Why Are Private Equity Firms Looking Hard at India? Ask Warburg Pincus

Why Are Private Equity Firms Looking Hard at India? Ask Warburg Pincus


In March, when the international private equity firm Warburg Pincus sold a $560 million stake in Bharti Tele-Ventures, India's largest publicly traded mobile telephony company, it created a sensation both in that country and among private-equity investors around the world. The transaction, on the Bombay Stock Exchange, was the largest block trade ever on the Indian market. It was also consummated in a breathtaking 28 minutes, prompting stock market observers in India to remark on the unexpected depth and maturity of their equity markets.


Private equity investors marveled at the profitability of the investment -- in a market that was in its infancy barely a decade ago. Money from U.S. private equity investors was going to Asia back then, but it was to destinations such as Indonesia and Thailand. India did not figure in most investors' definitions of "Asia" -- or at least not in any major way. The March transaction was the largest of a series of retrenchments, over several months, that saw Warburg reduce its 18.5% stake in Bharti to about 6%.


Warburg, which invested nearly $300 million in Bharti between 1999 and 2001, walked away with a profit of $800 million from selling two-thirds of its holdings. At Bharti's current share prices, Warburg's remaining 6% stake in the company is worth some $700 million, or more than twice what it originally invested. Bharti, which trails privately held Reliance Infocomm, had a sallow $100 million market capitalization when Warburg entered the scene. It now has a market capitalization of $15 billion. In 1999, Bharti had 104,000 subscribers. It now has 14 million.


So is the Bharti deal the tip of the iceberg or, alas, the entire iceberg? Two Warburg veterans at the center of the firm's activities in India from its inception in 1994 are emphatic that the Indian story is no one-deal wonder.


India has done well by Warburg, generating returns in "the mid-30s over 10 years," the firm's co-president, Charles R. Kaye, said during a presentation on October 11 organized by the University of Pennsylvania's Center for the Advanced Study of India. (Kaye will return to Philadelphia next month to speak at the Wharton India Economic Forum on November 17 and 18.) In turn, the firm has favored India. Warburg is the largest private equity investor in India by far, having ploughed $811 million into the country as of mid-2005. This amount is more than twice the $362 million Warburg has invested in China, according to data provided by the National Venture Capital Association in Arlington, Va.


Bears and Bulls

Warburg's vote of confidence in India is not universally shared. Globetrotting financial commentator Jim Rogers has written off the country as a haven for slow-moving bureaucrats who are insensitive to the needs of business. He has predicted a gloomy future for India not only as an economy but also as a country -- predicting its breakup into smaller nation states, torn apart by ethnic and religious strife.


But Rogers drove through India and sought out its most difficult political and economic terrain. Warburg has an office there. Rogers was dejected by the country's decaying roads and bridges. Warburg investors see investment opportunity in them. Rogers hated the rickety telephone landlines he encountered in India. Warburg investors, like millions of Indians who are simply bypassing the landlines and migrating to mobile telephony, fell in love with Bharti.


The Indian government reluctantly embarked upon political and economic reforms in 1991, after years of stifling government control of business and profligate spending on propping up failing state-run enterprises brought the country to the brink of bankruptcy. The reforms have continued unimpeded through four different coalition administrations with seemingly disparate economic ideologies, according to Dalip Pathak, the managing director at Warburg who spearheads the firm's strategy in India.

"There may be debate about the pace of reform, but not about its direction. Indian businessmen today very rarely point to government as an obstacle," Pathak says. As for that vaunted Indian bureaucracy, he mentions that Warburg repatriated its profits in 48 hours. It's easy to take money out of India, perhaps even easier than bringing it in, he jests.


What has Warburg discovered in India during the last decade? Pathak lists the developments that are exciting investors like him: Foreign institutional investment has boomed (more than $12 billion in 2003-04) as curbs on foreign investment in Indian industries have been relaxed; there is a virtually open skies approach to investment from the United States; and gross domestic product has grown at rates between 6.5% and 8% in recent years. The volatility of the Indian rupee has been curbed and inflation has declined. "There are smart people running that economy," Pathak says.


Declining inflation has meant lower interest rates, and in turn has goosed the equity markets. Since October 2004, the Bombay Stock Exchange's Sensitive Index, or Sensex, of 30 blue chip stocks has added 2,500 points, to cross 8,000. "We made a big bet on interest rates coming down, and it was the right bet to make," Pathak says. He even compares India favorably with parts of Europe in one surprising aspect: "Labor issues are far more difficult in France than in India," he says.


High Confidence

One of the biggest changes Pathak says he has noticed has nothing to do with numbers. "There has been a complete change in the confidence level of people in India," he says. The "tipping point" here was the contribution of Indian information technology companies to averting a worldwide Y2K meltdown. Suddenly, India's small IT companies went global, and the government -- long accustomed to regulating big industry but unfamiliar with IT -- had nothing to do with it. Now "most people believe they will not let government get in their way," Pathak says, "and that's why we keep putting money there."


There's a swagger in the step of India's business, and the country's government is showing signs it has caught the contagion, Kaye says. According to a 2003 Goldman Sachs report, "India's economy could be larger than all but the U.S. and China in 30 years." It's a prediction that doesn't appear far-fetched to Kaye and Pathak.


As Warburg's substantial divestment from Bharti shows, however, the investment firm has not lost its head over India. "Bharti has reached the scale and quality level that ensures it will have a long and bright future," Kaye says. But that very milestone means it is "less appropriate from a risk-reward perspective." That's investor-speak for "there's not enough upside left" in the company.


Warburg's other notable holdings in India include Rediff Communication, the country's largest consumer web portal; Gujarat Ambuja Cement; Sintex Industries, an industrial plastic-goods manufacturer with a 60% share of the market for water-storage tanks; Kotak Mahindra, a financial services conglomerate; Nicholas Piramal India, a major pharmaceutical company, and WNS Global Services, a business process outsourcing company.


As the list shows, Warburg's bets in India are hardly reckless. The firm generally sticks to the tried, true, big and stock-market listed. That is rarely a winning strategy for a private equity investor in the United States, but can be in India, where the pent-up demands of a billion people leave plenty of room to grow for even the largest conglomerates. So in India, the investment firm is not spending much time seeking out early-stage companies or funky technology. In fact a couple of its forays into tech were jettisoned. They involved minor investments, under $2 million each, Pathak says.


"Larger companies are less risky; listed companies are less risky," he says, citing the transparency afforded by India's capital markets. One other reason to pick big over small, in Pathak's view: Bigger Indian companies are increasingly seeking capital and acquisitions abroad, and if they play foul with Warburg, "they know they will never get investment abroad."


