India Rising

Economics International topics

May 19, 2005

Editor Maria L. Lanzeni +49 69 910-31723 [email protected]

India rising: A medium-term perspective India Special

•

India has come a long way from its inward-looking economic strategy of over 50 years ago. Economic liberalisation and the gradual opening up to the world have boosted growth and lifted millions of people out of poverty. This paper argues that the continuation of the reform process will allow India to stay on a high growth path of roughly 6% per year on average over the next 10 to 15 years. If reforms were pursued more aggressively, real GDP growth could reach 7%-8% per year.

•

India will thus become the fastest growing economy out of 34 developed and emerging markets during that period and the world’s third largest economy by 2020. Moreover, its GDP per capita will double, from roughly USD 2,500 today (at purchasing power parity) to almost USD 5,000 in 2020. Favourable demographics, increasing investment in education and infrastructure and further integration with the world economy are the factors behind our projections.

•

The implications of the projected growth trajectory are manifold. First, a larger, richer consumer market will emerge. Second, consumption patterns will change, with expenditure on healthcare and transport and communications growing substantially. Third, household savings will increase, given the large amount of people entering the working years phase. Fourth, there will be rising demand for diversified financial instruments to invest those savings.

•

IT-related services, textiles, the auto-ancillary industry and pharmaceuticals are expected to gain dynamism given India’s comparative advantages and current sectoral trends. The banking sector has an enormous catch-up potential which is likely to be unleashed by the new domestic investment landscape, gradual privatisation and opening up to foreign banks.

Technical Assistant Bettina Giesel +49 69 910-31745 [email protected] Deutsche Bank Research Frankfurt am Main Germany Internet: www.dbresearch.com E-mail: [email protected] Fax: +49 69 910-31877 Managing Director Norbert Walter

Author: Jennifer Asuncion-Mund, +49 69 910-31714 ([email protected])

India Special

May 19, 2005

Dear readers,

This study is the first in our new India Special series, which highlights the significance of India as a mega topic at Deutsche Bank Research. The series will depict India’s rising economic and political position and its implications for Asia and the world.

This overview assesses India's potential to become the fastest growing economy over the next 10-15 years, based on its favourable demographics and the growth-enhancing reforms in which the country has embarked. The study also identifies the sectors and industries that are likely to benefit most from India's ascent.

Subsequent issues for the India series will cover the following topics: Indo-German trade and investment relations Prospects for IT and IT-related services in India Regional and geopolitical implications of India's emergence India’s capital market institutions and outlook Pension fund reform in India and China India’s fiscal developments and prospects Banking sector outlook in India and China We hope that the analysis provided by this new series finds your interest and helps you in your work. Any feedback from our readers is highly appreciated.

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“No power on earth can stop an idea whose time has come.” Quoted from Victor Hugo by PM Manmohan Singh on his appointment as premier, May 2004

India is increasingly attracting the world’s interest as a result of the country’s impressive economic performance, brought about by the liberalisation process of the past two decades and the start of the march toward a functioning market economy. As reforms progressed, economic growth rose from an average of 3.7% in the 50s and 60s – the “Hindu rate of growth” – to a healthy 6% in the 90s (see chart). At least as importantly, social indicators also improved significantly. The poverty ratio dropped from more than 50% of the population in the 1 1950s to about 26% in recent years. Infant mortality as recorded by the UNDP almost halved from 127 per 1,000 live births in 1970 to 67 in 2002. We expect India to keep the steady growth pace of the last decade, i.e., roughly 6% per year, over the next 10 to 15 years. Favourable demographics, increasing investment in education and infrastructure and further integration with the world economy are the factors on which our projections are based. This performance will make India the fastest growing economy among 34 developed and developing countries, as 2 highlighted in a recent comparative study by DBR (see chart). Thus, GDP will double every 12 years and India’s economy will be the world’s third largest by 2020 (in purchasing power parity or PPP terms, i.e., excluding exchange rate effects), trailing only the US and China. In PPP terms, India’s GDP level will be approximately 40% of that of the United States in 2020, up from 27% in 2002. In the rest of this paper, we examine India’s likely economic picture over the next 10 to 15 years. Using DB Research’s proprietary quantitative growth model combined with qualitative analysis, we study the structural factors that support India’s economic growth potential and the obstacles that constrain the move towards an even higher growth rate. We also depict alternative growth scenarios. Finally, we assess possible future patterns in domestic consumption, savings and investment and analyse the implications for certain sectors, including the banking industry.

Improving growth performance amidst reforms GDP growth, % p.a.

Autarchic industrialisation*

Piece meal deregulation*

'51-'73

Pursuit of radical reforms*

'74-'91

10 9 8 7 6 5 4 3 2 1 0

'92-'04

*) The periods correspond to the development strategies followed by the government as depicted in Srinivasan & Tendulkar (2003)

India: Top growth performer India Malaysia China Thailand Turkey Ireland Indonesia Korea Mexico Chile USA Argentina Spain Brazil Canada

I. The factors that drive India’s growth

Average annual GDP growth rate, 2006-2020, % 0

1

2

3

4

5

6

7

Source: DBR

A. Population and demographic trends: India’s growth dividend nd

India has a population of just below 1.1 bn today, the 2 largest in the world after China, increasing at roughly 1.5% per year. Our model shows that while the growth rate is expected to moderate to around nd 1.3% by 2020, India will still have the 2 fastest population growth in our sample of 34 developed and developing economies. Importantly, India has a young population. As of 2002, roughly 33% of its population was below the age of 15 while only around 5% was above the retirement age of 65. This implies that over the next 10 to 15 years a big portion of the country’s population will be within the workingage group, implying a significant increase in the supply of labour. Moreover, this advantage is likely to remain for a long period since the dependency ratio (i.e., the share of the population either younger than 1 2

The World Bank (2003). Bergheim et al (2005).

