Economics
International topics
May 19, 2005
Editor
Maria L. Lanzeni
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maria-laura.lanzeni@db.com
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Managing Director
Norbert Walter
India rising: A medium-term perspective
India Special
• India has come a long way from its inward-looking economic strategy of over 50
years ago. Economic liberalisation and the gradual opening up to the world have
boosted growth and lifted millions of people out of poverty. This paper argues that
the continuation of the reform process will allow India to stay on a high growth
path of roughly 6% per year on average over the next 10 to 15 years. If reforms
were pursued more aggressively, real GDP growth could reach 7%-8% per year.
• India will thus become the fastest growing economy out of 34 developed and
emerging markets during that period and the world’s third largest economy by
2020. Moreover, its GDP per capita will double, from roughly USD 2,500 today (at
purchasing power parity) to almost USD 5,000 in 2020. Favourable demograph-
ics, increasing investment in education and infrastructure and further integration
with the world economy are the factors behind our projections.
• The implications of the projected growth trajectory are manifold. First, a larger,
richer consumer market will emerge. Second, consumption patterns will change,
with expenditure on healthcare and transport and communications growing sub-
stantially. Third, household savings will increase, given the large amount of peo-
ple entering the working years phase. Fourth, there will be rising demand for di-
versified financial instruments to invest those savings.
• IT-related services, textiles, the auto-ancillary industry and pharmaceuticals are
expected to gain dynamism given India’s comparative advantages and current
sectoral trends. The banking sector has an enormous catch-up potential which is
likely to be unleashed by the new domestic investment landscape, gradual priva-
tisation and opening up to foreign banks.
Author: Jennifer Asuncion-Mund, +49 69 910-31714 (jennifer.mund@db.com)
 India Special May 19, 2005

Dear readers,

This study is the first in our new India Special series, which highlights the significance of
India as a mega topic at Deutsche Bank Research. The series will depict India’s rising eco-
nomic and political position and its implications for Asia and the world.

This overview assesses India's potential to become the fastest growing economy over the
next 10-15 years, based on its favourable demographics and the growth-enhancing reforms
in which the country has embarked. The study also identifies the sectors and industries that
are likely to benefit most from India's ascent.

Subsequent issues for the India series will cover the following topics:

Indo-German trade and investment relations

Prospects for IT and IT-related services in India

Regional and geopolitical implications of India's emergence

India’s capital market institutions and outlook

Pension fund reform in India and China

India’s fiscal developments and prospects

Banking sector outlook in India and China

We hope that the analysis provided by this new series finds your interest and helps you in
your work. Any feedback from our readers is highly appreciated.

2 Economics
May 19, 2005 India Special

“No power on earth can stop an idea whose time has come.”
Quoted from Victor Hugo by PM Manmohan Singh on his appointment as premier,
May 2004

India is increasingly attracting the world’s interest as a result of the

Improving growth performance
country’s impressive economic performance, brought about by the lib-
amidst reforms
eralisation process of the past two decades and the start of the march 10
toward a functioning market economy. GDP growth, % p.a. 9
Pursuit of
As reforms progressed, economic growth rose from an average of radical 8
Piece meal 7
3.7% in the 50s and 60s – the “Hindu rate of growth” – to a healthy 6% deregu-
reforms*
Autarchic 6
in the 90s (see chart). industria- lation*
5
At least as importantly, social indicators also improved significantly. The lisation*
4
poverty ratio dropped from more than 50% of the population in the 3
1
1950s to about 26% in recent years. Infant mortality as recorded by the 2
UNDP almost halved from 127 per 1,000 live births in 1970 to 67 in 1
2002. 0
'51-'73 '74-'91 '92-'04
We expect India to keep the steady growth pace of the last decade, i.e.,
roughly 6% per year, over the next 10 to 15 years. Favourable demo- *) The periods correspond to the development strategies
graphics, increasing investment in education and infrastructure and followed by the government as depicted in Srinivasan &
Tendulkar (2003)
further integration with the world economy are the factors on which our
projections are based. This performance will make India the fastest
growing economy among 34 developed and developing countries, as
2 India: Top growth performer
highlighted in a recent comparative study by DBR (see chart).
India
Thus, GDP will double every 12 years and India’s economy will be the
Malaysia
world’s third largest by 2020 (in purchasing power parity or PPP terms,
China
i.e., excluding exchange rate effects), trailing only the US and China. In
Thailand
PPP terms, India’s GDP level will be approximately 40% of that of the
Turkey
United States in 2020, up from 27% in 2002.
Ireland
In the rest of this paper, we examine India’s likely economic picture over Indonesia
the next 10 to 15 years. Using DB Research’s proprietary quantitative Korea
growth model combined with qualitative analysis, we study the struc- Mexico
tural factors that support India’s economic growth potential and the Chile
obstacles that constrain the move towards an even higher growth rate. USA
We also depict alternative growth scenarios. Finally, we assess possi- Argentina
ble future patterns in domestic consumption, savings and investment Spain Average annual
and analyse the implications for certain sectors, including the banking Brazil
GDP growth rate,
industry. 2006-2020, %
Canada

I. The factors that drive India’s growth 0 1 2 3 4 5 6 7

Source: DBR

A. Population and demographic trends: India’s growth dividend

nd
India has a population of just below 1.1 bn today, the 2 largest in the
world after China, increasing at roughly 1.5% per year. Our model
shows that while the growth rate is expected to moderate to around
nd
1.3% by 2020, India will still have the 2 fastest population growth in
our sample of 34 developed and developing economies.
Importantly, India has a young population. As of 2002, roughly 33% of
its population was below the age of 15 while only around 5% was
above the retirement age of 65. This implies that over the next 10 to 15
years a big portion of the country’s population will be within the working-
age group, implying a significant increase in the supply of labour.
Moreover, this advantage is likely to remain for a long period since the
dependency ratio (i.e., the share of the population either younger than