But success has brought competition. Several significant names in the U.S. private equity world are now operating in India, among them Intel Capital, Oak Hill Capital Management, the Carlyle Group, Citigroup Venture Capital International, General Atlantic Partners, CSFB Private Equity, and the California Public Employees Retirement System, or CalPERS. Most of them have invested only in the double digits so far -- Citigroup has invested as little as $23 million. But "we need to keep on our toes," Pathak says. Warburg is now looking to participate in India's raging real estate market, he adds. "Last year we were not." A growing number of Indian financial institutions, including Kotak, have created venture funds to tap into the sector's potential. Indian news media say fund managers expect returns of 20% to 30% a year.


Big Pool

"Being smart and having a lot of money is not a differentiator anymore," Kaye says. So Warburg is working assiduously to become a recognizable brand in India. It is doing that in part by staying close to the market, operating from offices in the commercial hub of Mumbai. Unlike many private equity firms, Warburg invests through a single fund worldwide. That allows it to be nimble in adapting to change, Kaye says. Warburg has more than $10 billion under management invested in more than 100 companies in Asia, Europe and the United States. In August it raised $8 billion more -- the largest single pool of capital the firm has raised since it was set up in 1966.


In India, Kaye and Pathak expect the thirst for capital will be unquenched for years to come. Just infrastructure improvements -- greater power generation, better highways and more efficient ports -- are estimated to require $20 billion to $25 billion in investments each year. For policy makers in India, Kaye says, the main social challenge is to lift 200 million people out of abject poverty. Infrastructure projects, far more than IT, have the potential to generate the large numbers of jobs needed to accomplish that task, he adds.


Towards the end of their session, a seminar participant asked Kaye and Pathak to describe their "most pessimistic scenario" for India's future. Both men were silent. That silence spoke as loudly as their optimistic presentation about the possibilities India holds for investors like Warburg.

The McKinsey Quarterly: What's next for Tata Group: An interview with its chairman

What's next for Tata Group: An interview with its chairman
Ratan Tata explains how the company is expanding abroad while cultivating an emerging mass market at home.

Ranjit V. Pandit

2005 Number 4

The hopes, challenges, and opportunities of India's globalizing economy are closely intertwined with those of Tata Group and its chairman, Ratan N. Tata. The country's second-largest conglomerate—with revenues of $17.8 billion (in the financial year ending 2005) and core interests ranging from steel, cars, and telecommunications to software consulting, hotels, and consumer goods—has come a long way since he stepped up as chairman, in 1991. That also happened to be the year when India launched the economic reforms that were to make it one of the world's fastest-growing economies.

When the 67-year-old Tata, a Cornell-educated architect, succeeded his uncle J. R. D. Tata at the helm of the then-stodgy company, he set out to unite, refocus, and modernize the sprawling group of almost 100 largely independent businesses. Helped by cash from its booming software unit (Tata Consultancy Services) and by the growth of India's economy, he has rebuilt its shareholdings in its largest subsidiaries (by revenue), including Tata Motors and Tata Steel, and increased its revenue sixfold. In 1995 he took on the passenger car business—an effort that three years later resulted in the launch of India's first indigenously designed, developed, and produced car, the Indica. The gamble paid off.

In 2000 Tata Group purchased the United Kingdom's Tetley Tea and followed this move with other big overseas acquisitions and investments. Restructuring or divesting nonperforming businesses, however, has proved to be more difficult.

In an interview with Ranjit Pandit, a director in McKinsey's Mumbai office, Tata spoke about the group's international strategy, his plan to create a $2,200 "people's car," his vision of India as a knowledge center for the world, and his dedication to the social responsibilities required from companies operating in developing markets.

The Quarterly: How would you describe Tata Group's growth strategies in a globalizing economy?

Ratan Tata: We have two guiding arrows. One points overseas, where we want to expand markets for our existing products. The other points right here, to India, where we want to explore the large mass market that is emerging—not by following but by breaking new ground in product development and seeing how we can do something that hasn't been done before.

The Quarterly: How do you select which countries to enter?

Ratan Tata: Our strategy has been a little more modest than a truly global one. We want to expand into geographies where, as a group, we can have a meaningful presence. Even though companies could probably be very satisfied in an Indian context with maybe a 5 percent market share in a foreign country, this is—at least in our view—not a sustainable level. So in the first instance we have chosen countries where we felt we could make an impact and, secondly, where we are able to participate, as we have in India, in the development of that country.

When you visit a country or examine a particular company, I think you intuitively know if there's an opportunity, and then you flesh out that opportunity in one form or other. If we get to the stage of justifying assembly or manufacturing operations, we will seek either to contract them or to invest in facilities in that country. That has been the way we have gone into, say, South Africa. An example of another way is South Korea, where we acquired the Daewoo truck company. We saw an opportunity in an entity that had a certain market share, that had a product line that we did not have, and that was a strategic fit for us. We brought in our marketing reach and made the company more profitable.

The Quarterly: Why South Africa?

Ratan Tata: I have been involved with South Africa for perhaps seven or eight years. There was such an enormous disparity between rich and poor, and I always felt that this large poor community had been exploited over the years. So I met [Thabo] Mbeki before he became president—this was in [Nelson] Mandela's time—and I said we really wanted to do something in South Africa to give to the country rather than take away from it.

One thing led to another. We started professional schools in South Africa that train people in trades so that they can be self-employed, and then I became more involved with the country by joining Mbeki's investment council. Eventually, this led to our launching our cars and trucks in South Africa, where we became quite successful, and then we were awarded a second network operator's contract for telecommunications in all of South Africa.

The Quarterly: Most of these big moves seem to be taking place in other developing countries. When will Tata be ready to go into developed markets?

Ratan Tata: We are, to some extent, in developed economies already. In Western Europe, I think Italy and Spain are among our most promising markets for automobiles. We're in software in several countries. We have made acquisitions to enter the hotel business, including in the United States. And we are now looking at opportunities to invest in steel companies in developed countries, but we are making sure that we have secure access to raw materials, because I really believe that owners of iron ore are going to rule the industry. They will be the OPEC1 of the steel industry.

The Quarterly: Turning to your plans for the Indian market, the most intriguing is perhaps the development of a people's car that would sell for 100,000 rupees.2 What's the thinking behind it?

Ratan Tata: It is propelled by the opportunity, but there is also a social or dreamy side to it. Today in India, you often see four people on a scooter: a man driving, his little kid in front, and his wife on the back holding a baby between them. It's a dangerous form of transportation, and it leads to accidents and hospitalizations and deaths. If we can make something available on four wheels—all-weather and safe—then I think we will have done something for that mass of young Indians. If you could position an all-weather car that was not a glorified scooter or a stripped-down car, then I believe there would be a market potential of one million cars a year.