Economics

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India Special

However, economic growth does not depend on population growth alone. The quality of labour input plays a critical role in unleashing the productive capacities and technical progress that ultimately lead to higher growth. In this light, India still has a long way to go, not least if compared with its regional peers, as the table below shows. Education for all Education inputs

Participation in education (% of relevant age group), 2001

Govt spending on education (% of budget)

Primary* India

12.7

China

Net primary enrolment ratio

Gross enrolment ratio Secondary

Tertiary

n.r.

99 114

48 68

11 13

83 93

Indonesia

9.6

111

58

15

92

Malaysia

25.2

95

70

26

95

Philippines

n.r.

112

82

30

93

Thailand

28.3

98

83

37

86

*) Gross enrolment ratio is the ratio of total enrolment, regardless of age, to the population of the age group that officially corresponds to the level of education shown. This is why the ratio can be higher than 100. Source: World Development Indicators, 2004

True, literacy standards in the country have improved substantially over the last five decades, rising from just 18% in 1951 to about 65% in 2001. But increasing this level further is critical in order to boost the country’s productivity, contribute to a higher degree of industrialisation and increase non-farm employment. Advances are particularly needed in the education of women. As of 2000, the female illiteracy rate was nearly twice the figure for the male population, at 54.6% and 31.6%, respectively. A study by India’s International Institute for Population Sciences found that a woman’s lack of 3 education correlated negatively with the health of her children . Therefore, the benefits of educating women seem especially high. Moreover, country-wide statistics mask glaring regional disparities in education, which are a reflection of differences in income levels and administrative capacities. For example, the state of Bihar recorded 4 literacy rates of 33% in 2001, compared with 75% in the state of Delhi. All these shortcomings notwithstanding, India fares admirably well in producing skilled workers. It possesses a large pool of scientists,

3 4

4

International Institute for Population Sciences (1995). Census India (2001).

Economics

36 34 32

2020

2015

30

2010

India Vision 2020, Planning Commission, Government of India

42 38

2005

“Education is the foundation for a vibrant democracy, growth of productivity and income and employment opportunities.”

44 40

2000

B. Human capital: pockets of excellence but low average level

%

bn

1995

Between 2003 and 2020, we estimate that India will be adding about 250 m workers to the labour pool. This means roughly 15 m on average per year. To put this into perspective, in two years, India would be adding all of Germany’s labour force!

Favourable demographics 1.6 1.4 1.2 1.0 0.8 0.6 0.4 0.2 0.0

1990

15 or older than 64 years) will decline steadily in the coming years (see chart).

May 19, 2005

Population (left) Dependency ratio (right) Source: UN, DBR

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India Special

trained IT specialists, technicians and engineers, many of whom, if not all, speak English fluently. There are roughly 380 universities and 1,500 research institutions around the country, from which 200,000 engineers, 300,000 non-engineering technicians and 9,000 PhDs graduate annu5 ally. The Institute of Management Development’s (IMD) 2004 report on st global competitiveness ranked India 1 in the world on engineering nd capabilities and 2 in availability of skilled labour (see chart). A declared government priority is to achieve 100% enrolment for all children aged 6 to 14 by 2020, supported by increased public expenditure on education. Whether the government can achieve this goal will mostly depend on the availability of public funds and the efficiency of their allocation. A concerted effort at the state and local levels regarding human development policies is especially critical in rural areas. Overall, we expect human capital – proxied by level of education – to rise appreciably over our forecast period, because of increased government expenditure in education and greater incentives for staying in school (e.g., higher income prospects). C. Rising integration into global trade and investment

Denmark India Singapore Philippines USA Germany Malaysia Hong Kong Russia Turkey South Korea Thailand Mexico Brazil China 0

2

4

6

8

10

*) Data are based on response from IMD's annual Executive Opinion Survey. High score equals high availability of skilled labour. Source: IMD Yearbook, 2004

While India has made significant inroads in opening its economy since it joined the World Trade Organisation (WTO) in 1995, there are still remnants of its inward-looking development strategy. India’s trade volume as a share of GDP pales in contrast with other major Asian countries, and its import tariffs remain comparably high (see charts). But the prospects for greater world integration are promising, since a political consensus is being reached on the need to further liberalise trade and capital account restrictions. Recent discussions on expanding trade agreements, e.g., with China, Singapore, Thailand and other ASEAN members, attest to India’s resolve to gain further access to world trade. The recent lowering of duties for non-agriculture products to 15% from 20%, albeit small, is a step towards opening the country further. Capital account restrictions, in particular those applying to foreign direct investment (FDI), are still numerous, although recent policy directives are laying the ground for greater FDI. (For a complete list of current guidelines on FDI please see the Appendix on page 14.) The potential for FDI flows to India seems considerable, not least due to the fact that flows are currently very small. The comparison with China is particularly striking: Annual FDI flows into India amounted to just 0.5% of GDP (USD 3 bn) in recent years on average, compared to about 4% of GDP for China (roughly USD 45 bn) (see chart on p. 6). But this may start to change if market deregulation and liberalisation make further progress. Interest from foreign investors is already significant. For example, leading executives of multinational corporations rd ranked India 3 in AT Kearney’s 2004 FDI Confidence Index (see chart on p. 6). D. Investment trends: huge potential in infrastructure

A still closed economy 200 Merchandise trade, % of GDP

150 100 50 0

1990 India

2000 China

2003 Malaysia

Thailand

Source: DBR

Tariffs remain high 60 % Average of ASEAN-5* India

50 40 30 20 10 0

1990

As a consequence of persistent shortfalls in public revenues, public investment has fallen continuously over the years, leading to severe infrastructure bottlenecks. The quality of India’s ports, airports and railways leaves much to be desired. Moreover, India has one of the lowest electricity consumption levels in the world, at just 365 units per capita in 2001, attributed primarily to an unreliable supply and inadequate distri-

5

High availability of skilled labour*

2001

*) Indonesia, Malaysia, Philippines, Singapore and Thailand Source: World Development Indicators, 2004

India Department of Industrial Policy and Promotion (2004).

