India: On the Rise?

The best-performing stock market in the world during the second quarter was India even outpacing Japan's solid performance. Stocks headquartered in India make up 14% of the MSCI Emerging Market Index, the largest share of any country other than China and Taiwan.

There are several reasons why India has become increasingly important to the global economy and markets:

• India's economy is now the world's fifth biggest, recently surpassing the United Kingdom. India's GDP is expected by economists to grow faster than 6% in each of the next three years, compared to the U.S., which is expected to grow less than 2%. The International Monetary Fund forecasts India to be the third-largest economy by the end of the decade, overtaking both Japan and Germany.
• India's population is set to surpass China's this year according to the United Nations, which has predicted India will end 2023 with 1.429 billion people. China is forecasted to end the year with 1.426 billion. Thirty years of a "one child" policy in China and the high cost of raising children has resulted in the fertility rate falling to 1.2 births per woman in China, while India's rate is 2.0 births per woman.

• India has the world's largest democracy, with a capitalist economy and the world's most popular leader, Prime Minister Modi. As the world looks to "de-risk" supply chains in Asia, some are looking to India. Demonstrating the desire to work with India on their shared goals, President Biden threw a formal banquet for Modi at the White House and the leaders of Congress invited him to address a joint session in early June.

For decades, foreign companies invested in China setting up factories while India's manufacturing sector lagged. India did not follow China's development approach of restricting outbound capital flows and directing excess domestic savings towards infrastructure and foreign exchange reserves. Rather, India has been subject to swings in capital flows and regulatory land-use restrictions that have hindered infrastructure development.  Currency volatility forced India's central bank to try to offset the impact of irregular capital flows with aggressive hikes and cuts to defend the currency. Currently, India may be seeing positive momentum on these issues of infrastructure and currency that may help spur growth momentum in manufacturing.

• India is making changes to increase its attractiveness as a manufacturing base. India is known for IT outsourcing, but the sector only employs a small fraction of the workforce. The pandemic highlighted the supply chain risks of concentrated manufacturing bases in Asia, and western policymakers desire to "de-risk" Asian supply chains may mean a shift to India. Modi's government is making efforts to attract companies by offering incentives for producing in India, easing regulatory burdens and investing billions of dollars in improving the country's infrastructure. It is showing some signs of success. For example, Apple is expected to move some iPhone manufacturing to India.
• India's currency may become less volatile through the purchase of Russian oil. India may be less prone to capital outflows as Russia receives rupees in exchange for oil exports to the country. Should the trade relationship become longer lasting, Russia may avoid converting the rupees into western government bonds and instead hold them in Indian government bonds used to fund India's massive infrastructure needs. This should lead to capital inflows and a stronger rupee, which would be a powerful combination that may lower long-term rates in India, supporting stocks and real estate values and potentially contribute to greater stability in India's monetary policy.
• India is benefiting from cheap energy, a critical manufacturing input. India's purchases of Russian oil, coal, and other energy products since the war began in Ukraine offer a cost advantage to manufacturing.

India's positive momentum faces some risks for investors.

• India's path to becoming a manufacturing powerhouse is not easy. India is challenged with lower productivity, labor-skills mismatch, inconsistent manufacturing quality, poor infrastructure, complicated investment rules, labor and land-use regulations. In contrast to India, China's government takes quick and decisive action with little political opposition in the way.
• Climate could pose a challenge to India's growth. This past June, temperatures in India soared as high as 115˚ F, part of an increasing pattern of intense heat waves in the country over the past decade. The World Bank has flagged India as likely to be one of the first places in the world where heat waves breach the human survivability threshold. The potential for increasingly intense heatwaves poses a risk to lives, agriculture, manufacturing, and political stability.
• India's stocks are typically expensive but are even more so now. India has a unique growth story relative to the emerging-market (EM) universe, as it has been more domestically focused than other Asian economies. Its young demographic and small manufacturing share of GDP gives it a runway for growth and as a result, its stocks tend to trade at a premium to the EM universe. However, Indian stocks are currently even more expensive than their longer-term average and a larger premium to the EM universe than usual.

India's growth momentum may carry it to the top three global economies in size before the end of the decade, if it is able to capitalize on its transformative initiatives. It will take time for companies to evaluate if they are able to achieve the quality and reliable manufacturing needed to open and maintain operations in the country. India's stocks are expensive, perhaps already pricing in high expectations. Holding a broad mix of exposure to emerging markets includes meaningful exposure to Indias growth, but also diversification to help insulate from its risks.

Michelle Gibley, CFA^®, Director of International Research, and Heather O'Leary, Senior Global Investment Research Analyst, contributed to this report.