1
The World Bank (2003).
2
Bergheim et al (2005).

Economics 3
 India Special May 19, 2005

15 or older than 64 years) will decline steadily in the coming years (see
Favourable demographics
chart).
1.6 44
Between 2003 and 2020, we estimate that India will be adding about 1.4
bn %
42
250 m workers to the labour pool. This means roughly 15 m on average 1.2 40
per year. To put this into perspective, in two years, India would be add- 1.0
ing all of Germany’s labour force! 38
0.8
36
0.6
B. Human capital: pockets of excellence but low average level 0.4 34

“Education is the foundation for a vibrant democracy, growth of produc- 0.2 32

tivity and income and employment opportunities.” 0.0 30

1990

1995

2000

2005

2010

2015

2020
India Vision 2020, Planning Commission, Government of India
However, economic growth does not depend on population growth Population (left)
alone. The quality of labour input plays a critical role in unleashing the Dependency ratio (right)
productive capacities and technical progress that ultimately lead to Source: UN, DBR
higher growth. In this light, India still has a long way to go, not least if
compared with its regional peers, as the table below shows.

Education for all

Education Participation in education (% of relevant age group),
inputs 2001

Net primary
Govt spending
Gross enrolment ratio enrolment
on education (%
ratio
of budget)
Primary* Secondary Tertiary
India 12.7 99 48 11 83
China n.r. 114 68 13 93
Indonesia 9.6 111 58 15 92
Malaysia 25.2 95 70 26 95
Philippines n.r. 112 82 30 93
Thailand 28.3 98 83 37 86

*) Gross enrolment ratio is the ratio of total enrolment, regardless of age, to the population of the age group that
officially corresponds to the level of education shown. This is why the ratio can be higher than 100.

Source: World Development Indicators, 2004

True, literacy standards in the country have improved substantially over

the last five decades, rising from just 18% in 1951 to about 65% in
2001. But increasing this level further is critical in order to boost the
country’s productivity, contribute to a higher degree of industrialisation
and increase non-farm employment.
Advances are particularly needed in the education of women. As of
2000, the female illiteracy rate was nearly twice the figure for the male
population, at 54.6% and 31.6%, respectively. A study by India’s Inter-
national Institute for Population Sciences found that a woman’s lack of
3
education correlated negatively with the health of her children . There-
fore, the benefits of educating women seem especially high.
Moreover, country-wide statistics mask glaring regional disparities in
education, which are a reflection of differences in income levels and
administrative capacities. For example, the state of Bihar recorded
4
literacy rates of 33% in 2001, compared with 75% in the state of Delhi.
All these shortcomings notwithstanding, India fares admirably well in
producing skilled workers. It possesses a large pool of scientists,

3
International Institute for Population Sciences (1995).
4
Census India (2001).

4 Economics
May 19, 2005 India Special

trained IT specialists, technicians and engineers, many of whom, if not

all, speak English fluently. There are roughly 380 universities and 1,500 High availability of skilled labour*
research institutions around the country, from which 200,000 engineers, Denmark
300,000 non-engineering technicians and 9,000 PhDs graduate annu- India
5 Singapore
ally. The Institute of Management Development’s (IMD) 2004 report on Philippines
st
global competitiveness ranked India 1 in the world on engineering USA
nd
capabilities and 2 in availability of skilled labour (see chart). Germany
Malaysia
A declared government priority is to achieve 100% enrolment for all Hong Kong
children aged 6 to 14 by 2020, supported by increased public expendi- Russia
ture on education. Whether the government can achieve this goal will Turkey
South Korea
mostly depend on the availability of public funds and the efficiency of Thailand
their allocation. A concerted effort at the state and local levels regarding Mexico
human development policies is especially critical in rural areas. Overall, Brazil
China
we expect human capital – proxied by level of education – to rise ap-
preciably over our forecast period, because of increased government 0 2 4 6 8 10
expenditure in education and greater incentives for staying in school *) Data are based on response from IMD's annual Executive
(e.g., higher income prospects). Opinion Survey. High score equals high availability of skilled
labour.

C. Rising integration into global trade and investment Source: IMD Yearbook, 2004

While India has made significant inroads in opening its economy since
it joined the World Trade Organisation (WTO) in 1995, there are still A still closed economy
remnants of its inward-looking development strategy. India’s trade vol- 200
ume as a share of GDP pales in contrast with other major Asian coun- Merchandise
tries, and its import tariffs remain comparably high (see charts). trade, % of GDP
150
But the prospects for greater world integration are promising, since a
political consensus is being reached on the need to further liberalise
trade and capital account restrictions. Recent discussions on expanding 100
trade agreements, e.g., with China, Singapore, Thailand and other
ASEAN members, attest to India’s resolve to gain further access to 50
world trade. The recent lowering of duties for non-agriculture products
to 15% from 20%, albeit small, is a step towards opening the country
0
further.
1990 2000 2003
Capital account restrictions, in particular those applying to foreign direct India China Malaysia Thailand
investment (FDI), are still numerous, although recent policy directives Source: DBR
are laying the ground for greater FDI. (For a complete list of current
guidelines on FDI please see the Appendix on page 14.)
The potential for FDI flows to India seems considerable, not least due Tariffs remain high
60
to the fact that flows are currently very small. The comparison with %
China is particularly striking: Annual FDI flows into India amounted to 50
just 0.5% of GDP (USD 3 bn) in recent years on average, compared to Average of
ASEAN-5* 40
about 4% of GDP for China (roughly USD 45 bn) (see chart on p. 6).
But this may start to change if market deregulation and liberalisation India 30
make further progress. Interest from foreign investors is already signifi-
cant. For example, leading executives of multinational corporations 20
rd
ranked India 3 in AT Kearney’s 2004 FDI Confidence Index (see chart 10
on p. 6).
0
D. Investment trends: huge potential in infrastructure 1990 2001

