Without reforms to boost returns for multinational capital, Narendra Modi's 'Make in India' campaign will face testing times.
China and India are no longer producing enough output for investors to risk their increasingly expensive capital in these large emerging markets.
That’s less of an issue for China, which wants to move away from investment-led growth. But it’s a problem for India, which is embracing just such a strategy.
In both countries, the difference between real gross domestic product (GDP) growth and real interest rates has now shrunk to about the same level as in the United States and Britain.
The gap is a crude measure of how much an average company can hope to earn by borrowing and investing. Call it the “potential profit gap”.
Things were different a decade ago. Back then, GDP growth in China and India was 10 to 13 percentage points higher than their inflation-adjusted cost of capital.
Such a wide potential profit gap, much bigger than in rich nations, drew investors to the two large emerging economies. But since then, output growth has slowed, and real interest costs have risen. Businesses no longer have a compelling reason to put their next factory in China or India.
Take the People’s Republic. China’s above 10 per cent GDP growth has slowed to about seven per cent. Meanwhile real interest costs have surged to five per cent, thanks to deflating producer prices.
The growth-interest rate differential is, thus, just two per cent. It could narrow further if output growth keeps waning and Beijing decides to lift controls on the maximum interest rates that banks can pay depositors.
A scramble for deposits may end up pushing real interest costs even higher.
India’s real interest rate is lower than China’s, but so is its growth rate. The potential profit gap is, therefore, similar to China’s two per cent.
This is unappetising for many potential investors. To them, the United States economy, with output growth of 2.3 per cent and real interest costs of 0.6 per cent, is no less attractive.
China’s manufacturing capacity is already massive. In some industries such as steel, it’s excessive. But the implication for India is worrisome. With global companies content to sit on cash, Prime Minister Narendra Modi’s “Make in India” campaign to revive manufacturing could face testing times.
The antidote is as obvious as the malady. Reforms could lift productivity of new investment, boosting the potential for returns. Last year, it took $7.6 of fresh capital to produce $1 in extra output in India, according to Morgan Stanley.
That’s almost double the average between 2000 and 2010. Simplifying indirect taxes and easing shortages of infrastructure, energy and skilled labour could go a long way toward making India attractive for investors again.
Some progress could occur even without reforms. Stung by five years of double-digit inflation, the central bank is keeping interest rates high to re-establish its credibility as a preserver of savers’ wealth.
But with global oil prices easing, India’s inflation is slowing. In 2015, Indian interest rates could fall, even as the economy revives from two years of sub-five per cent growth.
The growth pickup, though, is unlikely to be spectacular. Global demand is too anaemic for a quick return to the nine per cent plus increases in GDP that the country witnessed between 2005 and 2007.
Similarly, real interest rates can only decline meaningfully – without exposing the economy to a risk of capital outflows – if the national savings rate improves in tandem.
That, in turn, will require the government to boldly scale back its Budget deficit by curbing wasteful subsidies and privatising state-run companies.
Had India paid enough attention to fiscal and other reforms when domestic interest rates were far lower than GDP growth, the country would by now have been ready to host some of the lower-end manufacturing activity that can no longer be profitable in China.
But New Delhi blew that opportunity. Caught in a messy and avoidable tax dispute, a Nokia factory near Chennai, once a symbol of India’s manufacturing ambition, has stopped production.
A setback like that wouldn’t have mattered some years back. It’s deeply concerning now, when the Modi administration is saddled with the unenviable challenge of boosting output and creating jobs in a world that’s unfriendly to investment and growth.
The bleak global climate for investment could turn more hostile if global disinflation turns into outright deflation.
Once savers in rich countries earn a positive real rate of return by just hoarding cash, they will demand even higher compensation for putting their wealth to work in riskier emerging markets such as India.
These countries will then have to rely entirely on their domestic savings to find resources for growth.
That might require India, which has nowhere near China’s high savings rates, to settle for slower growth.
Just how deflationary the world economy proves to be, and just how effectively Mr Modi’s policies can counter the pall of gloom, will concern investors deeply.
To see why, consider the recent warning against “Asiaphoria” by HarvardUniversity’s Lant Pritchett and former United States Treasury Secretary Lawrence Summers. Their analysis shows that fast-growing countries tend to lose their momentum and become average.
If India goes down that route, and fails to maintain its six per cent per capita GDP growth of between 2000 and 2010, the $1.8-trillion economy will grow to just about $3.8 trillion in 20 years. However, if past growth rates are maintained, GDP could expand to $6.8 trillion over the same period.
The $3-trillion difference is very important for long-term equity investors who use estimates of future – or “terminal” – growth rate of earnings or dividends in their models for valuing stocks.
If Mr Modi’s reforms start fading and it starts looking like India’s economy is heading for an eventual slide into ordinariness, investors will have to mark down their expectations.
Messrs Pritchett and Summers don’t say why fast growth must be ephemeral. They just note the historical record. But it will still be a tragedy if a country that has a fifth of the world’s youth accepts a slowdown before it’s inevitable.
Among Mr Modi’s many tasks in 2015, a crucial one will be to beat back the emerging-market blues and convince investors that India is special.