The Quarterly: How do you make such an undertaking profitable?

Ratan Tata: Today we're producing a $7,000 car, the Indica. Here we're talking about a $2,200 car, which will be smaller and will be produced in larger volumes, with all the high-volume parts manufactured in one plant. We're also looking at more use of plastics on the body and at a very low-cost assembly operation, with some use of modern-day adhesives instead of welding. But the car is in every way a car, with an engine, a suspension, and a steering system designed for its size. We will meet all the emissions requirements. We now have some issues concerning safety, mainly because of the car's modest size, but we will resolve them before the car reaches the market, in about three years' time.

In addition—and this again touches on the social dimension—we're looking at small satellite units, with very low breakeven points, where some of the cars could be assembled, sold, and serviced. We would encourage local entrepreneurs to invest in these units, and we would train these entrepreneurs to assemble the fully knocked-down or semi-knocked-down components that we would send to them, and they would also sell the assembled vehicles and arrange for their servicing. This approach would replace the dealer, and therefore the dealer's margin, with an assembly-cum-retail operation that would be combined with very low-cost service facilities.

The Quarterly: You have launched another new low-cost venture—building a chain of basic hotels, the indiOne. What's the philosophy behind it?

Ratan Tata: It's exactly the same as the philosophy for the car, and it's a philosophy that's also being thrown out as a challenge to our watch company—why can't we produce a watch at a much lower price to go on everyone's wrist? The mandate has gone out to our people that we now really need to look seriously at the needs of the larger part of the Indian income pyramid, where most consumers can be found.3 If we don't do that, I think the Chinese will come and do it for us.

We have been a very measured, very cautious group, which has looked at the market, decided what was safe, and then moved in. We need instead to lead and not just follow. We have to take more risks and gain predominance in that manner. Targeting the larger part of the income pyramid is an important part of what Tata will be doing.

The Quarterly: What about going into China and producing for the emerging middle market there?

'Targeting the larger part of the income pyramid is an important part of what Tata will be doing'
Ratan Tata: We haven't found what we can do as yet in China. It's been very difficult to understand the market, at least for me. It is a market that seems, on the one hand, subservient to international brands and, on the other, very price conscious and very willing to buy unbranded products or local brands. It's pricing isn't fully comprehensible. In Beijing, you know, I was taken to some little alley where watches and clothing were sold. The watches were extremely attractive and very similar to known brands, but some had stopwatch buttons that didn't work. So I don't really understand the Chinese market. But if we could identify the right product, I think we would move in there. We do have a memorandum of understanding with a Chinese car company to manufacture our current car under its brand, but we haven't seen much action from that side.

The Quarterly: China is manufacturer to the world. What position do you see for India in a globalized economy?

Ratan Tata: If we play our cards right as a country, we could be a supplier of IT services and IT solutions to the world. We could also be a product-development center for pharmaceuticals. We could be a very good global R&D center in biotechnology and in some of the emerging technologies, such as nanotechnology, provided we really give them the focus they would need.

Does India have an entrepreneurial advantage over China? See "China and India: The race to growth."
If I may draw a somewhat oblique analogy: Singapore, which has done so much to build its biotech infrastructure, strangely isn't looking at creating any homegrown enterprises. I'm sure 90 to 95 percent of what comes out of Singapore's biotech infrastructure is the work of US companies and others. In India I would say it would be very different. It would be local—Indian—scientists and entrepreneurs establishing start-ups, very similar to the way this happened in Silicon Valley. Do we have the venture capital to support them? Probably not. Do we have government support? Probably not. But if we can get these supporting things in place and synchronize them with the need to create more risk-taking platforms, then I think some very interesting things could happen in India. We may not become the manufacturing base of the world, but I think we could be very much a knowledge center for the world.

The Quarterly: Do you see this as a joint government-business project or as something that happens through market forces?

Ratan Tata: We're so far behind on the infrastructure that the government will have to play a very active role. It may be a public-private partnership, but for the most part it will have to be the government.

The Quarterly: Why would India win in the knowledge area?

Ratan Tata: India has people with skills. And it has people with considerable intellectual capabilities who have been leaving India because the opportunities were not there. We have to create these opportunities. So if you are asking, why should this happen if all things remain as they are, the answer is that it won't. But if we can hold onto our best people in India, if we can attract our best people back, if we can create a sense of opportunity and reward, then I think India could be a very different place.

Indians coming back to India really go through a cultural shock. They give up a lot in terms of the quality of life, the education of their children, the availability of medical facilities. This will also have an impact when we want to hire people who are not Indians, as we will have to do in a world without boundaries. Even if we start only with pockets of the country and make those pockets less of a cultural shock, the benefits will spread. In some ways, this is what China did with the economic zones.

The Quarterly: You serve as chairman of the government's investment commission. Why do you think many foreign companies are reluctant to set up shop in India?

Ratan Tata: In some areas, rules and laws are more investor friendly in India than they are in some other countries, and in some areas they are less so. Most investors today cite caps on foreign investments as a deterrent. But there are sectors where even 100 percent is permitted, and you don't see people rushing in there. India has an impeccable record of repatriation of profits, so it's not that, either. But a new investor looking at India does run up against different ministries, with each one seeming to have a different angle on the investment and throwing up roadblocks. So companies don't really come in as they do in China or Singapore, where they get clearance and are free to start their operations quickly. And once investors are in India, they quite often find that one bureaucrat interprets the law differently from another bureaucrat. All of us in India live with this. You can have an excise official in Maharashtra who takes a different view of the duty structure than an excise person in Bihar does. You'll go to court and fight that, but you're used to it. But a US, European, or Japanese company finds this terribly debilitating and gets all upset over it.

So I think a number of things, including red tape and corruption, deter investors from coming to India, which is a market with a middle class of 250 million people. It is a terrific opportunity for growth because you have the larger part of the pyramid rising in prosperity.

The Quarterly: Tata Group had to change when you stepped up as chairman, in 1991. What do you hope people will say in the future about you and your impact on Tata?

Ratan Tata: We used to live in a world of just raising our top line. I would hope people will say that I've helped make the Tata companies more competitive and more conscious about costs and the bottom line. I would hope they remember me for bringing the group together, because we were often referred to as a loose federation of companies that competed and fought with each other. By creating a common brand and a codified framework for how we operate, I think we have brought the group much closer together. I would feel sad to be remembered for not being able to change the structure of the company more radically.

The Quarterly: What about Tata Group's impact on India's economic development and consumers?