As a consequence of persistent shortfalls in public revenues, public *) Indonesia, Malaysia, Philippines, Singapore and Thailand

investment has fallen continuously over the years, leading to severe Source: World Development Indicators, 2004
infrastructure bottlenecks. The quality of India’s ports, airports and rail-
ways leaves much to be desired. Moreover, India has one of the lowest
electricity consumption levels in the world, at just 365 units per capita in
2001, attributed primarily to an unreliable supply and inadequate distri-

5
India Department of Industrial Policy and Promotion (2004).

Economics 5
 India Special May 19, 2005

bution networks. This compares unfavourably with 893 units per capita
6
in China or 1,729 in Brazil in the same period. FDI: Room to catch-up
Similarly, despite having one of the most extensive transport systems in 60
the world, the sector continues to suffer from acute capacity and quality USD bn
constraints. India’s total road network (in km) is twice the length of 50
7
China’s. Its poor quality, however, inhibits greater efficiency in the de- 40
livery of goods, with the consequence that the volume of goods hauled
lags considerably that in China. 30

In the agricultural sector, inadequate investment in irrigation facilities 20

continues to expose farming to the vagaries of the monsoon. This partly
explains the sector’s low productivity: while it employs about two-thirds 10
of the total population, it only contributes just a quarter to total GDP. 0
The country’s leaders are addressing the situation, calling on domestic 1995 1997 1999 2001 2003
and foreign investors to help bridge its financing requirements in infra- China FDI Flows India FDI Flows
structure. According to Prime Minister Manmohan Singh, India requires
Source: UNCTAD
a total of USD 150 bn in the next few years to finance its infrastructure
development (rail, airport, seaport).
While this amount seems daunting, we believe that appropriate policies
that lure domestic and foreign investors may go a long way in achieving High investor confidence in India
the goal. The policy framework for the infrastructure sector has 1 CN (1)
changed favourably over time, including the lifting of FDI caps, as men- 2 US (2)
tioned in the previous section. The telecoms sector is the only remain- 3 IN (6)
ing infrastructure sector where an FDI ceiling (49%) still exists. The 4 UK (7)
government has laid out long-term investment plans for infrastructure 5 DE (5)
projects and established roadmaps, thus allowing investors to structure 6 FR (11)
projects and conduct feasibility assessment appropriately and consis- 7 AU (19)
tently with their time and risk profiles. 8 HK (22)
Regarding public funds, the government has announced its intention to 9 IT (12)
tap part of the stock of foreign exchange reserves, about USD 15 bn in 10 JP (15)
total over the next three years, in order to jump-start the construction of 15 MY (23) FDI
infrastructure. Here, careful implementation is required in order not to 20 TH (16) Confidence
25 TW (20) Index, 2004*
compromise the fiscal consolidation underway and lead to inflationary
pressures. 0.0 0.5 1.0 1.5 2.0 2.5
Last but not least, domestic savings could contribute to the financing of *) Low values indicat e low conf idence. 2003 ranking in ( ).
infrastructure projects. The favourable demographic trends cited above Source: AT Kearney
will help lift the household savings rate noticeably (our estimates point
to a level of 30% of GDP in 2020 from roughly 23% today). If the cur-
rent reform-minded policy course is pursued further, there is a fair
chance that these savings will be channelled to much-needed domestic Inadequate expenditure mix
investment projects. 14
% of GDP 13
E. Policy and institutional determinants of growth
12
Empirical analysis suggests that policies which aim to stabilise the 11
economy are conducive to growth. However, sensible macroeconomic 10
policies may not be enough to trigger high growth if the institu-
9
tional/regulatory framework is not appropriate.
8
Development expenditure 7
Macro policies: a more stable environment ahead
Non-development expenditure
6
Inflation has declined significantly in recent years, stabilising at a level
1980-81
1982-83
1984-85
1986-87
1988-89
1990-91
1992-93
1994-95
1996-97
1998-99
2000-01
2002-03

of roughly 5%. But the monetary authorities’ success in maintaining

relative price stability going forward will require improvements in fiscal
policies. India’s large fiscal deficit, a legacy of the expansionary fiscal
Source: Annual Report, Reserve Bank of India
policies pursued by the government in the late 1980s, is acknowledged

6
World Development Indicators (2004).
7
World Development Indicators (2004).

6 Economics
May 19, 2005 India Special

to be its Achilles’ heel. Public deficits since then have been very high at Governance indicators*
around 10% of GDP. Control of
India’s poor public finances have placed significant constraints on Corruption
growth. The so-called “development expenditure”, i.e., capital expendi-
ture on areas such as infrastructure that generates high social returns, Rule of Law
has fallen constantly as a percentage of GDP since the early 1990s. At
the same time, non-development expenditure, particularly interest on Regulatory
government debt, has risen continuously (see chart on p. 6). Effectiveness