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bution networks. This compares unfavourably with 893 units per capita 6 in China or 1,729 in Brazil in the same period.

FDI: Room to catch-up

Similarly, despite having one of the most extensive transport systems in the world, the sector continues to suffer from acute capacity and quality constraints. India’s total road network (in km) is twice the length of 7 China’s. Its poor quality, however, inhibits greater efficiency in the delivery of goods, with the consequence that the volume of goods hauled lags considerably that in China.

60

USD bn

50 40 30

In the agricultural sector, inadequate investment in irrigation facilities continues to expose farming to the vagaries of the monsoon. This partly explains the sector’s low productivity: while it employs about two-thirds of the total population, it only contributes just a quarter to total GDP. The country’s leaders are addressing the situation, calling on domestic and foreign investors to help bridge its financing requirements in infrastructure. According to Prime Minister Manmohan Singh, India requires a total of USD 150 bn in the next few years to finance its infrastructure development (rail, airport, seaport). While this amount seems daunting, we believe that appropriate policies that lure domestic and foreign investors may go a long way in achieving the goal. The policy framework for the infrastructure sector has changed favourably over time, including the lifting of FDI caps, as mentioned in the previous section. The telecoms sector is the only remaining infrastructure sector where an FDI ceiling (49%) still exists. The government has laid out long-term investment plans for infrastructure projects and established roadmaps, thus allowing investors to structure projects and conduct feasibility assessment appropriately and consistently with their time and risk profiles. Regarding public funds, the government has announced its intention to tap part of the stock of foreign exchange reserves, about USD 15 bn in total over the next three years, in order to jump-start the construction of infrastructure. Here, careful implementation is required in order not to compromise the fiscal consolidation underway and lead to inflationary pressures. Last but not least, domestic savings could contribute to the financing of infrastructure projects. The favourable demographic trends cited above will help lift the household savings rate noticeably (our estimates point to a level of 30% of GDP in 2020 from roughly 23% today). If the current reform-minded policy course is pursued further, there is a fair chance that these savings will be channelled to much-needed domestic investment projects.

20 10

1995

1997

1999

China FDI Flows

0 2003

2001

India FDI Flows

Source: UNCTAD

High investor confidence in India 1 2 3 4 5 6 7 8 9 10 15 20 25

CN US IN UK DE FR AU HK IT JP MY TH TW

(1) (2) (6) (7) (5) (11) (19) (22) (12) (15) (23) (16) (20)

FDI Confidence Index, 2004*

0.0 0.5 1.0 1.5 2.0 2.5 *) Low values indicat e low conf idence. 2003 ranking in ( ).

Source: AT Kearney

Inadequate expenditure mix 14 % of GDP

E. Policy and institutional determinants of growth

12

Empirical analysis suggests that policies which aim to stabilise the economy are conducive to growth. However, sensible macroeconomic policies may not be enough to trigger high growth if the institutional/regulatory framework is not appropriate.

11 10 9 8

6 7

6

World Development Indicators (2004). World Development Indicators (2004).

Economics

Source: Annual Report, Reserve Bank of India

2002-03

2000-01

1998-99

1996-97

1994-95

1992-93

1990-91

1988-89

1984-85

1982-83

1980-81

1986-87

Development expenditure Non-development expenditure

Macro policies: a more stable environment ahead Inflation has declined significantly in recent years, stabilising at a level of roughly 5%. But the monetary authorities’ success in maintaining relative price stability going forward will require improvements in fiscal policies. India’s large fiscal deficit, a legacy of the expansionary fiscal policies pursued by the government in the late 1980s, is acknowledged

13

7 6

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to be its Achilles’ heel. Public deficits since then have been very high at around 10% of GDP. India’s poor public finances have placed significant constraints on growth. The so-called “development expenditure”, i.e., capital expenditure on areas such as infrastructure that generates high social returns, has fallen constantly as a percentage of GDP since the early 1990s. At the same time, non-development expenditure, particularly interest on government debt, has risen continuously (see chart on p. 6). The government has taken some initial steps toward fiscal consolidation. The Fiscal Responsibility and Budget Management Act, passed in 2002, binds fiscal managers to specific deficit targets each year, with a 8 goal to bring down total deficit and revenue deficit to 3% and 0% of GDP, respectively, by 2008/2009. The introduction of the VAT system in April 2005 is another critical measure expected to contribute to fiscal consolidation. Finally, a moderate resumption of the privatisation drive will also provide relief to public finances.

Institutional and regulatory environment: established, but still inefficient India is a large country, not only with regard to its size but also in terms of culture, languages, religions and contrasting convictions. Notwithstanding the country’s heterogeneous society, there is an established and binding institutional framework, which includes a legal system, capital market regulators and banking supervisors. However, the efficiency and efficacy of these institutions leaves much to be desired. World Bank indicators on governance and on obstacles in doing business show significant room for improvement in India not only compared with advanced Asian economies like Singapore, but also in relation to China (see charts). For example, India’s rigid labour laws are often criticised as unwieldy. Firms with more than 100 employees can not easily retrench workers. Larger firms and foreign companies resort to elaborate measures to circumvent the country’s cumbersome labour laws. Reform proposals have been long debated but a concrete directive toward a more flexible labour system remains elusive. However, it is likely that, as economic liberalisation progresses further, the opportunity (and the pressure) for change in the institutional framework will arise as well.

II. India’s unique economic development: by-passing the industrialisation phase? Economic development often follows a sequence whereby the share of the agriculture sector in GDP declines progressively, with offsetting increases in the shares of the industry and service sectors. As an economy marches toward maturity, the share of industry in GDP stabilises or contracts a little while that of services advances further (see chart).

