A country's long-term economic outlook depends on many diverse factors. However, arguably the single most important determinant is sound policymaking. In this respect, while perfection is impossible, what matters most is ensuring incremental progress by having the right overall direction of travel in as many key areas as possible. With this kind of perspective in mind, few would doubt that over the past decade or so India passes the overall directionality test.
Looking ahead, we think there are a handful of standout policy factors will be especially pivotal for India’s future growth outlook. In particular, this includes the policy of competitive federalism, progress towards a comprehensive new digital eco-system and the push for more renewable energy sources. While these are all essentially domestic policy factors, externally too, it seems that geopolitical trends are looking increasing favorable for India.
The importance of policymaking and policy directionality
According to standard economic theory, long-term economic growth boils down in large part to improvements in labor productivity. Other factors, such as labor availability and the labor participation rate also matter, but as Paul Krugman noted, “productivity isn't everything, but in the long run, it is almost everything.” When we drill down further into what drives productivity, the three key factors are physical capital, human capital, and technological change. Crucially, all these elements are all highly influenceable by policymaking.
Theory aside, even when thinking empirically of emerging economies that have successfully transitioned to developed country levels, arguably the single most important factor is good policymaking. Clearly sound polices also needs to be combined with good implementation, which in turn links to factors such as the rule of law, institutional strength, and the quality of political leadership.
When it comes to policymaking, the list of areas for further improvement in India (such as labor and land reforms) is large. However, significant progress elsewhere means the overall direction of travel on the policy front is still good. Among the oft-cited reform examples are the easing of restrictions on foreign investment and stronger bankruptcy laws. A particularly notable example worth highlighting specifically, was the move to a new tax regime in 2017, which included the introduction of a Goods and Services Tax across all states. This resulted in drastic tax simplification, effectively creating a ‘common market’ across all 36 union states, that greatly enhanced internal trade efficiency, as well supporting revenue growth and fiscal consolidation.
Such progress has certainly helped India's business climate, which over the last decade is reflected in rising foreign direct investment (FDI) inflows (see Chart 1 below) and strong average real GDP growth.
Chart 1. India FDI inflows (2011–2022)
Source: Reserve Bank of India. Note: figures for 2021-22 are provisional.
Going forward however, the challenge for India will be ensuring the overall direction of travel remains positive in most key areas, and in this respect, we think four key factors could have a big impact.
1. Competitive federalism
An important driver of India's ongoing development journey, and one which perhaps does not receive much credit, is the policy of state empowerment. Prior to 2014, Indian economic policymaking was largely promulgated through a centralized Planning Commission, which much like in China, would dictate five-year national development plans. However, it was recognized that such a one one-size-fits-all approach was totally ill-suited to a diverse country like India, with distinct regional strengths/weaknesses and varying levels of economic development.
In 2015, Indian Prime Minister Narendra Modi's government, replaced the old top-down model, with a new bottom-up approach, whereby state governments were given much greater autonomy, backed up by rising fiscal allocations. Crucially, individual states were given more license to compete with each other, as part of the new policy of competitive federalism – indeed, this was a key stated objective of the NITI Aayog, the new apex public policy body formed in 2015 to replace the Planning Commission. Rather than dictating policies, NITI Aayog plays a facilitatory role, including encouraging best practice and assessing and ranking states across key development metrics.
Figure 1. Indian state rankings by composite score
Source: ‘State Ranking 2023’, CareEdge Ratings. Note: the overall composite rankings are derived based on the performance of Indian states across the seven key pillars of: Economic, Fiscal, Financial inclusion, Social, Infrastructure, Governance, and Environment.
The underlying rationale of competitive federalism is an explicit acknowledgement that individual states are best placed to make policies that are best aligned locally. States competing actively with each other stimulates efforts to improve local business conditions in order to attract investment and to boost growth. At the same time, more focus on local competitive advantages reduces waste and improves resource allocation.
For competitive federalism to work however, it is essential that states are empowered more over time. This is partly reflected in Indian states' share of central revenues rising from 32% in 2015–2016 to 42% 2021–2022. However, given just eight years in existence, the policy of competitive federalism is still in its relative infancy, with significant potential for increasing autonomy and interstate competition in coming years.
