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India could miss the shift underway in global trade, unless...

Economic Report

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Also published on Bloomberg/Quint, October 29, 2019

  • India might be able to benefit from the US-China trade war, as firms increasingly are shifting production lines out of China. India tops the ranking in our Where Will They Go index (including market size), which measures the attractiveness of countries for production activities which previously took place in China
  • However, the potential upside of these production shift across Asia should not be overstated. President Trump could launch measures against Asian countries that might benefit substantially from offshoring from China. It is no secret that he wants US companies to move activities ‘back home’ and he has shown protectionist muscle against India and Vietnam before
  • What is clearly hurting India’s attractiveness as an investment destination, is the current economic slump. We have revised our economic growth forecast for fiscal q2 downward to 4.2%. Moreover, if Prime Minister Modi does not take up the structural reform gauntlet, it will be hard for India to see growth rates exceeding 7 percent any time soon

The Dutch see opportunities in India…

The King and Queen of the Netherlands visited India in October and in a beautiful display of openness and respect, Queen Máxima wore traditional desi attire during the visit, namely a sari. The Dutch royal visit to India is typical of the increased Dutch focus on improving economic and political ties with India. It is surprising that both countries have such weak trade ties, given that there are so many opportunities up for grabs on both sides. For Dutch entrepreneurs, India offers an enormous internal market with ample business opportunities. In turn, Dutch entrepreneurs have the knowledge and state-of-the-art technologies to provide solutions to India’s economic and environmental challenges, e.g. raising productivity and efficiency of its Food & Agri (F&A) sector, enhancing water preservation or shifting towards renewable energy. Fortunately, the Netherlands does have a favorable track record on foreign direct investment (FDI) in India, which rose from USD 10bn in 2014 to USD 20bn in 2017.

…which is understandable given India’s economic potential

The Dutch are not the only ones to have noticed India as a destination for long-term investments. Companies from Japan to the US are eyeing India as well. In fact, we think FDI to India could increase markedly in the near future due to the US-China trade war. Foreign firms were already shifting production lines out of China due to rising wage costs, but uncertainty caused by the US-China trade war will most likely put this development into overdrive.

So why would companies pick India as an investment destination? In a recent report we developed a Where Will They Go (WWTG) index. In this index we map the attractiveness of countries for production activities which previously took place in China, based on four criteria:

1) export basket similarity compared to China;
2) real manufacturing wages;
3) the attractiveness of the long-term investment climate measured by the World Bank Ease of Doing Business index;
4) institutional quality measured by the World Bank Governance Indicators.

India is ranked number five on our WWTG index (Table 1a), partly because its exports are similar to China’s exports (something which indicates skill abundancy in similar sectors) and because real manufacturing wages are lower than in China. If we had included market size as a fifth criteria in our WWTG index, India would have topped the list as the most attractive destination (Table 1b).[1] So it is no surprise that we already see some companies (e.g. Samsung, Procon Pacific, Pegatron and Foxconn) expanding business activities on Indian soil at the expense of their Chinese operations, although this is, of course, only anecdotal evidence.

There is definitely a window of opportunity for India, but we also caution that the potential upside should not be overstated either. There is a fair chance President Trump will launch protectionist measures against Asian countries that might benefit substantially from offshoring from China. It is no secret that Trump wants US companies to move activities ‘back home’ and he has shown protectionist muscle against India and Vietnam before.

Table 1a: India ranks top 5 in the Where Will They Go (WWTG) index
Table 1a: India ranks top 5 in the Where Will They Go (WWTG) indexSources: Macrobond, Word Bank, 2018 JETRO survey, Rabobank calculations
Table 1b: When including market size, India even tops the list
Table 1b: When including market size, India even tops the listSources: Macrobond, Word Bank, 2018 JETRO survey, Rabobank calculations

India’s economic crisis is taking a toll on its investment attractiveness

What is clearly hurting India’s attractiveness as investment destination is the current economic slump. Since July 2018, growth of gross domestic product (GDP) has consistently slowed down from 8% in fiscal Q4 2017/18 to a surprisingly low 5% in Q1 in fiscal 2018/19. Although the Reserve Bank of India (RBI) reduced its growth forecast for fiscal 2019/20 from 6.9% to 6.1%, it believes that the economy has bottomed out and is finding its way up again with growth forecast of 5.3% in FQ2, 6.6% in FQ3 and 7.2% in FQ4.

Figure 1: Will economic growth in fiscal q2 slow to 4.2%?
Figure 1: Will economic growth in fiscal q2 slow to 4.2%?Source: Rabobank calculations, Macrobond

We are not convinced that the near-term prospects are already changing for the better. We have recently crunched the numbers with our nowcasting models and expect GDP growth to slow even further to 4.2% in fiscal Q2. Economic growth has not slowed to those levels since the taper tantrum in 2013. Moreover, we believe that for fiscal 2019/20 growth will come out at a bleak 5.2%.

The high-frequency economic data, which provides the input for our nowcasting models, do not look too rosy either (Table 2). Many indicators are flashing deep red and we do not see India’s economic growth making a rebound in the upcoming quarter.

Table 2: High-frequency indicators do not look rosy
Table 2: High-frequency indicators do not look rosySource: Macrobond, Rabobank

So what is the government doing to curb the economic slowdown?

In the last couple of months the government announced several measures, such as the merger of state-owned banks, an acceleration of INR 700bn worth of capital infusion for banks, and the announcement of a corporate tax cut from 30% to 22%. Although the financial sector measures are a step in the right direction, we are not too sure the current policy package is sufficient to kick-start the faltering economy. In fact, we are quite skeptical about the long-term effectiveness of the widely praised corporate tax cut. For one, we have doubts that the tax cut will trickle down to consumers. Firms are still struggling with liquidity shortages and in some cases working capital is being completely crunched by late payment of tax credits. Therefore, it is likely that firms will prefer to hoard additional revenues rather than lower prices to boost market shares. Moreover, the corporate tax cut erodes the government's already weak revenue base and puts additional strains on India’s fiscal position. The bottom line is that the government measures address symptoms of India’s faltering economic growth instead of its root causes.

Does Modi have the political power to make structural reforms?

What the Indian economy needs is a structural reform agenda to tackle some of its deeply-rooted economic problems, such as the inefficient F&A sector, low formal female labor participation rates, labor market rigidity, the weak public banking sector, ineffective land acquisition laws and the poor quality of the education system. The National Democratic Alliance (NDA) has not been able to force any breakthroughs on adopting reforms on these topics in Modi’s first term, mainly due to a gridlock in Rajya Sabha (India’s Upper House). And it is questionable if the outcome of the latest state elections in Maharashtra and Haryana will change this situation. So Modi has a tough task ahead. Even if the NDA does manage to get a majority in the Upper House in the coming years, we will have to wait and see whether the broad structural package that the Indian economy desperately needs will actually be launched. If PM Modi does not take up the reform gauntlet, we believe it will be hard for India to see growth figures returning to 7% any time soon. This will surely be a missed opportunity for international investors, but more importantly, it will be detrimental for the Indian people.

 

Footnote

[1] We disregarded economic size as a variable in our initial analysis because we mostly focussed on attractiveness from a production-cost perspective rather than a market-size perspective.

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Author(s)
Hugo Erken
RaboResearch Global Economics & Markets Rabobank KEO
+31 6 2223 1650
Raphie Hayat
RaboResearch Global Economics & Markets Rabobank KEO
+31 6 1038 7752

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