With GDP growth between 7.5% and 9.6% in each of the last five fiscal years, India's economic success story has been similar to China's.

There are however big differences between the 2 countries. China's economy is industry-driven (industry accounts for about 46% of GDP in China compared to 27% in India) whereas India's is services-driven (services contribute some 55% to India's GDP compared to 40% in China).

The importance of its service sector makes the Indian economy quite unique in the developing world. China is developing in a similar way to most western economies. It started with agricultural reform, moved into low-cost manufacturing, is now moving into higher value-added manufacturing and will eventually break into internationally tradeable services. India, on the other hand, has what Edward Luce in his book "In spite of the gods" (1) calls a schizophrenic economy in that it is both global with a rapidly growing software sector, and medieval with more than 70% of the population still living in villages and depending on agriculture for their livelihood. It is both modern with over 250 million mobile phone subscribers and antiquated with a poorly organized retail environment and millions of under-scale 'mom and pop' enterprises.

To fulfil its potential, India today faces 2 major challenges : the need to modernise agriculture and provide more manufacturing jobs for its under-employed rural population (2). Though India is theoretically self-sufficient in food production, productivity in the agricultural sector is rapidly declining and output depends to a significant extent on weather conditions. To improve the structural outlook for the agricultural sector, regrouping of lands, food price liberalization and investment in irrigation would be necessary. India's electoral politics make these reforms hard to get through.

Even if the necessary agricultural reforms were undertaken, India would still need to find ways of helping a rural population left without jobs. It is far from certain that the manufacturing sector would be able to absorb this excess rural labour.
The fact that India has some of the strictest labor laws in the world means that India's manufacturing sector is essentially capital intensive and employs relatively few people compared to China's.

It is ironic that people who think that India's economic success story is more sustainable than China's usually cite democracy as one of India's biggest advantages. While it is certainly true that democracy, an independent legal system and free press are valuable assets, they also slow down the reform process compared to China's system of combining central planning with market-oriented reforms (especially in India where the central government depends on the support of communist parties that oppose reform at national level but encourage it in states where they govern). Apart from agriculture, this can also be seen in India's totally inadequate infrastructure. The country's failure to invest in infrastructure over the last decades has led to a shortage of quality roads, ports and power. Infrastructure spending has however increased dramatically in the last years. Given that it is driven by a top-down commitment from the government and has broad acceptance from the major political parties, it will remain one of India's major growth drivers going forward.

Since its high of early January, India's stock market has lost over 35%. Much of this decline is due to the general economic malaise (recession risks, inflation risks, financial crisis) that is weighing on all the equity markets. India has lost more than most other markets because Indian companies were very highly valued in early January and because contrary to the 3 other 'BRIC' countries (Brazil, Russia and China), India's rising fiscal and current account deficits make it vulnerable in times of increasing risk aversion. The other reason for the fall in equity prices is rising inflation, with the inflation rate rising to over 11% in May, the highest number in 15 years.

The current stock market correction (which comes after the Sensex index rose from 3,000 to 20,000 between 2003 and 2007) will gradually offer long-term investors a good entry point into India's economic development. (The average decline in equity prices during India's last 3 big bear markets has been around 50% from peak to trough). Policy responses to the rise in inflation, both on the monetary and fiscal side, have been rapid and pre-emptive. As described above, India faces some serious challenges but there are some trends an investor can reasonably bet on.

The first is the growth in India's software sector as a leading provider of IT (Information Technology), BPO (Business Process Outsourcing) and Product Engineering Services. Companies like Infosys Technologies and Wipro Ltd. will benefit from that trend. Second, there is the growth in financial services especially in those segments that are linked to consumer credit (mortgage loans, credit cards). A bank like ICICI Bank is well positioned to capture part of that growth (financial stocks have been particularly hard hit in the current stock market correction given the inflation scare). Third there is the Indian consumer. A recent McKinsey report on consumption in India predicts a quadrupling in the size of the consumer market. One way to play that trend is to invest in Hindustan Unilever. Finally there is the infrastructure story that bodes well for a company like Larsen&Toubro.

(1) Edward Luce: In Spite Of The Gods; Abacus
(2) India's IT sector is important for the economy but is not an answer to the question of how to provide jobs for the rural population. To quote Edward Luce: "Less than 7% of India's dauntingly large labour force is employed in the formal economy. That means that only about 35 million people out of a total of 470 million have job security in any meaningful sense; and only about 35 million Indians pay income tax, a low proportion by the standards of other developing countries. (...) Of the 35 million or so Indians with formal sector jobs, 21 million are direct employees of the government. This leaves around fourteen million working in the private 'organised' sector. Of these, just over a million- or about 0.25% of India's total pool of labour- are employed in information technology, software, back-office processing and call centres."

Photos : © Marc Erpelding, 2008