The government has taken some initial steps toward fiscal consolida- Government
tion. The Fiscal Responsibility and Budget Management Act, passed in Effectiveness
2002, binds fiscal managers to specific deficit targets each year, with a Political
8
goal to bring down total deficit and revenue deficit to 3% and 0% of Stability
GDP, respectively, by 2008/2009. The introduction of the VAT system in
April 2005 is another critical measure expected to contribute to fiscal Voice and
Accountability
consolidation. Finally, a moderate resumption of the privatisation drive
will also provide relief to public finances. 0 2 4 6
Singapore China India
Institutional and regulatory environment: established, but still
inefficient *) The six governance indicators are measured in units
ranging from about -2.5 to 2.5, with higher values
India is a large country, not only with regard to its size but also in terms corresponding to better governance outcomes. Data have
of culture, languages, religions and contrasting convictions. Notwith- been rescaled to 0-5.

standing the country’s heterogeneous society, there is an established Source: World Bank Governance Index 2002
and binding institutional framework, which includes a legal system,
capital market regulators and banking supervisors.
"Obstacles in doing business"
However, the efficiency and efficacy of these institutions leaves much to indicators
be desired. World Bank indicators on governance and on obstacles in
doing business show significant room for improvement in India not only Employment
compared with advanced Asian economies like Singapore, but also in law index*
relation to China (see charts).
For example, India’s rigid labour laws are often criticised as unwieldy. Procedures
Singapore
to enforce a
Firms with more than 100 employees can not easily retrench workers. China
contract
Larger firms and foreign companies resort to elaborate measures to India
circumvent the country’s cumbersome labour laws. Reform proposals Days to
have been long debated but a concrete directive toward a more flexible start a
labour system remains elusive. However, it is likely that, as economic business
liberalisation progresses further, the opportunity (and the pressure) for Number of
change in the institutional framework will arise as well. start up
procedures
II. India’s unique economic development: by-passing
the industrialisation phase? 0
*) High score = very rigid labour laws
50 100

Economic development often follows a sequence whereby the share of Source: World Development Indicators, 2004

the agriculture sector in GDP declines progressively, with offsetting

increases in the shares of the industry and service sectors. As an
economy marches toward maturity, the share of industry in GDP stabi- Changing structure of output as
lises or contracts a little while that of services advances further (see economic development
chart). progresses
80
India’s economic transition, however, has been unusual. It appears to % of GDP 70
have skipped the industrialisation phase and advanced immediately to 60
a services sector-led economy, which now constitutes about 50% of 50
GDP – compared with about 25% five decades ago. The lack of devel- 40
30
opment of India’s industry is mainly explained by the presence of stifling
9 20
regulation, such as the policy of small-scale industry (SSI) reservation 10
0
8
Revenue deficit represents the excess of current expenditures over total revenue. Low-income Middle- High-income
9
When an item is classified as belonging to a SSI, investment in plant and equipment countries income countries
becomes subject to a specific limit. As a consequence, firms that produce these items countries
are inhibited from achieving economies of scale and greater efficiency, thus reducing
Agriculture Industry Services
their competitiveness. While the number of reserved items categorised under the SSI
Source: World Development Indicators, 2004

Economics 7
 India Special May 19, 2005

and the inflexible labour laws. The agricultural sector’s share of GDP,
meanwhile, declined to roughly 23% in FY 2003/2004 from just below A services-led economy
60% in 1951.
1983
What makes India’s development even more unusual is the relatively Services
constant share of employment in each sector. The agricultural sector
still employs the majority of the workforce, comprising 60% of the total.
The services sector, on the other hand, employs just 25% of the total
labour supply (see charts). This phenomenon also partly explains why Industry % of labour force
urbanisation has been slow to develop. % of GDP
The IMF points to the critical role which economic liberalisation and a
growing demand for services exports in the 1990s played in increasing
10 Agriculture
the services sector’s dominance in GDP.
Surprisingly, IT represents a small fraction (less than 5%) of the ser-
vices sector. The most prominent sub-sectors which have grown rapidly 0 20 40 60 80
as a result of economic liberalisation, are business services (which
includes IT but as a minor percentage), communications and banking.
2000
However, given India’s availability of a high-skilled workforce in IT- Services
related areas, it is likely that this sub-sector will grow substantially as a
share of total services.
% of labour force
The question arises whether India can do without a sizeable manufac- % of GDP
Industry
turing sector. We think not. Manufacturing would provide India with a
needed source of sustainable growth, and would contribute to further
reducing poverty. A key pre-requisite for the future expansion of manu-
facturing activities in India is the improvement of the skills of the rural Agriculture
population. Combined with further liberalisation in agriculture, a more
educated rural population will find it easy to move from farming to more
productive areas. At the same time, this process should help to boost 0 20 40 60 80
rural incomes, thus generating demand for the manufacturing sector. Source: Reserve Bank of India, Ministry of Finance
By developing its industry, India would become more like its Asian
counterparts, whose economic growth over the past two decades has
evolved hand-in-hand with increased industrialisation (see chart). The Industrialisation has room to
transition from agricultural to industrial employment would also be in- catch-up
strumental in the path toward greater urbanisation, which the govern-
ment projects will increase to 40% from the current level of 28%. China

III. India’s growth potential: DB Research’s foresight

ASEAN-4*
model for growth11
Population growth, fixed capital investment, human capital and open- Low & mid
ness are the four drivers in our proprietary model for long-term GDP income
% change in
forecasts. The model approach leads to an average growth rate of total countries**
manufacturing
GDP of 5.5% per year for the period 2006-20. value-added,
India 1990-2000
Our analytical framework is theoretically based and is extended by
using human capital as a measure of the quality of labour input and
trade openness to capture institutional efficiency. These two variables 0 100 200 300
allow us to explicitly and comprehensively model technological pro- *) Indonesia, Malaysia, Philippines, Thailand
**) As classified in World Development Indicators, 2004
gress. This contrasts with growth accounting calculations, which arbi-
trarily assume convergence of per capita income levels without provid- Source: World Development Indicators, 2004

ing a fundamental explanation for the advance in technology.

