taj-mahal-in-page

The election of Prime Minister Narendra Modi in a landslide victory last year may have marked the beginning of an important new chapter for India. The Bharatiya Janata Party (BJP) won a majority in the lower house, a first in over 30 years. Modi is widely regarded as a solid, pro-business leader with an impressive track record.

A year later, encouraging signs are emerging. Economic growth appears to be accelerating when most other emerging economies are cooling, as the Modi government successfully advances its reform agenda. Meanwhile, lower oil prices have helped reduce inflation and India’s current account deficit.

This focus article looks at the key initiatives and reforms proposed so far. While Modi’s commitment to eliminate corruption and accelerate short-term growth is generally well appreciated, most of the benefits from proposed reforms will likely take years to materialize. India has the potential to lead emerging economies by generating strong, sustainable growth for years to come. But, there are risks to this story.

Background: obvious potential, but a few false starts

India benefits from a very large, young, and entrepreneurial working-age population. GDP per capita is less than 25% of China’s, leaving plenty of room for catch-up. Yet over the past decade, the Indian economy has struggled to live up to this potential. The need for reform became increasingly evident as protectionism and bureaucracy held back growth.

India has experienced a fall in investments over the past few years. The lack of infrastructure has long presented a roadblock to stronger growth, yet many large-scale projects were cancelled as bureaucracy and corruption made permitting challenging.

The previous government introduced several worthwhile initiatives over the years, but rarely delivered as it faced several corruption scandals. Meanwhile, loose monetary policy from the Reserve Bank of India (RBI) combined with fiscal stimulus pushed inflation to uncomfortably high levels. The rupee fell precipitously, the Indian stock market retreated, foreign capital was withdrawn, and the country’s fiscal and current account deficits widened considerably.

Introducing “modinomics”

Modi’s election victory was attributed to two major factors:

  • Strong Desire for Change: The prior government, Indian National Congress (in an alliance with the United Progressive Alliance), was plagued by corruption and failed to deliver on many of its promises. The broad popular support for Modi in a country characterized by considerable diversity in religious practices reflects widespread frustration with the previous regime and strong desire for change.
  • Modi’s Proven Track Record: Modi had been the chief minister of Gujarat, one of India’s 26 states. Under his leadership, Gujarat experienced significant improvements in infrastructure, a boost in foreign investment, industrial expansion, and GDP growth twice that of the national average.

A closer look at key initiatives

Typically, when a country transitions from a low-income to middle-income economy, the industrial sector expands faster than the agricultural and services sectors. However, in India’s case, the industrials sector’s contribution to total GDP has been stagnant at about 15% for over three decades. Meanwhile, India’s relatively high education standards and the widespread use of English led to stronger growth in the services sector, which has contributed significantly to GDP growth. Employment growth, however, has lagged given the services sector’s lower labour intensity relative to the industrial sector. As the Indian economy continues to expand, the country will need to focus on the development of its industrial base in order to provide jobs for a fast-growing working-age population. Modi is pushing forward a number of initiatives to address the issue: 

  • The “Make in India” Campaign: This campaign was launched with the goal of positioning India as a manufacturing hub. The Delhi-Mumbai Industrial Corridor (DMIC) is slated for development as a global manufacturing and investment destination. The goal is to increase manufacturing’s share of GDP to 25% from 15% by creating sustainable smart cities where manufacturing will be the key economic driver. This initiative should also have a positive ripple effect on the industrials, telecom, IT, retail, and health care sectors. The campaign looks to create 100 million new manufacturing jobs by 2022.
Manufacturing PMI: Liftoff

Source - RBC Dominion Securities, Bloomberg

Leading indicators remain supportive and indicative of the India growth story..

  • Simplification of Taxes for Foreign and Domestic Business Investments: The 2015 budget cut the corporate tax rate to 25% from 30% over four years while eliminating some more targeted incentives.
  • The “Pradhan Mantri Jan-Dhan Yojana” (Prime Minister’s People Money Scheme): Only 35% of India’s adult population held bank accounts at the end of 2013, while an even smaller percentage used banks for financial transactions on a regular basis. The Jan-Dhan Yojana program has resulted in the opening of over 100 million new bank accounts so far. This, along with the national identity card campaign known as Adhaar launched by the earlier government, should prevent leakage of subsidies to ghost beneficiaries by allowing the dissemination of public subsidies only to those entitled to receive them.
  • Developing “Smart Cities”: Over the past decade, per-capita GDP grew four times faster in urban areas relative to rural India, where approximately 30% of the population still lives below the poverty line. As part of the smart cities initiative, 100 smart cities and satellite towns are expected to be built around existing cities over the next few decades, which should help accelerate rural to urban migration. For 2015, $1.2B in government funding has been allocated to this initiative, with a focus on completing the first three smart cities. They make extensive use of technology to avoid some of the problems residents of large cities often face due to poor planning and maintenance. The focus will be on transportation, IT, communication, infrastructure, health care, and education.
  • National Optical Fibre Network (NOFN): In 2011, the Indian government committed $17B to the rollout of a national optical fibre network and the digitization of 250,000 villages, designed to accelerate the socioeconomic development of rural areas by connecting 600 million people.
The Indian government committed $17B to the rollout of a national optical bre network connecting 600 million people.

