that is how Kotak Mahindra Bank and HDFC Ltd, our two largest Indian holdings, have been capitalizing on India’s extensive and ineffective state involvement in the banking sector to support their long-term growth trajectory. The Indian banking sector today is saddled with more than 10% non-performing loans (NPLs), thanks to the reckless behaviors of the public sector banks during India’s credit boom following the great financial crisis. The public sector banks represent two-thirds of the system’s total assets and almost 100% of the system’s NPLs. Setting the public sector banks on the right path would require overcoming four “R” hurdles: Recognition, Resolution, Recapitalization, and Reform, and today these public sector banks have barely cleared the first. As a result, the Indian economic machine is currently running with two-thirds of its financial engines turned off, and only one-third – where Kotak and HDFC play – powering its credit growth. With their clean balance sheets and excess capital, we believe Kotak and HDFC will continue gaining market share as the public sector banks continue retreating in the upcoming years.
Kotak and HDFC are just two of many extraordinary Indian companies in our portfolio, which illustrate our fundamental, bottom-up investment approach. As volatility increases in the Indian equity market, and global equity at large, we remain focused on finding such companies, paying appropriate prices for them and constructing a durable portfolio that is well-positioned to outperform.