To estimate a reliable model for long-run growth in India, we take the
experience of other countries into account, but still allow for country-
specific business cycles. We run a panel estimation with the “pooled
mean group” technique to quantify the linkages between real per capita

fell following the reforms in the 1990s, the number of reserved items at roughly over
400 is still significant.
10
Rodrik and Subramanian (2004).
11
This section was contributed by Stefan Bergheim.

8 Economics
May 13, 2005 India Special

GDP and the four fundamental drivers of growth, taking account of the Growth scenarios for India
information in the time series. 6
The model’s forecasts for the four growth drivers stem from a three- GDP per capita
USD, '000 (PPP) "Indian tiger"
stage approach. Extrapolation of their trajectories of the past 20 years is 5
the starting point. The exception is population growth, where we use the
UN’s forecasts. The second stage takes information from levels and
changes in other countries into account to dampen excessive move- "Measured pace of
4
reforms"
ments in the trajectories generated in the first stage. The third and most
important stage captures structural breaks through a broad-based
country-specific assessment of six clusters of trends in politics, society, 3
business and technology – based on the country expert’s assess- "Reform holdup"
12
ment. For example, DBR expects India to increasingly seize the op- 2
portunities offered by globalisation, and this is reflected in the trend

2002

2004

2006

2008

2010

2012

2014

2016

2018

2020
called “Global networking in business in economics”.
DBR’s model yields an annual per capita GDP growth of 3.9% and total
GDP growth of 5.5% on average in 2006-20 in the baseline outlook. Changes in income
Since the model is not equipped to take into account factors such as distribution: Urban
the high social return from expected investment in infrastructure, we 70
believe that growth is likely to be higher than the baseline, i.e., in the 60 % population
vicinity of 6%. 1992-93
50
1998-99
IV. Alternative scenarios 40
30
The growth path depicted above is our most likely scenario (with a
probability of about 60%), based on the expected trajectory for the 20
growth drivers and the course of policies. We call this scenario “meas- 10
ured pace of reforms”. Of course, it is conceivable that the pace of pol- 0
icy reform will be different – either faster or slower – than we currently <=35 36-70 71-105 106-140 >140
expect. Therefore, we have devised two alternative scenarios. (L) (LM) (M) (UM) (H)
Annual income (INR, '000)
Upside scenario: “Indian Tiger” (p = 30%)
Under this scenario, the government’s approach to liberalising the Rural
70
economy is much more aggressive than at present, and implementation
60 1992-93
of reforms is deeper and more rapid in spite of occasional opposition
50 1998-99
from other political parties. In particular, privatisation resumes at a simi-
lar pace as in FY 2003/2004. Privatisation revenues support the gov- 40
ernment’s drive to narrow its revenue deficit. Liberalisation in sectors of 30
the economy which had remained closed so far attracts larger inflows of 20
foreign direct investment. The government invests strongly in the agri- 10
% population
cultural sector in order to reduce the country’s dependence on the va- 0
garies of the monsoon. Social tensions arising from the widening in- <=35 36-70 71-105 106-140 >140
come disparities between rich and poor are kept in check by the gov- (L) (LM) (M) (UM) (H)
ernment within the parameters of the “Common Minimum Pro- Annual income (INR, '000)
13
gramme” , without affecting the investment climate or jeopardising the
fiscal consolidation process. All-India
70
Under this scenario, the economy grows at an average rate of 7.5% 60
% population
over the next 10-15 years. This growth rate is close to – albeit still be-
50 1992-93
low – the government’s own long-term target of 8.5% to 9%, as denoted
14 40 1998-99
in its document “India Vision 2020”.
30
Downside scenario: “Reform holdup” (p = 10%) 20
10
Under this scenario, economic liberalisation policies are held back by
0
frequent and protracted resistance to economic reforms. The fiscal
<=35 36-70 71-105 106-140 >140
(L) (LM) (M) (UM) (H)
Annual income (INR, '000)
12
“The trends that will shape future growth” on DBR’s website provides a map of these
trends. L=Low; LM=Lower middle; M=middle;
13
The Common Minimum Programme (CMP) is a blueprint of the government’s UM=Upper middle; H=High
economic and social goals that emphasises empowering the poor and rural areas. Source: National Council of Applied Economic Research
14
India Planning Commision (2000).

Economics 9
 India Special May 19, 2005

deficit worsens further, arising from increases in subsidies, the failure to

rationalise tax collection and the inability to divest ailing publicly-owned
companies. The government may be compelled to re-capitalise some of
these companies, thus denting further its goal to rein in the fiscal deficit.
Investor confidence is adversely affected, with foreign direct investment
failing to pick up. Agriculture remains dependent on the vagaries of the
monsoon given inadequate public investment in the sector. In this sce-
nario, real economic activity slows to an average of around 4.0% in
2006-2020. This growth rate, while quite respectable in an international
comparison, is very close to the paltry (by Indian standards) “Hindu rate
of growth” of the 50s and the 60s, and is insufficient to generate much
of an improvement in the standard of living of the Indian population.