Ratan Tata: What I feel most proud of is that we have been able to grow without compromising any of the values or ethical standards that we consider important. And I am not harping on this hypocritically. It was a major decision to uphold these values and ethics in an environment that is deteriorating around you. If we had compromised them, we could have done much better, grown much faster, and perhaps been regarded as much more successful in the pure business sense. But we would have lost the one differentiation that this group has against others in the country. We would have been just another venal business house.

The Quarterly: Will Tata's social values endure after you leave?

Ratan Tata: I would hope so. I think it is wrong for a company in India to operate in exactly the same way, without any additional responsibilities, as if it were operating in the United States, let's say. And even in the United States, I think if you had an enlightened corporation that went into the Deep South, you would see more of a sense of social responsibility, of doing more for the community, than the company might accept in New York City or Boston. Because it is inevitable that you need to be a good corporate citizen in that kind of environment. And companies that are not good corporate citizens—that don't hold to standards and that allow the environment and the community to suffer—are really criminals in today's world.

About the Authors
Ranjit Pandit is a director in McKinsey's Mumbai office.

Notes
1Organization of Petroleum Exporting Countries.

2About $2,200.

3V. T. Bharadwaj, Gautam Swaroop, and Ireena Vittal, "Winning the Indian consumer," The McKinsey Quarterly, 2005 special edition: Fulfilling India's promise, pp. 42–51.

Reform in India - Democracy's drawbacks

Democracy's drawbacks

Oct 27th 2005 | DELHI AND KOLKATA
From The Economist print edition


Sustained growth in India would be all the more impressive if the government could pass its reforms. But the road is blocked by politics



IN CITY after city, India is booming. Visit Delhi or Mumbai or Hyderabad, and they are full of shining new office towers and American-educated MBAs. The suburb of Palm Meadows (pictured) outside Bangalore, the home of high-tech and outsourcing, looks like the richer blocks of Los Angeles. The stockmarket has risen by more than 20% this year (see chart 1), though it slipped back a bit this month. In the second quarter, India's GDP grew by 8.1% compared with the same period last year. After annual growth of around 7% in 2003 and 2004 (see chart 2), the country is on course, many economists think, to repeat the trick this year and next.

India's IT companies are world-beaters. Firms such as Tata Consultancy Services, Infosys and Wipro, which owe their success to large, co-operative software-development projects for companies in America, are now beginning to compete directly with the big IT multinationals for large consultancy contracts. Out of this IT infrastructure has grown a huge business in “outsourcing” almost any business process that can be performed remotely, from answering a call in a help centre to interpreting an X-ray. The largest outsourcing firm relaunched itself in September as Genpact, partially disguising its origins as the Indian back-office of General Electric, and expects to exceed $1 billion in annual sales by 2008.

These service businesses have thrived because they have capitalised on India's strengths—computer skills, fluency in English—and are not hostage to its weaknesses. Yet those weaknesses are all too obvious, and are the reason why India on many counts still lags behind its neighbour-rival, China. India has lousy infrastructure, bumbling and burdensome regulation and restrictive labour laws. And economic reform now appears to have stalled in political recriminations.

Last year's election gave no party a clear majority. A delicate arrangement allowed Manmohan Singh, of the left-of-centre Congress party, to take office as prime minister, while a committee was set up to negotiate policy between Congress and its coalition partners (together called the United Progressive Alliance or UPA) on the one side, and the Left Front of Communists and other left-wing parties on the other. The committee, however, has not managed to meet since June, though on October 26th there were rumours that it was about to. Meanwhile, the Communists—without whom the coalition has no majority in Parliament—are getting truculent. They staged a four-month boycott of the co-ordination committee to press their policies and then, in concert with the trade unions, called a one-day general strike on September 29th. It was ignored in many places, but the banks, along with the Communist stronghold of Kolkata (Calcutta), were paralysed.

When Mr Singh was finance minister, in the 1990s, it was he who pushed through the measures that kick-started reform in India. Without the support of the Left Front, however, he can do nothing more. His most significant legislative achievement to date has been a law that guarantees 100 days' employment to every household in India's 200 poorest districts. Though the Left Front loves it, many economists reckon that much of the money—as much as 1% of GDP, by some estimates—will be wasted or stolen.

The list of what Mr Singh has been prevented from doing is much longer. Completely ruled out has been any progress on liberalising India's notoriously rigid labour laws. The key battleground is a rule preventing any company with more than 100 employees from making redundancies without obtaining approval from local labour boards. According to the Left Front, this protects workers from unscrupulous employers. In fact, it makes employers wary of taking on new staff, opening new factories or, in the case of smaller companies, growing beyond the threshold of 100. It protects unionised labour, in short, at the expense of those not in work.

The Left Front, which draws most of its support from organised labour, does not greatly care. Its eyes are on state elections due next year in West Bengal (whose capital is Kolkata) and Kerala, the two biggest states where the Communists are strong. Those who are losing out from unreformed labour laws are hundreds of millions of people now marginally employed in the countryside. These people need jobs in manufacturing if India is to improve its record on poverty, as well as growth. Jobs could be found in the labour-hungry textile industry, especially now that, with the ending of the developed world's protectionist Multi-Fibre Arrangement, India's textile exports are booming. As it is, a jobless boom is going on in manufacturing, which is growing at 7% annually, but without increasing employment.

Touches of xenophobia
India's antiquated laws are not only preventing it from exploiting the textile boom as successfully as China (whose textile businesses are so successful that they provoke retaliation). They are also pushing it far behind China in terms of foreign direct investment. FDI has been the most important driver of China's growth, not just because of the money involved (more than $60 billion last year) but also because of the technology, expertise, marketing relationships and much else that this money represents. India's showing has been far less impressive: about an eleventh of China's haul last year (see chart 3).

One chief reason for the discrepancy is that India imposes caps on FDI in a host of economically important, or politically sensitive, sectors: insurance, aviation, coal-mining, media and much else. Chief among these is retailing. Though franchise operations are allowed, foreign direct ownership is banned, which explains why even Delhi's smartest shopping areas are scruffy and chaotic places with limited stock.

Mr Singh's government would like to raise the caps, and had some success at first. It proposed in February, for example, that the cap for telecoms investment should be lifted from 49% to 74%, and this has just, at last, been approved. But the Left Front is violently opposed to any tinkering with the rules for FDI in retailing. Its leaders appear to accept that the advent of, say, Wal-Mart would generate many jobs, since much of what the company sold would be domestically produced (Wal-Mart spends $15 billion a year in China). But they worry that millions of small retailers would be put out of work. For those who want to move out of farm work, a small shop is often their first choice.