Governance indicators* Control of Corruption Rule of Law Regulatory Effectiveness Government Effectiveness Political Stability Voice and Accountability 0 Singapore

6 India

Source: World Bank Governance Index 2002

"Obstacles in doing business" indicators Employment law index* Procedures to enforce a contract

Singapore China India

Days to start a business Number of start up procedures 0

50

100

*) High score = very rigid labour laws Source: World Development Indicators, 2004

Changing structure of output as economic development progresses % of GDP

8

Low-income countries

Revenue deficit represents the excess of current expenditures over total revenue. When an item is classified as belonging to a SSI, investment in plant and equipment becomes subject to a specific limit. As a consequence, firms that produce these items are inhibited from achieving economies of scale and greater efficiency, thus reducing their competitiveness. While the number of reserved items categorised under the SSI

4

*) The six governance indicators are measured in units ranging from about -2.5 to 2.5, with higher values corresponding to better governance outcomes. Data have been rescaled to 0-5.

India’s economic transition, however, has been unusual. It appears to have skipped the industrialisation phase and advanced immediately to a services sector-led economy, which now constitutes about 50% of GDP – compared with about 25% five decades ago. The lack of development of India’s industry is mainly explained by the presence of stifling 9 regulation, such as the policy of small-scale industry (SSI) reservation

9

2 China

Agriculture

Middleincome countries

80 70 60 50 40 30 20 10 0

High-income countries

Industry

Services

Source: World Development Indicators, 2004

Economics

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and the inflexible labour laws. The agricultural sector’s share of GDP, meanwhile, declined to roughly 23% in FY 2003/2004 from just below 60% in 1951. What makes India’s development even more unusual is the relatively constant share of employment in each sector. The agricultural sector still employs the majority of the workforce, comprising 60% of the total. The services sector, on the other hand, employs just 25% of the total labour supply (see charts). This phenomenon also partly explains why urbanisation has been slow to develop. The IMF points to the critical role which economic liberalisation and a growing demand for services exports in the 1990s played in increasing 10 the services sector’s dominance in GDP. Surprisingly, IT represents a small fraction (less than 5%) of the services sector. The most prominent sub-sectors which have grown rapidly as a result of economic liberalisation, are business services (which includes IT but as a minor percentage), communications and banking. However, given India’s availability of a high-skilled workforce in ITrelated areas, it is likely that this sub-sector will grow substantially as a share of total services. The question arises whether India can do without a sizeable manufacturing sector. We think not. Manufacturing would provide India with a needed source of sustainable growth, and would contribute to further reducing poverty. A key pre-requisite for the future expansion of manufacturing activities in India is the improvement of the skills of the rural population. Combined with further liberalisation in agriculture, a more educated rural population will find it easy to move from farming to more productive areas. At the same time, this process should help to boost rural incomes, thus generating demand for the manufacturing sector. By developing its industry, India would become more like its Asian counterparts, whose economic growth over the past two decades has evolved hand-in-hand with increased industrialisation (see chart). The transition from agricultural to industrial employment would also be instrumental in the path toward greater urbanisation, which the government projects will increase to 40% from the current level of 28%.

III. India’s growth potential: DB Research’s foresight model for growth11 Population growth, fixed capital investment, human capital and openness are the four drivers in our proprietary model for long-term GDP forecasts. The model approach leads to an average growth rate of total GDP of 5.5% per year for the period 2006-20. Our analytical framework is theoretically based and is extended by using human capital as a measure of the quality of labour input and trade openness to capture institutional efficiency. These two variables allow us to explicitly and comprehensively model technological progress. This contrasts with growth accounting calculations, which arbitrarily assume convergence of per capita income levels without providing a fundamental explanation for the advance in technology. To estimate a reliable model for long-run growth in India, we take the experience of other countries into account, but still allow for countryspecific business cycles. We run a panel estimation with the “pooled mean group” technique to quantify the linkages between real per capita

10 11

8

fell following the reforms in the 1990s, the number of reserved items at roughly over 400 is still significant. Rodrik and Subramanian (2004). This section was contributed by Stefan Bergheim.

Economics

A services-led economy 1983 Services

% of labour force

Industry

% of GDP

Agriculture

0

20

40

60

80

2000 Services % of labour force % of GDP

Industry

Agriculture

0

20

40

60

80

Source: Reserve Bank of India, Ministry of Finance

Industrialisation has room to catch-up China

ASEAN-4* Low & mid income countries**

% change in manufacturing value-added, 1990-2000

India 0

100

200

*) Indonesia, Malaysia, Philippines, Thailand **) As classified in World Development Indicators, 2004 Source: World Development Indicators, 2004

300

India Special

DBR’s model yields an annual per capita GDP growth of 3.9% and total GDP growth of 5.5% on average in 2006-20 in the baseline outlook. Since the model is not equipped to take into account factors such as the high social return from expected investment in infrastructure, we believe that growth is likely to be higher than the baseline, i.e., in the vicinity of 6%.

6 GDP per capita USD, '000 (PPP)

"Indian tiger"

5

"Measured pace of reforms"

4

3 "Reform holdup" 2020

2018

2016

2014

2012

2010

2008

2 2006

The model’s forecasts for the four growth drivers stem from a threestage approach. Extrapolation of their trajectories of the past 20 years is the starting point. The exception is population growth, where we use the UN’s forecasts. The second stage takes information from levels and changes in other countries into account to dampen excessive movements in the trajectories generated in the first stage. The third and most important stage captures structural breaks through a broad-based country-specific assessment of six clusters of trends in politics, society, business and technology – based on the country expert’s assess12 ment. For example, DBR expects India to increasingly seize the opportunities offered by globalisation, and this is reflected in the trend called “Global networking in business in economics”.

Growth scenarios for India

2004

GDP and the four fundamental drivers of growth, taking account of the information in the time series.

2002

May 13, 2005

Changes in income distribution: Urban 70 60

% population

50

1992-93

IV. Alternative scenarios

40

1998-99

The growth path depicted above is our most likely scenario (with a probability of about 60%), based on the expected trajectory for the growth drivers and the course of policies. We call this scenario “measured pace of reforms”. Of course, it is conceivable that the pace of policy reform will be different – either faster or slower – than we currently expect. Therefore, we have devised two alternative scenarios.