2. Digitalization: Driving efficiency and growth
Arguably India's single most fruitful policy push area of the past decade is the ongoing drive to build a comprehensive new digital eco-system. Once known as India stack and later rebranded as Digital Public infrastructure (DPI), this refers to the collection of public-facing digital platforms that are having a major positive impact on many sectors of the economy.
India's DPI is essentially based on the three key layers of identity, payments and data management. The most critical foundational element is a biometric digital-identity system that now covers virtually all of India's 1.4 billion people. A data management layer was launched in 2015, which makes use of a unique 12-digit identity system to give citizens government-guaranteed secure online access to key documents, such as tax papers and vaccination certificates. The digital payments layer, called the Unified Payments Interface (UPI), was launched in 2016 and enables mobile payments. In combination, the net benefit of DPI can be summarized as citizens being able to verify their identities, attain key documents, and make payments via personal phones easily and securely.
As with most forms of physical public infrastructure, the responsibility for the key building blocks of DPI naturally lies with the government.
Government responsibility makes sense given public benefits, such as the efficient processing of direct social transfers, and aiding the implementation of sustainable development objectives. The International Monetary Fund estimates that shifting welfare benefits payments to digitally-linked bank accounts drastically cut losses from corruption to the tune of US$34 billion, or over 1% of India's GDP between 2013 and March 2021.
However, it is important to note that the benefits of India's DPI extend far beyond the public realm, in areas such as e-commerce, expanding banking and credit access, and helping innovation. A remarkable sign of this is how a country once renowned for the dominance of informal, cash transactions is rapidly embracing digital payments. Indeed, Chart 2 below shows that in April 2023, in volume terms, the UPI platform accounted for 88% of all non-cash payments in India's retail sector, up from 56% in April 2020. Likewise, a stunning cost benefit example in the private sector is the digital system reportedly bringing down know your customer due diligence costs for banks from as high as INR700 to just INR3 per application, thus also contributing to a drastic lowering of loan processing costs by almost 75%.1
Chart 2. UPI digital payments platform's % share of total credit transfers
Source: ‘Payment System Indicators’, Reserve Bank of India, June 2023; Reserve Bank of India - Payment System Indicators (rbi.org.in).
3. Energy transition: Driving opportunity and growth
One of the top policy objectives of the Indian government is to pursue a cleaner and less carbon-intensive model of economic development. A notable target in this regard, as shown in Chart 3 below, is ensuring that 50% of electricity needs are generated from renewable energy sources by 2030. Numerous indicators suggest India is heading in the right direction in its energy transition journey. For example, it recently claimed the global fourth spot in terms of installed renewable energy capacity (after China, the US, and Germany). Still, India's sheer size and room for growth, implies a hugely growing appetite for energy, as seen for example in the addition of 50m new home electricity connections ever year (on average) in the past decade.
Chart 3. Electricity generation by source in India
Source: Statista, IEA, November 2022. *government target. https://www.statista.com/chart/27963/india-energy-mix/.
The broad elements of India's energy transition aspirations are now fairly clear. This includes pursuing increased electrification, greater penetration of cleaner fuels in the energy mix, accelerated adoption of energy efficient technologies and improved material efficiency. Of course, all of this will require huge investments at both federal and state level, as well as from the private sector.
The International Energy Agency has estimated that for India to achieve its target of net-zero carbon emissions by 2070, annual investment of US$160 billion (around 4.7% of GDP) will be needed, on average, across its energy economy between now and 2030 alone – which is around three times the level of recent years. Going forward, the sizeable outlays India needs for its energy transition should be a major driver of both investment opportunities and economic growth for many years to come.
4. Geopolitical tailwind
While policymaking is necessarily endogenous, other key directionality factors can be more exogenous in nature. In India's case, a key instance of this is in the realm of geopolitics – in particular, the increasing rivalry between the world's number of one and number two economies, the US and China respectively. In this respect, as the world's biggest democracy, and fifth largest economy, which also has a huge land border with China, India in many ways seems like an ideal strategic ally for the US.