Mr Singh remains optimistic, but on slender grounds. With the Left Front so adamant, nothing is likely to happen. And the same is true of privatisation, or its younger sibling, disinvestment, the selling of minority stakes in state-controlled companies. From the very start of its tenure, the government was forced by the Left Front to agree not to privatise nine so-called “crown jewels”, or leading state-owned companies. But the Left has taken advantage of its position to go beyond what was originally agreed. When, in June, the government announced plans to sell a 10% stake in Bharat Heavy Electricals, an engineering firm, the Left Front vigorously objected. Although the sale does not require legislation, and so could be enacted by the minority government, the government shows no stomach for doing so.

Another disappointment—though the word is perhaps inappropriate, since no one ever expected a Congress government to have the necessary courage—is the failure even to attempt to do anything about the mountain of subsidies that distort the Indian economy. Often badly targeted, benefiting middle-class people more than the poorest, they consume a shocking 14-15% of GDP.

Worst of all, Indian politics may actually be retreating to its bureaucratic past. Take oil pricing, a complex statist rigmarole that had been moving from the hands of government to those of a regulator. Under Mr Singh, price decisions are again being taken by the government.

The prime minister's instincts are sometimes depressingly bureaucratic. Faced with obvious and longstanding problems, he commissions a study on them. The latest strategy document appeared in September from a specially convened National Manufacturing Competitiveness Council. It listed the most pernicious difficulties for manufacturers: power shortages, taxes and the “inspector raj”. No one was surprised by these, or felt much hope they would be fixed.

Removing the brake
It may seem odd, if reform is so important, that the economy is doing so well without it. There are a number of reasons. The biggest is that the Indian economy is so strong, structurally and cyclically, that it can ride out a period of wobbly policy. India's young population gives it a fast-growing workforce and a declining proportion of dependants. Over the next few decades, that will be good for savings and investment. Industry, meanwhile, has recovered from a splurge of over-investment in the mid-1990s. It has improved efficiency and is now both reaping the benefits and investing again in new capacity.

The government started to get out of business's way in the 1980s and, especially, after a balance-of-payments crisis in 1991. At that point Mr Singh, as finance minister, was given the freedom to bring in reforms by an unexpectedly brave prime minister, Narasimha Rao. Since then, government has been unable to put an absolute crimp on growth. Many important reforms—especially trade liberalisation, but also the dismantling of the “licence raj” of bureaucratic obstacles to enterprise—are well in train and not in reverse.

Too many are still losing out
Almost every budget since 1991, including this year's, has cut import tariffs and freed more industries from “reservation” for small firms, a big hindrance to competitiveness in businesses that might benefit from economies of scale. This year, moreover, saw the introduction of one long-planned reform, a standardised value-added tax imposed at state level. Typically, politics meant that not all states fell into line, and implementation has been patchy. Yet the tax may eventually not only bring new fiscal stability, but also reduce the burden of cascading excise and sales taxes that is one of the biggest handicaps facing manufacturers. Modest, piecemeal reform, in other words, is not quite dead.

The government's priorities—investment in infrastructure, agriculture, basic education and primary health care—are also right, given that the big macroeconomic stuff was mostly done in the 1990s. But they all need money, and that requires fixing the budget. India's fiscal deficit is now 8% or so of GDP if both state and central governments are counted—an improvement after six years of double-digit deficits, but still too high. Public finances have been in a mess for so long that it seems almost impolite in government circles to mention them.

The deficit, which goes largely on interest payments (40% of recurrent spending), defence, subsidies and civil-service wages and pensions, leaves little room for big capital investments. Some new airports, ports and roads are being built, and the “Golden Quadrilateral” highway, linking India's four biggest cities, is being expanded to six lanes. But Mr Singh wants a good deal more. Improving India's infrastructure, he says, is his top priority. Hence his government's zeal for “public-private partnerships” to finance and construct it.

A standard concession agreement is to be produced soon, modelled on successes with toll roads, where concessionaires have put in competitive bids for government grants. For some projects, the government does not need parliamentary approval and can proceed anyway. Other projects, however, such as airports, will run into objections from the left. It is therefore hard to see these partnerships making much of a dent in what Montek Singh Ahluwalia, the prime minister's chief planner, calls India's “infrastructure deficit”.

Might the left-wing parties ever become less obstreperous, and realise that reforms like these are of benefit to all Indians? It is possible. Jairam Ramesh, a Congress member of parliament who played a big role in writing the “common minimum programme” that defines relations between the UPA and the Left Front, floats the interesting theory that, now that Congress has enacted the Employment Guarantee Act that the Left was so keen on, the Left may prove a little keener on asset sales. They would, after all, be a way of paying for all those jobs.

From the Left Front come faint signs of accommodation. Prakash Karat, the general secretary of the CPI (M), the most important party within the group, is, like Mr Ramesh, adamant that full-scale privatisation of profitable public enterprises is not on the agenda. But he says the party is “ready for a discussion” on how to raise resources for spending on the poor.

Among the most eloquent advocates of a re-think is, in fact, a senior Communist, Buddhadeb Bhattacharjee, chief minister of West Bengal, a state of 82m people run for 28 years by the Communists and their allies. On September 30th, the day after Communist-affiliated trade unions had brought his capital, Kolkata to a halt, he could scarcely conceal his exasperation. He told The Economist that the trade unions—and many of his party comrades—had become “one-dimensional”, representing only the interests of the 30m or so workers in India's “organised” sector.

Mr Bhattarcharjee concedes that some of his colleagues in Delhi do not seem to grasp that economic reform could benefit a much bigger number of workers than those who belong to unions. If they do, they perhaps see political benefits in ignoring it. But “Here, we are running a government. We have to fulfil the aspirations of the people.” To that end, he is trying to turn Kolkata into a hub for the information-technology industry by declaring it a “public utility” where strikes are banned, and has started going abroad to bang the drum for inward investment.

Jobs for the poor
Such enthusiasm may start to shift the political balance back towards reform, but it looks unlikely. For the foreseeable future, both left-wing intransigence and lack of decent infrastructure—in particular, a chronic shortage of electricity—will constrain India's growth. An average annual rate of 6-7%, as in the past decade, does not seem a tall order. But a gear-shift to a durable growth rate of 8-10% still seems out of reach.

Without it, that burgeoning workforce may seem less of an advantage. Shankar Acharya, a former government economist now at a Delhi think-tank, worries that between now and 2051 nearly 60% of India's population increase will come from four “populous, poor, slow-growing northern states with weak infrastructure, education systems and governance”.

China has sucked surplus agricultural labour into factories by the tens of millions. India's manufacturing industries, by contrast, have progressed by becoming more productive. They are still not a big source of rural employment. As a good liberal economist, Mr Singh says he does not believe in having an “industrial policy” or picking favourites. Create decent infrastructure, and industry will come—and he sees huge potential, as do many others, in food-processing. His finance minister has spoken of 12m new jobs in the textile sector alone in the next five years.