V. Expected growth changes in consumption and

savings patterns
India’s projected growth trajectory, together with demographic de-
velopments, will have a critical influence on consumption and sav- India's household consumption
ings patterns in the next few years. bundle in 2002 …

A larger, richer market

If our expectations are fulfilled, the size of the Indian economy (meas-
ured in USD at PPP) will almost triple between 2002 and 2020. Thus, it
will become equivalent to 40% of the US economy and 3 times the size
of the German economy in 2020, compared with 27% and 1.3 times,
respectively, in 2002. Food Transport & comm
Not only will the market be much larger, it will also be much richer. GDP Healthcare Others
per capita will more than double in the period, from USD 2,300 in 2002
(in USD at PPP) to almost USD 5,000 in 2020, not very different from a Source: Reserve Bank of India

middle-income Asian country like Thailand today.

This substantial rise in per capita income, coupled with the sheer size of … and in 2020?
the Indian population, will give a tremendous impulse to the rise of a
mass-consumption market.
Moreover, due to structural changes in income distribution that have
occurred over the past decade, a sizeable fraction of the poorest seg-
ments of the population has migrated to a higher income class, implying
a larger potential consumption capacity. Not surprisingly, this effect has
been more pronounced in urban than in rural areas. There, in a matter
of six years, the share of the population classified as “low income” de- Food Transport & comm
clined by half, while the proportion in the “upper middle” and “high” Healthcare Others
classes increased significantly (see charts, p. 9).

India’s changing consumer bundle

Engel’s Law predicts that as income rises, the share of food in individ-
ual consumption baskets declines, while that of non-food goods in-
crease. This has certainly been the case in India so far: Spending on
Life-cycle hypothesis
food as a percentage of real household consumption dropped from
about 66% in 1950 to 45% in 2002. Transportation and communication Income, consumption
expenditures, on the contrary, experienced a sharp increase from Debt
around 2.8% of household consumption in 1950 to about 16% recently. accumulation
Dissaving
This trend is expected to continue. Taking Thailand as proxy for a coun-
try with a per capita income similar to that expected for India in 2020, Saving
the proportion of food in India’s consumption bundle could decline to
around 30% over the next 10-15 years, while transport and communi-
cation and healthcare could rise to 28% and 12%, respectively. Of
Retirement
course, the rise in the former category is related to the progress in Working yrs.
yrs.
building an adequate infrastructure network. Regarding healthcare
spending, the significant increase should be driven by, first, a population Youth yrs. Time
whose life expectancy is expected to rise further, and, second, lifestyle

10 Economics
May 19, 2005 India Special

changes – stemming from improved consciousness about health and

well-being – which are associated with higher per capita income.

Growing household savings

The young structure of the Indian population means that a huge cohort
will enter the working years phase in the next decade or so. The size of Household financial investment
this group has been estimated at 40% of India’s population, or 266m (2003)
15
people. According to the life-cycle hypothesis , this should bring about Shares &
a very sizeable increase in household savings (see chart). Taking the debentures,
Cash,
past five years as reference, household savings could pick up to at Claims 2%
10%
16 on govt
least 30% of GDP by 2020 from the current level of 22.6%.
18%
Thus far, investments made by households have characteristically been
conservative and poorly diversified. Of the household domestic savings
in 2002, roughly 54% of the total went into physical assets, while the Provident
balance was invested in financial instruments. The lion’s share of the & pension
fund,
latter was accounted for by bank deposits, followed at a distance by
13%
government bonds. Investment in equities, either through direct owner-
ship or via mutual fund purchases, was muted (see chart). However,
Bank
recent trends indicate growing ownership – albeit at a gradual pace – of
deposits
mutual funds by households, suggesting their willingness to venture Life insurance 42%
into other asset classes that offer higher expected returns in the future. fund, 15%
Given India’s relatively young population, a lower risk aversion leading Source: Reserve Bank of India
to increasing demand for non-traditional investment products is to be
expected. Adding to that a rising income level for this population group,
and a defined-contribution pension reform in the making, the scope for Security environment: legislation
expansion in investment services appears large going forward. in place
IN CN PH
VI. Outlook for selected industries
Copyright
Besides the already booming IT sector, we expect the textile, auto- Patent
mobile, pharmaceutical and banking industries to benefit from In-
Digital signatures
dia’s further market deregulation and internationalisation.
Hacking
Business Process Outsourcing (BPO) Privacy
India has become a major hub for outsourcing of IT-based business Data protection 1)
processes. Global demand is driven by multinational firms’ bid to cut Vertical spec. law
operating and production costs to maintain their competitiveness. India 1) Data protection law at a draft stage.
supplies a wealth of technical and engineering skills at competitive Source: NASSCOM
costs. The country’s other clear advantages are friendly government
policies for IT exports, an English-speaking environment and good
quality-control systems. Its security and privacy laws also appear ahead
of those of its major competitors in the region (see table).
Export revenues from the BPO sector rose 40% yoy in FY 2003/2004,
from USD 2.5 bn in FY 2002/2003 to roughly USD 3.6 bn. The US is by
far the biggest market for India’s BPO industry, representing 80% of the
business. However, this could start to change if, as increasingly feared,
US legislation limits US firms’ ability to outsource their business activi-
ties. This could be balanced, however, by new markets such as Europe,
where the big Indian IT companies have started to make inroads.

