India insight: $10 trillion GDP by 2030? Not quite, but almost

This was written by Bloomberg Intelligence economist Abhishek Gupta. It first appeared on the Bloomberg Terminal.

For India, developing late is going to be harder than developing early. For the early risers – Japan, South Korea, and China – a combination of free trade and low labor costs provided a critical jump-start. India, with its protectionist policies and tough industrial labor laws, treaded a different path to seek growth in its services economy. A rising tide of protectionism, and automation that erodes developing countries’ low-cost advantage, mean growing its manufacturing sector now will be even more challenging.

• Even so, Bloomberg Economics sees huge potential for India’s economy. For now, it will be driven mostly by service industries, capitalizing on a demographic boost, high savings rates and investment, and productivity gains as India plays technological catch-up.
• Mukesh Ambani, chairman of conglomerate Reliance Industries Ltd., said a $10 trillion economy by 2030 is “inevitable.”
• In our view, that would be an optimistic outcome. To get there, India would need to unleash its manufacturing sector – requiring Prime Minister Narendra Modi to reform the rigid and politically fraught labor laws.

India could become the third largest economy by 2026

• In our base-case projections, GDP will grow from $2.7 trillion in 2019 to $5 trillion by 2025 and $8.4 trillion by 2030. This amounts to an average annual real growth rate of 8%, and would make India’s economy the third largest by 2026, behind China and the U.S.
• India will graduate from a lower-middle-income to an upper-middle-income economy over the next decade. We estimate per-capita income will rise from $2,000 currently to around $5,700 in 2030.
• To be sure, it won’t be a smooth ride. Such long-term projections can easily be thrown off by disruptive forces, ranging from climate change to trade protectionism and populist policies. For India, some of these negatives, though, also present opportunities.

Looking ahead, Bloomberg Intelligence expects the first-term reforms of the Modi government, including a clean-up of the banking sector, a new bankruptcy law, and a new indirect tax structure, to mark a transition to a faster-growth trajectory. These should lift potential growth to 8% from around 7.4% now. At the same time, Bloomberg Intelligence expects a recovery in actual growth, picking up from an estimated 6.2% in fiscal 2020 to 8.5% in fiscal 2025 – which would also close the negative output gap.

Base case: Demographics, productivity to push up trend in GDP

Demographic dividend is energized by higher education

We expect India’s demographic dividend to support higher trend growth relative to the last decade. A major reason – we expect more workers with higher levels of education to join to the labor force, particularly females in rural India.

• The trend of rising education levels pushed down the labor force participation rate to 36.9% in 2018 from 42.8% in 2005. While education attainment levels are expected to continue rising, we expect a growth recovery to encourage the educated to return to the labor force, countering any further drop in the participation rate.
• India’s unemployment rate increased to 6.1% in 2018 from 3.7% in 2012 as actual growth slipped below potential. Looking ahead, our base case assumes participation and unemployment rates will remain at current levels.
• We expect higher employment growth to increase India’s trend GDP growth rate by 0.3 percentage point over the next decade. Additionally, a more-educated labor force should also boost productivity.
• While increased U.S. protectionism could mean lower global growth ahead, it also presents an opportunity for India to grab a bigger share of the world’s manufacturing. Any capacity lost by China with a projected exit of 30 million secondary educated workers from its workforce over the next decade could be easily absorbed by India. We consider this only as an optimistic case, though, as it would require hard-to-do reforms to bring flexibility to retrenchment laws and reductions in labor compliance costs.

India to keep adding secondary educated workers in the next decade 

Lower interest rates and public capex to sustain capital boost

The contribution of net capital stock dropped to around 3.2 ppt in India’s trend growth rate of 7.4% in fiscal 2019, down from 3.6 ppt in fiscal 2011. This was due to a sharp decline in private-sector investment growth, reflecting over-capacity and excessive leverage buildup during the high-growth years of 2004 to 2011.

Looking ahead, our base case assumes higher public capex and a gradual recovery in private capex driven by lower interest rates. This would deliver net capital stock growth of an average 8% per annum over the next decade. Assuming a 40% income share for capital, this translates to a steady 3.2 ppt contribution to India’s trend growth rate of 8% ahead.