As Modi's recent high-profile state visit to the US in June 2023 illustrated, India's partnership with the US now really appears to be moving to a higher gear. Indeed, in the effusive words the new US-India Global and Strategic Partnership agreement, “no corner of human enterprise is untouched between the two great countries.” Among the more notable areas of cooperation highlighted in the joint communique were technology and the transition to clean energy. Both of which key growth drivers for India, where it can look to leverage the vast know-how, capital strength and direct patronage of the US.
A major consequence of increasing US-China trade tensions has been global multinational companies seeking to lessen their supply chain reliance on China. This is an area where India, helped by its regional labor cost advantage (see Chart 4 below) can look to fill the gap. Given a surge in Indian electronics exports to the US between 2018–2022, directionality on this front may already seem good. However, India's overall market share in US electronics imports remains tiny, at less than 1%. As such, amid increasing talk of China Plus One (C+1) and China Plus Two (C+2) strategies, this suggests a real opportunity for India to harness geopolitical trends and local reforms to address its historic weak link of manufacturing.
Chart 4. India's labor cost advantage
Source: Oxford Economics/Haver Analytics, July 2023
Investment implications
We think the directionality of key economic reforms, coupled with geopolitical trends are highly supportive for India's long-term growth and investment outlook. On the equities side, the push for clean energy means India today is the venue for some of the world's biggest renewable energy projects in the world, helping the likes of India's largest decarbonization solutions company as well as its largest wind turbine producer. At the same time, the digital infrastructure revolution, combined with improving physical infrastructure (including internet connectivity), is fueling a boom in e-commerce.
On the bond side too, the strengthening Indian economy and ongoing reforms have supported key credit fundamentals, such as tax intake relative to GDP and FX reserves, as well enhancing local currency stability. In turn, growing confidence in its ability to manage key risks is enabling an increasingly receptive environment for foreign investors. This is reflected in Indian bond markets today being more accessible to foreign investors than ever before. A particularly important driver (and key reform in itself) of this was the launch of the Fully Accessible Route (FAR) in 2020, which enabled designated government bond securities to be purchased by foreigners on a restriction-free basis.2
With the pool of index-eligible FAR securities now approaching US$400 billion, constituting over 30% of the government bond market and growing continuously, and an overall market that is over US$2 trillion in size with very good liquidity, the argument for India's inclusion into global bond indices is strong. Its weight in existing Asian local currency bond indices is also overdue for an increase, to better reflect the improved accessibility of the market. Investors currently own less than 2% of the domestic bond market, barely featuring in global portfolios and suggesting plenty of room to grow in the years ahead.
For investors, increasing accessibility means the chance to enhance diversification and get exposure to a relatively stable, high yielding and large bond market of a major fast-growing country that has consistently outperformed for many years.
Putting everything together
In summary, when assessing the long-term outlook for any country, taking an approach of looking at the directionality of key policy factors can be useful. While this is necessarily a continuous process, and with many areas for further improvement still, India is ticking many boxes on this front, at present. Of particular note, we think are the policy of competitive federalism, the expanding national digital eco-system and efforts to secure India's energy transition.
At the same time, more exogenously, India looks especially well placed to gain from the dominant geopolitical trend of increasing US-China rivalry. One specific area where India can look to harness both geopolitical and domestic reform directionality, is by capitalizing on global companies’ increasing efforts to reduce supply-chain reliance on China.
The directionality of all these key factors should have a major positive impact in terms of driving investment opportunities and growth in India for years to come. In turn, and perhaps most importantly of all, robust and sustained investment and growth should benefit the lives of India's 1.4 billion citizens, including by taking millions more people out of poverty.
1 https://www.thehindubusinessline.com/economy/aadhaar-brought-down-kyc-cost-to-3-from-as-high-as-700-says-nirmala-sitharaman/article66740192.ece, April 2023
2 Following the launch of the Fully Accessible Route (FAR) in 2020, a growing number of Indian government bonds were designated as FAR securities, meaning they could be purchased by foreign investor without any of the previous quota restrictions. Prior to this, Foreign Portfolio Investors (FPIs) – i.e. those with foreign investor licenses, still needed to get government or corporate bond quotas to be able to buy the respective bonds and these quotas also had various other restrictions associated with them (like maturity and exposure restrictions). Today however, once foreign investors have a FAR license, they are free to buy FA-designated government bonds without any restrictions.
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