Textiles
DB Research expects India to emerge as one of the winners of the
17
textile trade quota expiry in December 2004. In the years prior, the
Agreement on Textiles and Clothing (ATC), along with the preferential
treatment agreements, restricted the exports of many Asian clothing

15
Modigliani & Brumberg (1954).
16
For a similar projection see Sanyal (2004).
17
Heymann (2005).

Economics 11
 India Special May 19, 2005

manufacturers to the US and EU. India had by far the highest export tax
equivalent for its trade with the US and EU (see chart). The removal of Export tax equivalents of quotas
the quota system will likely unleash significant potential for India to in- in clothing trading
crease its exports to the major developed markets.
IN
India’s strengths include a rich availability of inputs such as a large
CN
labour force, low-cost production and manufacturing of raw materials
(e.g. cotton and yarn). However, the surge of the industry is likely to be TH
gradual, particularly compared with China, which will emerge as the HK
main beneficiary of the end to textile quotas. This is explained by LK
China’s better infrastructure, which allows higher production and oper- BD
USA
ating efficiency, and more open export policies. Notwithstanding, as EU-15
ID
manufacturers will seek to diversify their import sources, India will cer-
tainly benefit. With expectations of further economic liberalisation, India PH
is expected to emerge as a highly competitive supplier of textiles and VN
clothing in the near future. HU
PL
Auto-ancillary industry
TR %
India’s auto-ancillary sector is becoming rapidly integrated into the
global industry. Outsourcing of production by large auto-component 0 10 20 30 40
manufacturers to India is expected to increase further as they seek to Source: WTO (model calculation using 1997 as base year)

cut costs. India’s advantages also include high engineering skill levels
and established production plants.
A recent report showed that this sector could grow to between USD 33
bn and USD 40 bn by 2015, from USD 6.7 bn in 2003, while exports
have the potential to soar from USD 1 bn in 2003 to between USD 20
18
bn and USD 25 bn by 2015. While these may still be relatively small
amounts considering a global industry size worth USD 700 bn, they
nonetheless reveal that India is capable of capturing broader pieces of
the pie over time. The key challenges ahead include quality upgrading
and dismantling of unfavourable government policies. Increasing joint
ventures between Indian companies and international players should
contribute to improving their efficiency, operation and technology.

Pharmaceuticals
The Indian pharmaceutical sector may be entering a paradigm shift as it
has just started implementing a new product patent regime. The new
patent law effectively puts an end to Indian pharmaceutical companies’
practice of reverse-engineering the production of patented drugs. This
is expected to significantly increase multinational drug companies’ pro-
duction in India.
At the same time, despite the implementation of the patent regime, Credit to GDP: Financial
India is expected to maintain its place among the top global producers deepening beckons
of generic drugs, due to the country’s cost advantages and its availabil- 160
ity of high-skilled scientists. With an estimated USD 55 to 65 bn worth 2003, %
140
19
of drugs expected to go off-patent within the next 2 to 3 years , India
120
could potentially capture a good size of this.
100
Financial industry 80
The financial sector, in particular banks, plays an essential role in eco- 60
nomic development since it facilitates the intermediation between sav- 40
ings and investment, thus fostering economic growth. As discussed in 20
the previous section, Indian banks have been the main recipient of 0
household savings. However, they have not performed well in mobilis-
India Korea Thailand Malaysia
ing these funds into loans, as evidenced by a very low ratio of credit to
Source: World Development Indicators, 2005
GDP (see chart). Instead, a big portion of banks’ assets (25%) is in-

18
McKinsey & Co. (2004).
19
Ernst & Young (2004).

12 Economics
May 19, 2005 India Special

vested in domestic government bonds. This is expected to change,

however, as the financial sector embarks upon far-reaching reforms in
the coming years by allowing further participation of foreign investors,
for example.
Equally, the transformation of India’s financial sector calls for further
strengthening of its regulatory standards. The country’s regulatory bod-
ies – the Reserve Board of India, Securities and Exchange Board of
India and Insurance Regulation and Development Agency – need to
work in concert to, among other things, improve corporate governance
and promote minority shareholders’ rights. The increase in capital mar-
ket investment also requires the implementation and enforcement of
20
widely accepted standards such as the “Prudent Man Rule”.
The landscape of India’s banking sector is expected to change gradu-
ally, on the heels of the two-phase roadmap for reform presented by the
Reserve Bank of India (RBI) recently. Currently, India’s banking system
remains dominated by public sector banks (roughly 70% of total bank-
ing assets are in government-owned banks) with still relatively low par-
ticipation of foreign banks (about 10% of total assets).The first phase of
the roadmap, in place already, is likely to usher in consolidation in do-
mestic public and private banks. It allows for the relaxation of several
regulations for foreign banks, such as limits on expansion of their
branches. Moreover, foreign bank acquisition of local private banks
identified by the RBI as “in need of restructuring” is now permitted, sub-
ject to a 74% cap. The second phase of the roadmap, which will com-
mence in 2009, will allow foreign bank ownership of any local private
bank, within an overall limit of 74%.
The merits of greater foreign bank participation include technological
and management skills transfer and improved efficiency. In India, fur-
ther improvements in risk management are of the essence. One area of
concern is the continued existence of government-directed lending to
the so-called “priority sectors”, which originate about half of the bad
21
loans in the banking sector.
Additionally, the anticipated rise in household savings depicted above
will call for greater efficiencies in the banking system to meet the pub-
lic’s changing investment appetite. Banking sector reform, including the
participation of foreign banks, will adequately prepare the system to
meet this challenge.