They are sorely needed. India's information-technology firms are world-beaters, but the entire IT and office-service industry employs only about 1m people. None of the Asian tigers, not even Singapore, managed its rapid climb into the ranks of middle-income and rich countries without a boom in export-oriented manufacturing. India is unlikely to be different.

When he speaks of following the “Chinese model”, Mr Singh seems to admit this. But it remains sadly true that the free market that has helped the tigers so much often works better in Communist China than in India—not least thanks to India's own democratically elected Communist politicians.

Reforming India's financial system - McKinsey Quarterly, 2005 Special Edition: Fulfilling India's promise

Reforming India's financial system
Its underdevelopment is hindering the country's economic growth.

Diana Farrell and Susan Lund

The McKinsey Quarterly, 2005 Special Edition: Fulfilling India's promise

With a gross domestic product that is growing by more than 7 percent a year, India has made remarkable progress since opening its economy, in 1991. The country has accomplished this feat despite the substantial handicap of an underdeveloped financial sector.

At about $900 billion, India's stock of financial assets—including bank deposits, equities, and debt securities—is one-fifth the size of China's (Exhibit 1).1 The gap is widening: by 2010, China's financial stock will reach $9 trillion, while India's will remain below $2 trillion.

But in allocating capital, particularly to private companies, India's financial system is more effective than China's, largely because the market share of more efficient foreign and privately owned banks in India has crept up to 25 percent. Many nonperforming loans have been cleaned up, and while the true figure is hard to determine, they are now estimated at around 9 percent of all lending,2 compared with up to 40 percent in China. India's stock market is booming, and its best companies list shares abroad.

Still, to finance economic growth, India must raise its investment rate substantially, as McKinsey Global Institute (MGI) research shows. If that is to happen, the financial system must mobilize savings more effectively—a goal that calls for reducing the government's fiscal deficit, which crowds out private investment, and for reforming banks and capital markets. The government resists these steps for fear of job losses. Ultimately, however, the effect would be to create hundreds of thousands of new jobs in the financial sector and to generate faster growth in the whole economy.

Elusive savings
Why is the stock of financial assets so small? Not because Indians save too little: although the country's gross national savings rate is half of China's, it isn't bad by international standards (Exhibit 2). Furthermore, chronic government budget deficits depress the savings rate. Despite the fact that Indians should save more, the main challenge is to capture more of the existing savings.

India nationalized banks in 1969 in order to provide banking service to the masses. But penetration is low: just 40 percent of households have signed up as borrowers or depositors. Deposits represent 60 percent of GDP, compared with 190 percent in China and 142 percent in Japan.

India's capital markets have hardly done better to mobilize savings. Retail investors are few, though the stock market lists roughly 5,000 companies, has a market capitalization that (at roughly 50 percent of GDP) is comparable to the eurozone's, and offers a variety of derivatives and other complex products. Corporate bonds make up 1 percent of India's stock of financial assets, compared with 10 percent in Thailand, 20 percent in Malaysia, and 30 percent or more in South Korea, the United States, and most of Europe.

Instead of putting money into financial assets, Indian households invest more than half of their savings in physical ones such as land, houses, cattle, and gold (Exhibit 3). In rural areas, the proportion is even higher. In fact, India's people—mistrustful of banks—are the world's largest consumers of gold. They possess $200 billion of it, equal to nearly half of the country's bank deposits, and last year bought $10 billion worth, nearly twice the amount of the foreign direct investment India received. Households could earn higher returns by investing in financial assets, and the country would be better off if savings were pooled to finance more productive investments.

Efficiency: India's advantage
Room for improvement remains, but the Indian financial system is better than its Chinese counterpart at allocating capital, as demonstrated by India's improving level of nonperforming loans and the amount of capital funneled to private industry. India's banks have made a big effort over the past two years to clean up nonperforming loans. Although the current level is still higher than it is in developed countries, it is a fraction of China's. Continuing to follow good lending policies will be vital. As the low interest rates that have recently kept some loans afloat start to rise, banks will probably be tested.

Private-sector companies in India have better access to funds than do those in China. Small and midsize enterprises account for 45 percent of India's bank loans to businesses and generate 23 percent of the industry's revenues. According to the World Bank, 54 percent of small and midsize Indian companies had access to bank overdraft facilities in 2002, as compared with 26 percent of Chinese ones.3 All but 60 of the roughly 5,000 companies listed on the Bombay Stock Exchange are privately owned or foreign joint ventures, which together account for roughly 70 percent of its market cap. Private-sector companies represent a small fraction of the market cap of the Shanghai Stock Exchange.

Nonetheless, capital could be allocated more efficiently. The Reserve Bank of India still insists that priority sectors (such as agriculture and small business) receive at least 40 percent of all loans and advances and that 25 percent of all bank branches serve rural and semi-urban areas. These requirements distort lending decisions and operational efficiency. Of the loans to priority sectors, 23 percent, far higher than the level elsewhere in the economy, end up as nonperforming—evidence that the scale of this lending makes little sense (see "What Indian consumers want from banks").

What's more, "lazy banking" constrains lending. Interest rates in India fell constantly over the past decade, and as bond prices rose banks could make easy money by using deposits to buy government bonds financing the fiscal deficit. Windfall treasury gains made banks more profitable but crowded out lending and private investment. Indian banks hold government bonds equal to 46 percent of their deposits, far more than the statutory minimum and nearly equal to their lending.4 In 2003, two-thirds of the new assets that India's commercial banks acquired were government securities. Over the past year, however, interest rates have stabilized and the banks are realizing that they must focus again on lending.

Financing the investment gap
A comprehensive MGI study of India's economy in 2000 found that it would have to increase the investment rate to at least 30 percent of GDP to grow by 10 percent a year.5 Given today's investment rate—nearly 25 percent—an additional $35 billion is required. The government reckons that a further $100 billion will be needed over the next ten years to upgrade the country's crumbling infrastructure.

What should governments do to attract investment? See "The truth about foreign direct investment in emerging markets"
Domestic savings are the only plausible source of extra funding, so more of them must be mobilized. Foreign direct investment alone won't fill the gap: although China is the world's largest recipient, for example, the $60 billion it received in 2004 was only 10 percent of domestic savings. Indian policy makers, in contrast to China's, remain ambivalent about foreign direct investment; in 2004 India received just $5.3 billion of it. Even doubling this figure—which would require a major policy shift—could provide little more than 10 percent of the additional funds needed. The government has proposed using foreign-exchange reserves to finance infrastructure investments, but this move would add only $3 billion to $5 billion annually.

