India Could Miss The Shift Underway In Global Trade, Unless...

The King and Queen of the Netherlands visited India in October and in a beautiful display of openness and respect, Queen Maxima 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, for example raising productivity and efficiency of its food and agriculture sector, enhancing water preservation or shifting towards renewable energy. Fortunately, the Netherlands does have a favourable track record on foreign direct investment in India, which rose from $10 billion in 2014 to $20 billion 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 United States are eyeing India as well. In fact, we think FDI to India could increase markedly in the near future due to the U.S.-China trade war. Foreign firms were already shifting production lines out of China due to rising wage costs, but uncertainty caused by the U.S.-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 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, 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 the fifth criterion in our WWTG index, India would have topped the list as the most attractive destination.

So it is no surprise that we already see some companies like 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.

It is no secret that Trump wants U.S. companies to move activities ‘back home’ and he has shown protectionist muscle against India and Vietnam before.

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

What is clearly hurting India’s attractiveness as an investment destination, is the current economic slump. Since July 2018, the growth of gross domestic product has consistently slowed, down from 8 percent in April-June 2018 (Q1FY19) to a surprisingly low 5 percent in Q1FY20. Although the Reserve Bank of India reduced its growth forecast for FY20 from 6.9 percent to 6.1 percent, it believes that the economy has bottomed out and is finding its way up again with a growth forecast of 5.3 percent in Q2, 6.6 percent in Q3 and 7.2 percent in Q4 of FY20.

We are not convinced that the near-term prospects are already changing for the better.

Economic growth has not slowed to those levels since the taper tantrum in 2013. Moreover, we believe that for FY20, growth will come out at a bleak 5.2 percent.

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

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 Rs 70,000 crore worth of capital infusion for banks, and the announcement of a corporate tax cut from 30 percent to 22 percent. 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.

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 food and agriculture sector, low formal female labour participation rates, labour market rigidity, the weak public banking sector, ineffective land acquisition laws and the poor quality of the education system. The National Democratic Alliance had not been able to force any breakthroughs on adopting reforms on these topics in Prime Minister Narendra Modi’s first term, 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 Modi does not take up the reform gauntlet, we believe it will be hard for India to see growth figures returning to 7 percent any time soon. This will surely be a missed opportunity for international investors, but more importantly, it will be detrimental for the Indian people.

Hugo Erken is Head of International Economics, and Raphie Hayat is Senior Economist, at Rabobank.

The views expressed here are those of the authors, and do not necessarily represent the views of BloombergQuint or its editorial team.