30 20 10 0 <=35 (L)

36-70 71-105 106-140 >140 (LM) (M) (UM) (H) Annual income (INR, '000)

Upside scenario: “Indian Tiger” (p = 30%) Under this scenario, the government’s approach to liberalising the economy is much more aggressive than at present, and implementation of reforms is deeper and more rapid in spite of occasional opposition from other political parties. In particular, privatisation resumes at a similar pace as in FY 2003/2004. Privatisation revenues support the government’s drive to narrow its revenue deficit. Liberalisation in sectors of the economy which had remained closed so far attracts larger inflows of foreign direct investment. The government invests strongly in the agricultural sector in order to reduce the country’s dependence on the vagaries of the monsoon. Social tensions arising from the widening income disparities between rich and poor are kept in check by the government within the parameters of the “Common Minimum Pro13 gramme” , without affecting the investment climate or jeopardising the fiscal consolidation process. Under this scenario, the economy grows at an average rate of 7.5% over the next 10-15 years. This growth rate is close to – albeit still below – the government’s own long-term target of 8.5% to 9%, as denoted 14 in its document “India Vision 2020”.

Under this scenario, economic liberalisation policies are held back by frequent and protracted resistance to economic reforms. The fiscal

13

14

Rural

60

1992-93 1998-99

50 40 30 20 10

% population 0 <=35 36-70 71-105 106-140 >140 (L) (LM) (M) (UM) (H) Annual income (INR, '000)

All-India 70 60

% population

50

1992-93

40

1998-99

30 20

Downside scenario: “Reform holdup” (p = 10%)

12

70

“The trends that will shape future growth” on DBR’s website provides a map of these trends. The Common Minimum Programme (CMP) is a blueprint of the government’s economic and social goals that emphasises empowering the poor and rural areas. India Planning Commision (2000).

Economics

10 0 <=35 (L)

36-70 71-105 106-140 >140 (LM) (M) (UM) (H) Annual income (INR, '000)

L=Low; LM=Lower middle; M=middle; UM=Upper middle; H=High Source: National Council of Applied Economic Research

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deficit worsens further, arising from increases in subsidies, the failure to rationalise tax collection and the inability to divest ailing publicly-owned companies. The government may be compelled to re-capitalise some of these companies, thus denting further its goal to rein in the fiscal deficit. Investor confidence is adversely affected, with foreign direct investment failing to pick up. Agriculture remains dependent on the vagaries of the monsoon given inadequate public investment in the sector. In this scenario, real economic activity slows to an average of around 4.0% in 2006-2020. This growth rate, while quite respectable in an international comparison, is very close to the paltry (by Indian standards) “Hindu rate of growth” of the 50s and the 60s, and is insufficient to generate much of an improvement in the standard of living of the Indian population.

V. Expected growth changes in consumption and savings patterns India’s projected growth trajectory, together with demographic developments, will have a critical influence on consumption and savings patterns in the next few years.

India's household consumption bundle in 2002 …

A larger, richer market If our expectations are fulfilled, the size of the Indian economy (measured in USD at PPP) will almost triple between 2002 and 2020. Thus, it will become equivalent to 40% of the US economy and 3 times the size of the German economy in 2020, compared with 27% and 1.3 times, respectively, in 2002. Not only will the market be much larger, it will also be much richer. GDP per capita will more than double in the period, from USD 2,300 in 2002 (in USD at PPP) to almost USD 5,000 in 2020, not very different from a middle-income Asian country like Thailand today. This substantial rise in per capita income, coupled with the sheer size of the Indian population, will give a tremendous impulse to the rise of a mass-consumption market. Moreover, due to structural changes in income distribution that have occurred over the past decade, a sizeable fraction of the poorest segments of the population has migrated to a higher income class, implying a larger potential consumption capacity. Not surprisingly, this effect has been more pronounced in urban than in rural areas. There, in a matter of six years, the share of the population classified as “low income” declined by half, while the proportion in the “upper middle” and “high” classes increased significantly (see charts, p. 9).

Food

Transport & comm

Healthcare

Others

Source: Reserve Bank of India

… and in 2020?

Food

Transport & comm

Healthcare

Others

India’s changing consumer bundle Engel’s Law predicts that as income rises, the share of food in individual consumption baskets declines, while that of non-food goods increase. This has certainly been the case in India so far: Spending on food as a percentage of real household consumption dropped from about 66% in 1950 to 45% in 2002. Transportation and communication expenditures, on the contrary, experienced a sharp increase from around 2.8% of household consumption in 1950 to about 16% recently. This trend is expected to continue. Taking Thailand as proxy for a country with a per capita income similar to that expected for India in 2020, the proportion of food in India’s consumption bundle could decline to around 30% over the next 10-15 years, while transport and communication and healthcare could rise to 28% and 12%, respectively. Of course, the rise in the former category is related to the progress in building an adequate infrastructure network. Regarding healthcare spending, the significant increase should be driven by, first, a population whose life expectancy is expected to rise further, and, second, lifestyle

10

Economics

Life-cycle hypothesis Income, consumption Debt accumulation

Dissaving

Saving

Working yrs. Youth yrs.

Retirement yrs. Time

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India Special

changes – stemming from improved consciousness about health and well-being – which are associated with higher per capita income.