Four reforms will be needed if the financial system is to capture more of the country's domestic savings and to reduce the share financing the public debt.

Reduce the fiscal deficit
Cutting the deficit would raise India's savings rate and make room for more private investment. As opportunities to profit from government bonds fell, banks would also feel prompted to put more deposits into loans.

The 2000 MGI study showed that India's government could cut the deficit by 4 percent of GDP, thereby providing three-quarters of the $35 billion needed for additional investment.6 Such a cut would require the privatization of most state-owned companies, both to stop the subsidies they receive and to reap the sales revenue. Politically, this move would be difficult for the government, which has slowed plans to privatize some key state-owned companies for fear of job losses. But India's policy makers could ease the transition for displaced workers by ensuring that they get targeted retraining and can cover lost income with wage insurance policies.

India's policy makers must crack down on the informal economy of businesses that contravene tax and regulatory requirements
To reduce the deficit, India will also have to collect additional tax revenues. Since the reforms began, in 1991, the central government's tax receipts have fallen to 9 percent of GDP, from 10 percent. In China, over the same period, they rose to 19 percent of GDP, from 15 percent.7 India's move to enact a national value-added tax replacing myriad state and local imposts is an important first step because it greatly simplifies collection. But policy makers must crack down on the informal economy of businesses—estimated at more than one-quarter of India's economy—that flout tax and regulatory requirements.8 Doing so will not only raise tax revenues but also level the playing field for more productive and law-abiding companies.

Increase bank penetration
India's banks must do better at offering personal financial services to attract household savings. Today they mostly compete for the profitable business of affluent households, but appealing to unbanked rural ones is equally important. Building more branches in the countryside, as the largest state-owned banks have, isn't effective. Banks must develop a keener understanding of what rural households need and offer new products and distribution networks to suit them.9

In a potentially important step toward bringing millions of the poor into the banking system, the government has proposed to let Indians buy virtual, or "paper," gold in denominations as low as $2—an alternative to investing in jewelry and coins.10 Initially, banks would keep the gold to back up the paper; buyers (like people who purchase equity shares) could trade in it and get the current market value of whatever quantity they had bought. The goal is to let banks make loans based on their gold deposits, as they now do with cash deposits.

Another opportunity might come from revamping rural microfinance projects, which now mostly focus on providing credit to the poor but should also encourage them to open deposit accounts. Attracting money from Indian expatriates is an option too; they made net new deposits of $3.6 billion in 2004, bringing their total to $33.3 billion. Banks can do more to attract them by facilitating deposits abroad and remittances to families and by processing mortgage and utility payments for properties in India.

Reduce the cost of bank intermediation
More of the savings that India's financial system captures could finance investment if banks reduced their cut from matching savers and users of capital (Exhibit 4). Intermediation costs remain high mainly because state-owned banks, whose productivity is 10 percent of US levels, control three-quarters of bank assets. India's new private banks achieve an average productivity of 55 percent of US levels, and some of the best operate almost at world-class standards and list shares on the NYSE. Moving all Indian banks toward their productivity potential of 90 percent of US levels—an ambitious but achievable goal—would unleash $2.5 billion a year in savings. Interest rates could fall by 1 percent.

To achieve these gains, regulators must pursue reforms on several fronts. They should encourage consolidation, for example, particularly among smaller state-owned banks, and improve the corporate governance of banks by making their boards more independent and accountable. Other desirable moves include giving managers greater freedom to make operational reforms and easing the labor laws that prevent banks from rationalizing and redeploying their workforce, outsourcing back-office functions, and introducing productivity-based compensation. Bank regulators should also replace directed lending to priority sectors with market-based incentives, such as credit guarantees or loan subsidies. Regulators are considering many such reforms; the challenge is to move faster.

Perhaps the most politically contentious area is the role of foreign banks. Today they are not permitted to hold more than a 5 percent stake in any Indian bank, except when the central bank identifies weak private-sector institutions, which foreign banks can acquire outright. Moreover, their organic growth is constrained by restrictions on the opening of new branches. Those who defend these restrictions argue, with some merit, that state-owned banks need time not only to improve their operations before they face foreign competition but also to recover from the limitations imposed by directed lending and strict labor laws. But foreign banks bring credit-assessment and risk-management skills, as well as new technology and capital, and intensify competition. MGI research shows that foreign direct investment has uniformly positive effects on local economies.11 The current plan not to open the banking sector to foreign direct investment until 2009 will substantially delay these benefits at a time when India's economy needs more financial capital to grow. As 2009 approaches, policy makers may find new reasons to postpone liberalization.

Develop the capital markets
Equity and corporate-debt markets open new sources of funding for businesses, cut their cost of capital, give savers new investment options, and are essential to financing pension programs. India's stock market already performs well. Now it must diffuse the success of certain companies, such as those in IT and business process outsourcing, throughout the economy. Pension reform will be important. Since April, nongovernment provident funds (employee pension funds) have been allowed to invest 5 percent of their new inflows in shares and 10 percent in equity-linked mutual funds. Over the next few years, this will funnel an additional 200 billion rupees ($4.6 billion) into the stock market.12

Surprisingly, given India's Anglo-Saxon legal and institutional heritage, the country's corporate-bond market is underdeveloped. To spur its growth, policy makers must improve liquidity and price transparency. The required steps include consolidating government debt issues to establish a better yield curve and improve liquidity, widening the government securities market to include nonbank participants, and letting dealers short-sell and thus take two-way positions. It will also be necessary to change the pricing of interest rate futures and to let banks trade them, to allow repurchase-agreement transactions in corporate bonds, and to develop the derivatives market. These reforms will allow India's capital markets to evolve in a more balanced way, complementing the banking system.

For India to continue on its current trajectory, reforming the financial system must become a priority. Although policy makers fear that reform will cost jobs, the opposite is true. Today India's banking sector generates 2.5 percent of GDP and employs 900,000 people. With full reform, it could generate up to 7.5 percent of GDP and employ 1,500,000 people, as well as boost investment and growth throughout the economy.

About the Authors
Diana Farrell is director of the McKinsey Global Institute, where Susan Lund is a consultant.

The authors wish to thank Aneta Marcheva Key, Joydeep Sengupta, and Tim Shavers for their contributions to this article.

Notes
1The figures for China cover the mainland only and exclude Hong Kong and Macau. If they were included, China's financial stock would exceed $5 trillion. See Diana Farrell, Aneta Marcheva Key, and Tim Shavers, "Mapping the global capital markets," The McKinsey Quarterly, 2005 special edition: Value and performance, pp. 38–47.

2Fitch Ratings, April 1, 2005.

3India: Investment Climate Assessment 2004, World Bank.

4"Adieu, Paresse?" Economist, September 11, 2004.

