Is India the new China? A quantitative assessment

Previous blogs discussed the potential of India’s service sector and friend-shoring to propel growth. In this blog, using a quantitative framework we find that India should grow by about 5% over the next decades, well short of China’s growth rates at similar levels of development. In particular, India’s demographic dividend looks overhyped.

The analytical framework is the same used to assess China’s long-term growth prospects in a previous blog. Specifically, we break down past growth into the growth of production factors such as labour, capital, and human capital (weighted by their income share in GDP) plus productivity gains. Productivity gains are backed out as the residual GDP growth that factors of production cannot explain. One can then make reasonable forecasts for each of these production factors and productivity to derive long-term growth forecasts.

Forecasts of the production factors and productivity are usually informed by other countries’ experiences at similar levels of development. To determine which countries might serve as the best template for India’s future path, we compare India’s growth experience so far. India’s growth – in GDP per capita terms – falls short of China’s, Korea’s, and Taiwan’s at similar levels of development, but beats that of Thailand, Malaysia, Indonesia, and the Philippines. Therefore, using the combined experience of these seven countries seems the most plausible to us.

The grey line in the below graph shows the estimated relationship between productivity growth and the level of development based on the seven Asian countries (while actual data is only shown for a selected group on countries). As countries get richer and approach the technological frontier, productivity growth slows. India’s current productivity growth (denoted by the dark blue line) is above what one would expect based on its GDP per capita. Going forward we assume that India’s productivity growth converges with the estimated curve at a GDP per capita of US$8,000. This implies Indian productivity growth above the Asian “average” for the next 28 years.

India’s capital stock per worker is broadly in line with the experience of the other Asian countries at similar levels of development. However, the estimated relationship henceforth has a flatter slope than India’s curve so far. A flatter curve implies that the growth contribution of capital accumulation would fall. There is an upside scenario where this growth contribution does not fall, but higher capital accumulation leads to higher productivity growth and therefore faster development – this would also flatten the curve. While desirable, productivity growth is already above the Asian “average”, so we regard this as an upside risk rather than the base case.

We use the United Nations 2022 projections of working age populations to forecast the labour supply. Currently, the working age population is only growing around 1% per year, implying a growth contribution of 0.65 percentage points when weighted by labour’s income share in GDP. This growth contribution is falling henceforth and turns negative by mid-century. Note that these demographics are not particularly great. Among the seven benchmark economies five had significantly better demographics at similar development levels.

The labour supply can also increase by boosting skill levels or human capital in our framework. Specifically, each additional year of schooling boosts labour income and, by inference, labour input by 7%. Currently the average Indian attends eight years of schooling. We assume that years of schooling continue on their linear trend (common across countries) until they hit 13 years in 2057. This yields a constant growth contribution 0f 0.6 percentage points over the next few decades.

Putting it all together yields the following graph. It suggests, Indian potential growth is around 5% over the coming decades, or lower than in previous decades. This is due to the eroding demographic dividend and a pace of capital accumulation that is more in line with peers than in the past.

Relative to consensus we are at the lower end of forecasts. For example, Morgan Stanley in a recent blue paper postulates 6.6% growth over the next decade or so, while the OECD predicts 6%. However, model-based forecasts, for example by Goldman Sachs or JP Morgan are strikingly close to our own at 5.3% and 5.2%, respectively.

While our long-term growth forecast is maybe lower than expected, given much excitement about India on the sell-side these days, India remains an economy to reckon with at the global level. Specifically, India is to overtake Japan and Germany by 2032 to emerge as the world’s third largest economy and by 2050 should contribute more to global growth than the European Union.

What does all this mean for investments? Indian stocks are not cheap. They have de-rated against their emerging market peers on the back of investors shifting back into Chinese equities and linked to the Adani-Hindenburg episode. But despite the underperformance and de-rating, the relative PE ratio (vs EM) remains above the 10-year average, trading on a 60% premium to EM. Coupled with a growth outlook that is decent, but not spectacular, we remain on the side lines until equity valuations and sentiment are more enticing.