Growing household savings The young structure of the Indian population means that a huge cohort will enter the working years phase in the next decade or so. The size of this group has been estimated at 40% of India’s population, or 266m 15 people. According to the life-cycle hypothesis , this should bring about a very sizeable increase in household savings (see chart). Taking the past five years as reference, household savings could pick up to at 16 least 30% of GDP by 2020 from the current level of 22.6%. Thus far, investments made by households have characteristically been conservative and poorly diversified. Of the household domestic savings in 2002, roughly 54% of the total went into physical assets, while the balance was invested in financial instruments. The lion’s share of the latter was accounted for by bank deposits, followed at a distance by government bonds. Investment in equities, either through direct ownership or via mutual fund purchases, was muted (see chart). However, recent trends indicate growing ownership – albeit at a gradual pace – of mutual funds by households, suggesting their willingness to venture into other asset classes that offer higher expected returns in the future. Given India’s relatively young population, a lower risk aversion leading to increasing demand for non-traditional investment products is to be expected. Adding to that a rising income level for this population group, and a defined-contribution pension reform in the making, the scope for expansion in investment services appears large going forward.

Household financial investment (2003) Claims on govt 18%

Shares & debentures, 2%

Provident & pension fund, 13% Bank deposits 42%

Life insurance fund, 15% Source: Reserve Bank of India

Security environment: legislation in place IN

VI. Outlook for selected industries Besides the already booming IT sector, we expect the textile, automobile, pharmaceutical and banking industries to benefit from India’s further market deregulation and internationalisation.

Cash, 10%

CN

PH

Copyright Patent Digital signatures Hacking

Business Process Outsourcing (BPO)

Privacy

India has become a major hub for outsourcing of IT-based business processes. Global demand is driven by multinational firms’ bid to cut operating and production costs to maintain their competitiveness. India supplies a wealth of technical and engineering skills at competitive costs. The country’s other clear advantages are friendly government policies for IT exports, an English-speaking environment and good quality-control systems. Its security and privacy laws also appear ahead of those of its major competitors in the region (see table).

Data protection

1)

Vertical spec. law 1) Data protection law at a draft stage. Source: NASSCOM

Export revenues from the BPO sector rose 40% yoy in FY 2003/2004, from USD 2.5 bn in FY 2002/2003 to roughly USD 3.6 bn. The US is by far the biggest market for India’s BPO industry, representing 80% of the business. However, this could start to change if, as increasingly feared, US legislation limits US firms’ ability to outsource their business activities. This could be balanced, however, by new markets such as Europe, where the big Indian IT companies have started to make inroads.

Textiles DB Research expects India to emerge as one of the winners of the 17 textile trade quota expiry in December 2004. In the years prior, the Agreement on Textiles and Clothing (ATC), along with the preferential treatment agreements, restricted the exports of many Asian clothing 15 16 17

Modigliani & Brumberg (1954). For a similar projection see Sanyal (2004). Heymann (2005).

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manufacturers to the US and EU. India had by far the highest export tax equivalent for its trade with the US and EU (see chart). The removal of the quota system will likely unleash significant potential for India to increase its exports to the major developed markets. India’s strengths include a rich availability of inputs such as a large labour force, low-cost production and manufacturing of raw materials (e.g. cotton and yarn). However, the surge of the industry is likely to be gradual, particularly compared with China, which will emerge as the main beneficiary of the end to textile quotas. This is explained by China’s better infrastructure, which allows higher production and operating efficiency, and more open export policies. Notwithstanding, as manufacturers will seek to diversify their import sources, India will certainly benefit. With expectations of further economic liberalisation, India is expected to emerge as a highly competitive supplier of textiles and clothing in the near future.

Export tax equivalents of quotas in clothing trading IN CN TH HK LK USA

BD

EU-15

ID PH VN HU PL

Auto-ancillary industry India’s auto-ancillary sector is becoming rapidly integrated into the global industry. Outsourcing of production by large auto-component manufacturers to India is expected to increase further as they seek to cut costs. India’s advantages also include high engineering skill levels and established production plants.

%

TR 0

10

20

30

40

Source: WTO (model calculation using 1997 as base year)

A recent report showed that this sector could grow to between USD 33 bn and USD 40 bn by 2015, from USD 6.7 bn in 2003, while exports have the potential to soar from USD 1 bn in 2003 to between USD 20 18 bn and USD 25 bn by 2015. While these may still be relatively small amounts considering a global industry size worth USD 700 bn, they nonetheless reveal that India is capable of capturing broader pieces of the pie over time. The key challenges ahead include quality upgrading and dismantling of unfavourable government policies. Increasing joint ventures between Indian companies and international players should contribute to improving their efficiency, operation and technology.

Pharmaceuticals The Indian pharmaceutical sector may be entering a paradigm shift as it has just started implementing a new product patent regime. The new patent law effectively puts an end to Indian pharmaceutical companies’ practice of reverse-engineering the production of patented drugs. This is expected to significantly increase multinational drug companies’ production in India. At the same time, despite the implementation of the patent regime, India is expected to maintain its place among the top global producers of generic drugs, due to the country’s cost advantages and its availability of high-skilled scientists. With an estimated USD 55 to 65 bn worth 19 of drugs expected to go off-patent within the next 2 to 3 years , India could potentially capture a good size of this.

Credit to GDP: Financial deepening beckons 2003, %

160 140 120 100

Financial industry

80

The financial sector, in particular banks, plays an essential role in economic development since it facilitates the intermediation between savings and investment, thus fostering economic growth. As discussed in the previous section, Indian banks have been the main recipient of household savings. However, they have not performed well in mobilising these funds into loans, as evidenced by a very low ratio of credit to GDP (see chart). Instead, a big portion of banks’ assets (25%) is in-

60

18 19

12

McKinsey & Co. (2004). Ernst & Young (2004).