Strong new leadership at the Reserve Bank of India

In September 2013, Raghuram Rajan became governor of the Reserve Bank of India (RBI). He was previously chief economic adviser to India’s ministry of finance and also chief economist at the International Monetary Fund (IMF) from 2003 to 2007. He has promoted sustainable growth by tackling high inflation and driving real interest rates into positive territory. Rajan announced a number of measures to reduce volatility, improve investor confidence, and increase investment inflows as soon as he was nominated and appears to have successfully restored credibility, controlled inflation, and stabilized the rupee.

Inflationary pressure easing, recent rate cut should fuel growth 

A positive real deposit interest rate (the difference between rates paid on deposits and the rate of inflation) is generally a positive economic driver. However, because of high inflation rates, India in the past struggled with deeply negative real rates. 

Indian Inflation

Source - RBC Dominion Securities, Bloomberg

India inflation has declined rapidly and appears well- contained.

Interest Rate Differential Spread

Source - RBC Dominion Securities, Bloomberg

A positive interest rate differential spread buffers emerging market economies such as India from U.S. rate hikes.

More recently, the key drivers of inflation—rural wage growth, government spending, and global commodity prices—have rapidly moved in the right direction allowing the emergence of positive real rates across the board. Real deposit rates have been positive since January 2014, and currently stand at about 3.5%.

Falling oil prices (oil accounts for one-third of India’s imports) helped contain inflation and allowed Rajan to cut repo rates by 125 basis points to 6.75%. Fuel subsidies for households and a large import bill mean that a decline in oil prices reduces the trade and fiscal deficits for the country. The decline in rates should help support domestic demand and GDP growth.

Longer-term growth potential

Indian GDP has grown at 7.6% per annum over the past decade. The new government’s focus on tackling infrastructure bottlenecks, accelerating urbanization, and invigorating the manufacturing sector could potentially push growth closer to double digits.

India’s population is comparable to China’s (1.25 billion vs. 1.35 billion), yet GDP per capita is only $1,500 compared to China’s $6,800. India’s demographics are particularly encouraging, as more than 50% of the country’s population is under the age of 25 and two-thirds is under 35. By 2020, the average age in India is expected to be 29 years compared to 37 for China (see below chart).

India’s Population

Source - RBC Dominion Securities, CIA World Factbook

India will soon surpass China as the most populous country in the world with the bene t of a relatively younger working-age population.

Key risks

Political Stability: BJP is a one-man show and, while the Prime Minister has surrounded himself with individuals who helped him build Gujarat into a progressive state, quite a bit rests on Modi’s shoulders and on his ability to deliver. While BJP is in a fairly comfortable position now, as opposition parties appear to be floundering, their re-emergence over the next four years cannot be ruled out, in our view.

Rebound in Oil Prices: Low fuel prices have helped solve India’s inflation and deficit problems. A stronger-than-expected rebound in oil prices could represent a headwind.

U.S. Monetary Policy: All else equal, lower rates in the U.S. are better for capital flows into India. India’s aforementioned positive real rate of interest (currently about 3.5%) offers an attractive alternative in a world that is generally plagued by low rates. While the current level of real rates in India offers a buffer against U.S. rate hikes, capital flows to India could begin to slow should U.S. rates rise sharply in the coming years.

India’s Sensex Index has rallied almost 30% over the past two years.

An investment story with “legs”

The stars may have aligned for India. The combination of a pro-business prime minister pushing for structural reform, an RBI governor keen on fostering pro-growth policies, and lower oil prices should help unleash some of the country’s enormous economic potential. In a fast-growing economy, there is a tendency to take greater risks and amass debt. However, at this juncture, we believe that the benefits of increased investment in the country outweigh the risks.


It may take some time for the proposed reforms to yield the expected acceleration in economic growth and, ultimately, stronger earnings growth for Indian companies. India’s Sensex Index has rallied almost 30% over the past two years, pushing valuation to just over 17 times consensus forward earnings. Valuations still seem reasonable given what we believe is a multiyear opportunity ahead, yet patience is likely to be required and the political situation should be monitored closely.


Required disclosures
Research resources