Conclusion
India’s growth potential over the next 10-15 years sets the country at
the forefront of the developed and developing world. We expect that,
building on the country’s favourable demographics and sizeable talent
pool, the continuation of the reforms initiated over one decade ago will
unleash that potential and bring India to a more advanced stage of
development. There will certainly be obstacles along the way, but we
believe that the integration of India into the global economy and the
ensuing transformation of the country are here to stay. The pace of this
transformation will ultimately depend on the will of the Indian population
and the vision of its leadership.
Author: Jennifer Asuncion-Mund, +49 69 910-31714
(jennifer.mund@db.com)

20
The Prudent Man Rule states that “a fiduciary shall exercise the judgment and care,
under the circumstances then prevailing, which men of prudence, character and intel-
ligence exercise in the management of their own affairs, not in regard to speculation
but in regard to the permanent disposition of their funds, considering the probable in-
come as well as the probable safety of their capital.” [Association of Investment Man-
agement and Research, 1999.]
21
Asian Development Bank (2004).

Economics 13
 India Special May 19, 2005

Appendix: Selected foreign direct investment guidelines

Sector Cap ( %) Specifics

Infrastructure
Roads, h'ways, ports, harbours 100 Automatic route available*.
Telecom 49 For basic, cellular, value added services, subject to licensing requirements, and a
lock-in period for transfer of equity. 2004/05 budget proposed raising it to 74 per
cent; however, this is not yet operational.
100 For e-mail, voice mail, ISPs not providing gateways.
Restrictions include licensing, FDI beyond 49 per cent needs approval from FIPB,
and divestiture of 26 per cent in 5 years.
74 For ISPs with gateways, radio-paging and end-to-end bandwidth.
FDI beyond 49 per cent needs approval from Foreign Investment Promotion Board
(FIPB).
Other sectors
Agriculture 0 No FDI is permitted, with some exceptions.
100 Tea, including tea plantations. Restrictions apply, including approval from
government, divestiture of 26 per cent in five years, and approval in case of change
in land use.
Atomic minerals 74 For sub sectors, mining, separation, value addition and integrated activities.
Broadcasting 100 In TV software production.
49 In cable networks, direct to home.
Coal and lignite 100 For most activities in this sector.
74 For coal exploration or mining.
Defense and strategic industries 26 Automatic route not available. Subject to licensing and security requirements.
Domestic airlines 49 Automatic route not available. Subject to no direct or indirect equity participation by
foreign airlines.
Financial: Private 74 In the 2005/2006 Budget, foreign banks have been allowed to operate in India
sector banking through branch, wholly-owned subsidiary or subsidiary with aggregate foreign
investment up to a maximum of 74 per cent in a private bank, "identified by RBI for
restructuring".
Starting April 2009, foreign banks will be allowed to acquire up to 74 per cent in any
private sector bank in India.
Financial: Non-bank 100 Various minimum capitalisation norms for fund-based NBFCs.
financial companies
Financial: Insurance 26 Automatic route available, subject to obtaining license from the regulatory body.
2004/05 budget proposed raising it to 49 per cent; however, this is not yet
operational.
Housing and real estate 100 Applies to the development of integrated townships, with prior government approval.
No FDI allowed in other real estate subsector.
Mining 74 Automatic route available in the exploration and mining of diamonds and precious
stones.
100 Automatic route available in the exploration and mining of gold, silver and other
metals.
Petroleum (refining) 26 Cap applies to public sector units. Automatic route not available.
100 Cap applies to private Indian companies. Automatic route available.
Petroleum (other than refining) 100 Automatic route available. FDI of 100 per cent is possible in oil exploration in small-
and medium-size fields, petroleum product marketing, natural gas/LPG (approval
required).
Postal services 100 FDI of 100 per cent in courier services, with prior approval. No FDI allowed in the
distribution of letters.
Print media 100 Automatic route not available. FDI allowed in publishing/printing scientific and
technical magazines, periodics and journals.
26 In newspapers and periodicals dealing with current events, subject to editorial
control by Indian residents.
Trading 51 Automatic route available. Meant for export activities.
Venture capital Sectoral Automatic route available. Subject to Securities Exchange Board and Investments
caps apply (SEBI).
* FDI automatic route does not require prior approval from the Reserve Bank of India.

Source: India Article IV Report, March 2005, Reserve Bank of India

14 Economics
May 19, 2005 India Special

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Economics 15
 Current Issues Availab
le faste
r
by e-m
Global growth centres ail!!!

Substantiated, long-run growth forecasts are back in the limelight following the New Economy euphoria
and the emerging market crises over the past 10 years. Deutsche Bank Research uses an innovative
combination of modern growth theory, state-of-the-art quantitative techniques and systematic trend
analysis to analyse the long-run growth perspectives of 34 economies. We identify growth stars, explain
the reasons for their success and derive conclusions for companies, investors and policy-makers.

Global growth centres 2020: “Formel-G“ for 34

economies

With this introductory publication, Deutsche Bank

Research launches its new megatopic “Global
growth centres“. With the help of “Formel-G“
(Foresight Model for Evaluating Long-term
Growth), we identify the sources of economic
long-term growth and generate forecasts for 34
economies until 2020. India, Malaysia and China
will post the highest GDP growth rates over 2006-
2020 according to our “Formel-G“ approach.
Strong population growth, a rapid improvement in
human capital and increasing trade with other
countries allow average GDP growth of more than
5% per year in these three countries. Ireland, the
USA and Spain are the OECD economies
expected to grow most quickly.

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