Economics

40 20 0 India

Korea

Thailand Malaysia

Source: World Development Indicators, 2005

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India Special

vested in domestic government bonds. This is expected to change, however, as the financial sector embarks upon far-reaching reforms in the coming years by allowing further participation of foreign investors, for example. Equally, the transformation of India’s financial sector calls for further strengthening of its regulatory standards. The country’s regulatory bodies – the Reserve Board of India, Securities and Exchange Board of India and Insurance Regulation and Development Agency – need to work in concert to, among other things, improve corporate governance and promote minority shareholders’ rights. The increase in capital market investment also requires the implementation and enforcement of 20 widely accepted standards such as the “Prudent Man Rule”. The landscape of India’s banking sector is expected to change gradually, on the heels of the two-phase roadmap for reform presented by the Reserve Bank of India (RBI) recently. Currently, India’s banking system remains dominated by public sector banks (roughly 70% of total banking assets are in government-owned banks) with still relatively low participation of foreign banks (about 10% of total assets).The first phase of the roadmap, in place already, is likely to usher in consolidation in domestic public and private banks. It allows for the relaxation of several regulations for foreign banks, such as limits on expansion of their branches. Moreover, foreign bank acquisition of local private banks identified by the RBI as “in need of restructuring” is now permitted, subject to a 74% cap. The second phase of the roadmap, which will commence in 2009, will allow foreign bank ownership of any local private bank, within an overall limit of 74%. The merits of greater foreign bank participation include technological and management skills transfer and improved efficiency. In India, further improvements in risk management are of the essence. One area of concern is the continued existence of government-directed lending to the so-called “priority sectors”, which originate about half of the bad 21 loans in the banking sector. Additionally, the anticipated rise in household savings depicted above will call for greater efficiencies in the banking system to meet the public’s changing investment appetite. Banking sector reform, including the participation of foreign banks, will adequately prepare the system to meet this challenge.

Conclusion India’s growth potential over the next 10-15 years sets the country at the forefront of the developed and developing world. We expect that, building on the country’s favourable demographics and sizeable talent pool, the continuation of the reforms initiated over one decade ago will unleash that potential and bring India to a more advanced stage of development. There will certainly be obstacles along the way, but we believe that the integration of India into the global economy and the ensuing transformation of the country are here to stay. The pace of this transformation will ultimately depend on the will of the Indian population and the vision of its leadership. Author: Jennifer Asuncion-Mund, +49 69 910-31714 ([email protected]) 20

21

The Prudent Man Rule states that “a fiduciary shall exercise the judgment and care, under the circumstances then prevailing, which men of prudence, character and intelligence exercise in the management of their own affairs, not in regard to speculation but in regard to the permanent disposition of their funds, considering the probable income as well as the probable safety of their capital.” [Association of Investment Management and Research, 1999.] Asian Development Bank (2004).

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Appendix: Selected foreign direct investment guidelines Sector Infrastructure Roads, h'ways, ports, harbours Telecom

Other sectors Agriculture

Cap ( %) Specifics 100 49

Automatic route available*. For basic, cellular, value added services, subject to licensing requirements, and a lock-in period for transfer of equity. 2004/05 budget proposed raising it to 74 per cent; however, this is not yet operational.

100

For e-mail, voice mail, ISPs not providing gateways. Restrictions include licensing, FDI beyond 49 per cent needs approval from FIPB, and divestiture of 26 per cent in 5 years.

74

For ISPs with gateways, radio-paging and end-to-end bandwidth. FDI beyond 49 per cent needs approval from Foreign Investment Promotion Board (FIPB).

0 100

No FDI is permitted, with some exceptions. Tea, including tea plantations. Restrictions apply, including approval from government, divestiture of 26 per cent in five years, and approval in case of change in land use. For sub sectors, mining, separation, value addition and integrated activities.

Atomic minerals

74

Broadcasting

100 49 100 74 26 49

In TV software production. In cable networks, direct to home. For most activities in this sector. For coal exploration or mining. Automatic route not available. Subject to licensing and security requirements. Automatic route not available. Subject to no direct or indirect equity participation by foreign airlines.

74

In the 2005/2006 Budget, foreign banks have been allowed to operate in India through branch, wholly-owned subsidiary or subsidiary with aggregate foreign investment up to a maximum of 74 per cent in a private bank, "identified by RBI for restructuring".

Coal and lignite Defense and strategic industries Domestic airlines Financial: Private sector banking

Starting April 2009, foreign banks will be allowed to acquire up to 74 per cent in any private sector bank in India. Financial: Non-bank financial companies Financial: Insurance

100

Various minimum capitalisation norms for fund-based NBFCs.

26

Automatic route available, subject to obtaining license from the regulatory body. 2004/05 budget proposed raising it to 49 per cent; however, this is not yet operational.

Housing and real estate

100

Applies to the development of integrated townships, with prior government approval. No FDI allowed in other real estate subsector.

Mining

74

Automatic route available in the exploration and mining of diamonds and precious stones.

100

Automatic route available in the exploration and mining of gold, silver and other metals.

Petroleum (other than refining)

26 100 100

Postal services

100

Cap applies to public sector units. Automatic route not available. Cap applies to private Indian companies. Automatic route available. Automatic route available. FDI of 100 per cent is possible in oil exploration in smalland medium-size fields, petroleum product marketing, natural gas/LPG (approval required). FDI of 100 per cent in courier services, with prior approval. No FDI allowed in the distribution of letters.

Print media

100

Automatic route not available. FDI allowed in publishing/printing scientific and technical magazines, periodics and journals.

26

In newspapers and periodicals dealing with current events, subject to editorial control by Indian residents.

Petroleum (refining)

Trading Venture capital

Automatic route available. Meant for export activities. 51 Automatic route available. Subject to Securities Exchange Board and Investments Sectoral caps apply (SEBI).