Over the past five years, India has structurally lowered its inflation, aided by lower oil prices and a shift toward a tighter fiscal policy. This was generally supported by an accommodative monetary policy. This policy mix is likely to continue as the Reserve Bank of India continues to reduce financial repression of banks by lowering their regulatory requirement to hold government bonds.

Favorable demographic trends – a drop in the youth dependency ratio and higher life expectancy – should boost savings rates, allowing for real interest rates to decline by around 150 bps over the next decade, according to study by the International Monetary Fund.

The government has an ambitious target to increase public investment to 100 trillion rupees over the next five years from 35 trillion rupees over the last five. This would entail annual average growth of public capex increasing to 26% until 2024, up sharply from 16% during 2014-2019 and 10% during 2009-2014.

Public capex is strong, lower rates to revive private capex

India’s low per capital income, with one-fifth of its population below the poverty line according to 2011 census data, creates the risk of an emergence of populist policies. That would mean a rise in the government’s current expenditures – which would reduce room to step up capital expenditure. For example, Modi earlier this year gave in to the political appeal of an income support plan for distressed farmers. The same resources spent on agricultural capex would undoubtedly have been a better way to boost farmer incomes.

Factor productivity to rise on structural reforms

• We estimate that total factor productivity growth will increase from 4% at present to around 4.3% by 2025 and remain at that level. This projection is based on our study of India’s historical experience, which shows that a period of sustained reforms tends to be followed by a rise in potential growth. Major reforms carried out by the Modi government in its first term included:
• Welfare and inclusive schemes targeted at the poor – such as rural electrification, subsidies for rural and urban housing and toilets, health insurance and financial inclusion through opening of bank accounts – should improve productivity of the labor force.
• A new bankruptcy code that allows reallocation of inefficient labor and capital locked in loss-making firms, a new goods and services tax framework that removes inter-state barriers to trade, an improvement in the ease of doing business, and improved transportation infrastructure are already boosting overall efficiency.
• While demonetization was beset with poor implementation and impacted growth in the short term, Bloomberg Intelligence expects the benefit of resultant higher tax compliance to keep accruing.
• Further upside to productivity growth could come from India’s adaptability to the new digital economy. Smartphone users and data usage per smartphone have been increasing at a rapid pace as charges have declined over the past few years. This has enabled a steep rise in the internet economy led by ecommerce, digital payments and hyper-local logistics – creating millions of new jobs. In addition, the government is now preparing the deployment of 5G networks by next year, which could support new applications such as remote surgery and quality education in rural areas, real-time weather monitoring for agriculture, and smarter logistics among other uses.
• At the same time, climate change poses a downside risk. India has the highest population at risk from an impending water crisis. In the southern city of Chennai this year, for example, businesses asked employees to work from home due to a water shortage resulting from delayed monsoon rains.

History shows potential growth rises after reforms

Pessimistic scenario – $6.8 trillion economy by 2030

This scenario assumes that India is likely to get stuck in a below-potential growth trajectory averaging 7% over the next decade, with a roughly 20% depreciation in the rupee over this period. While the risk is low, the following forces mean the possibility exists:

• Given past experience, short-term policy errors – such as demonetization in 2016, excessively tight monetary policy in 2018, taxation overreach in 2019 – can’t be ruled out.
• India’s low per-capita income puts it at risk of populist economic policies, which means the government could under-deliver on investment and reforms.
• Global warming could put India’s vast coastline at heightened risk from rising sea levels.
• Finally, India’s dependence on imported crude oil makes it highly vulnerable to oil-price shocks.

Optimistic scenario – $10 trillion economy by 2030

India’s economy would need to grow at an average rate of 9% to reach $10 trillion by 2030, assuming a stable exchange rate. In our view, that’s unrealistic. The government would need to undertake a fresh set of major reforms to provide a boost to the manufacturing sector – adding flexibility to labor retrenchment laws, easing land acquisition rules, and cutting red tape by reforming the civil services.

A strong political mandate gives Modi a chance to speed up these reforms. But as a number of cases have shown – opposition to a land reform bill, and slow progress on easing labor retrenchment laws, for example – further large-scale reforms may be hard to pull off.