* FDI automatic route does not require prior approval from the Reserve Bank of India. Source: India Article IV Report, March 2005, Reserve Bank of India

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Bibliography Asian Development Bank (2004). Asian Development Outlook: Developing Asia and the World. Manila, Philippines. Association for Investment Management and Research. Standards of Practice Handbook. Charlottesville, VA. August 1999. Aziz, Jahangir (2002). Poverty Dynamics in Rural India. IMF Working Paper WP/02/172. Bergheim, Stefan (2005). Global Growth Centres 2020: Formel-G for 34 Countries. Deutsche Bank Research Current Issues, Frankfurt. Callen, Tim, Patricia Reynolds and Christopher Towe. India at the Crossroads: Sustaining Growth and Reducing Poverty. Washington, D.C. February 15, 2001. Census of India. Primary Census Abstract (2001). http://www.censusindia.net/t_00_006.html. Department of Industrial Policy & Promotion, Government of India (2004). Opportunities and Policy Challenges for Investment in India: Background Paper. New Delhi. Dutta, Amit (2004). Pharmaceuticals. Ernst and Young. Gordon, James and Poonam Gupta (2004). Understanding India’s Services Revolution. IMF Working Paper WP/04/171. Hausmann, Ricardo and Catriona Purfield (2004). The Challenge of Fiscal Adjustment in a Democracy: The Case of India. IMF Working Paper WP/04/168. Heymann, Eric (2005). WTO Textile Agreement Now Expired: China Maturing into the World’s Tailor. Deutsche Bank Research Current Issues, Frankfurt. India Planning Commission, Government of India (2002). Report of the Committee on India Vision 2020. New Delhi. India Planning Commission, Government of India (1997 and 2002). Ninth and Tenth Five Year Plans. New Delhi. International Monetary Fund (2003-2005). India: 2004 Article IV Consultation. Washington, D.C. International Monetary Fund (1998-2005). India: Selected Issues. Washington, D.C. Mangeleswaran, Ramesh and Rajat Bhargava (2004). Vision 2015 for the Indian Automotive Components Industry. McKinsey and Company. Modigliani, F. & Brumberg, R. (1954): Utility Analysis and the Consumption Function: An Interpretation of Cross-section Data. In: Kurihara, K.K (ed.): Post-Keynesian Economics. New Brunswick, NJ: Rutgers University Press. National Council of Applied Economic Research (2003). India Market Demographics Report 2002. New Delhi. Panagariya, Arvind (2004). India in the 1980s and 1990s: A Triumph of Reforms. IMF Working Paper WP/04/43. Purfield, Catriona (2004). The Decentralization Dilemma in India. IMF Working Paper WP/04/32. Reserve Bank of India (2005). RBI Unveils Roadmap for Presence of Foreign Banks in India and Guidelines on Ownership and Governance in Private Banks. Press Release March 28. Rodrik, Dani and Arvind Subramanian (2004). Why India Can Grow at 7 Percent a Year or More: Projections and Reflections. IMF Working Paper WP/04/118. Rodrik, Dani and Arvind Subramanian (2004). From “Hindu Growth” to Productivity Surge: The Mystery of the Indian Growth Transition. IMF Working Paper WP/04/77. Sanyal, Sanjeev (2004). India’s Changing Households. Global Markets Research, Deutsche Bank, AG. Srinivasan, T N and Suresh Tendulkar (2003). Reintegrating India with the World Economy. Institute for International Economics, Washington, DC. March 2003. Temple, Jonathan (1999). The New Growth Evidence. Journal of Economic Literature 37, pp. 112-156. Topalova, Petia. Overview of the Indian Corporate Sector: 1989–2002 (2004). IMF Working Paper WP/04/64. Velkoff, Victoria A. and Arjun Adlakha. Women’s Health in India. International Programs Centre. http://www.census.gov/ipc/prod/wid-9803.pdf The World Bank (2003). India: Sustaining Reform, Reducing Poverty. Washington, D.C. Economics

15

Current Issues Global growth centres

Availab le faste r by e-m ail!!!

Substantiated, long-run growth forecasts are back in the limelight following the New Economy euphoria and the emerging market crises over the past 10 years. Deutsche Bank Research uses an innovative combination of modern growth theory, state-of-the-art quantitative techniques and systematic trend analysis to analyse the long-run growth perspectives of 34 economies. We identify growth stars, explain the reasons for their success and derive conclusions for companies, investors and policy-makers.

Global growth centres 2020: “Formel-G“ for 34 economies With this introductory publication, Deutsche Bank Research launches its new megatopic “Global growth centres“. With the help of “Formel-G“ (Foresight Model for Evaluating Long-term Growth), we identify the sources of economic long-term growth and generate forecasts for 34 economies until 2020. India, Malaysia and China will post the highest GDP growth rates over 20062020 according to our “Formel-G“ approach. Strong population growth, a rapid improvement in human capital and increasing trade with other countries allow average GDP growth of more than 5% per year in these three countries. Ireland, the USA and Spain are the OECD economies expected to grow most quickly.

All our publications can be accessed, free of charge, on our website www.dbresearch.com. You can also register there to receive our publications regularly by e-mail. Ordering address for the print version: Deutsche Bank Research Marketing 60262 Frankfurt am Main Fax: +49 69 910-31877 E-mail: [email protected] © 2005. Publisher: Deutsche Bank AG, DB Research, D-60262 Frankfurt am Main, Federal Republic of Germany, editor and publisher, all rights reserved. When quoting please cite “Deutsche Bank Research“. The information contained in this publication is derived from carefully selected public sources we believe are reasonable. We do not guarantee its accuracy or completeness, and nothing in this report shall be construed to be a representation of such a guarantee. Any opinions expressed reflect the current judgement of the author, and do not necessarily reflect the opinion of Deutsche Bank AG or any of its subsidiaries and affiliates. The opinions presented are subject to change without notice. Neither Deutsche Bank AG nor its subsidiaries/affiliates accept any responsibility for liabilities arising from use of this document or its contents. Deutsche Banc Alex Brown Inc. has accepted responsibility for the distribution of this report in the United States under applicable requirements. Deutsche Bank AG London being regulated by the Securities and Futures Authority for the content of its investment banking business in the United Kingdom, and being a member of the London Stock Exchange, has, as designated, accepted responsibility for the distribution of this report in the United Kingdom under applicable requirements. Deutsche Bank AG, Sydney branch, has accepted responsibility for the distribution of this report in Australia under applicable requirements. Printed by: Druck- und Verlagshaus Zarbock GmbH & Co. KG