5Amadeo M. Di Lodovico, William W. Lewis, Vincent Palmade, and Shirish Sankhe, "India—From emerging to surging," The McKinsey Quarterly, 2001 special edition: Emerging markets, pp. 28–50.

6Amadeo M. Di Lodovico, William W. Lewis, Vincent Palmade, and Shirish Sankhe, "India—From emerging to surging," The McKinsey Quarterly, 2001 special edition: Emerging markets, pp. 28–50.

7"Sweatshops and technocoolies," Economist, March 3, 2005.

8Diana Farrell, "The hidden dangers of the informal economy," The McKinsey Quarterly, 2004 Number 3, pp. 26–37.

9David Moore, "Financial services for everyone," The McKinsey Quarterly, 2000 Number 1, pp. 124–31.

10Anand Giridharadas, "India hopes to wean its citizens from gold," International Herald Tribune, March 16, 2005.

11Diana Farrell, Jaana K. Remes, and Heiner Schulz, "The truth about foreign direct investment in emerging markets," The McKinsey Quarterly, 2004 Number 1, pp. 24–35.

12"Loosening up," Economist, February 3, 2005.

Why believe in India - McKinsey Quarterly, 2005 Special Edition: Fulfilling India's promise

Why believe in India
Because it has made tremendous progress—and there's more to come.

Ranjit V. Pandit

The McKinsey Quarterly, 2005 Special Edition: Fulfilling India's promise

India has always held great promise. Soon after independence, in 1947, its foreign reserves were among the world's largest, at $2.1 billion in 1950–51, and it accounted for 2.4 percent of global trade. Over the next 44 years, however, attempts to follow the Soviet model of self-sufficiency brought the country to the verge of bankruptcy. Domestic savings failed to keep pace with the investment needed to contain unemployment, especially as India's working-age population expanded. The crisis begged for drastic reform, and in 1991 the government delivered.

This reform program took its cue from China, which by 1991 had surpassed India on all major economic indicators. But in the shadow of the Chinese economic miracle, it is easy to overlook what India's reforms have accomplished during the past 14 years. A solid foundation for growth is now in place: the program of renewal, backed by successive governments, has increased the country's foreign reserves to an enviable $137 billion and raised annual economic growth from an average of around 4 percent in the four decades before reform to almost 7 percent today. Growth rates of 8 to 10 percent are within reach. The amount of foreign direct investment coming into the country, often cited as a failure of India's policy, has grown from about $100 million in the early 1990s to about $5.5 billion today. If China were not the yardstick used to measure India, this increase would be a matter for celebration, not censure.

The automotive and airline industries illustrate how far the country has come and how much further it could go with more foreign investment and competition. Since neither industry was high on anyone's political agenda, both were among the first to be deregulated. From just one state-owned airline in 1991, India now has eight competing carriers and is the world's second-largest commercial-aircraft market. On-time performance and service levels have risen dramatically and fares have dropped. As a result, passenger traffic is expected to grow by 20 percent annually over the next five years. In the automotive sector, deregulation sparked competition and led to the emergence of a local champion, Tata Motors, which has captured 15 percent of the domestic market. Total annual car sales have increased from around 150,000 in 1991 to more than 1,000,000 today, while the industry's employment has tripled. Successes like these allowed the government to liberalize many other sectors, though retailing, banking, defense, and the news media remain the notable holdouts.

Extensive reforms have also affected India's capital markets, corporate and individual tax regimes, and judiciary. Such measures as easing capital controls, liberalizing equity pricing, and creating a regulatory authority (the Securities and Exchange Board of India) have been instrumental in bringing the country's money markets on par with those in the developed world. As a result, foreign investors can easily move funds in and out of India. Individual and corporate income taxes have been reduced to levels in line with those in the rest of Asia. And judicial reform has empowered citizens, giving them an effective tool to fight, for example, corruption, voter fraud, human-rights violations, and environmental degradation.

These efforts have made India one of the world's fastest-growing economies. In the future, the government must focus on stimulating domestic demand—a vital step if it hopes to attract the foreign investment needed to reach its growth targets. In addition, the country must intensify its efforts in important areas of reform in order to build a more competitive economy that benefits businesses and consumers alike.

Act to boost demand
Indians save too little to finance the economic growth needed to provide jobs for the country's expanding working-age population. Our projections show that the economy must grow by 8 to 10 percent a year or risk markedly higher unemployment, so foreign investment is essential to fill the gap.

Restrictive policies have also limited gains in foreign direct investment in some Chinese industries. See "Making foreign investment work for China."
But most foreign companies see India only as a source of low-cost skilled labor, particularly in IT, not as a major market for products and services. This crucial distinction helps explain why China attracts upward of ten times more foreign direct investment than India does. (Investment restrictions, to be addressed later, are also an important factor.) As part of the government's efforts to attract more foreign investment, the country must take three steps to stimulate domestic demand.

First, the Reserve Bank of India (the central bank) must keep interest rates regionally competitive to sustain a buoyant economy. Since 2002, the bank has reduced them to the current 6 to 8 percent, from 14 to 18 percent. Spurred by this decline, consumer lending has increased by more than 30 percent a year, and residential construction and consumer durables have also seen healthy growth.

Second, India's 28 states and union territories must all implement the value-added-tax (VAT) system1 introduced in April. Eight have yet to do so. The VAT system will allow overall consumption taxes to fall to 15 to 20 percent by 2007, from the current 30 to 60 percent, thus releasing a flood of latent demand. China, for example, experienced a sudden increase in demand in 1994, when the government introduced a standard 17 percent VAT on factory prices2 for most manufactured goods and services. India can expect a similar surge once the VAT system has been fully implemented, since for every 25-percentage-point decline in prices, consumer demand increases three- to fivefold, according to our estimates. States that have already adopted the standard VAT rate have experienced, on average, a 12 percent increase in tax collections for the second quarter of this year. These results suggest that the government has room to reduce overall consumption taxes even further—to around 12 percent—without affecting its revenues.

Last, state governments must work to reduce their budget deficits. The central government has pledged to cut its deficit to 3 percent of GDP by 2009, from the current 4.3 percent. But as the center tightens its belt, state governments have allowed their deficits to grow steadily, for an aggregate state deficit of 5.1 percent of GDP today. As a result, the combined deficit of the central and state governments has held steady at about 8 to 9 percent of GDP throughout the reform effort. These deficits not only put pressure on interest rates but also lead to massive government borrowing, which siphons off funds that would otherwise be available for capital investment or consumption. Servicing this debt is also a huge burden, so the government must cut the total public deficit to 4 to 6 percent of GDP.

Increasing competition
To unlock India's true potential, accelerated consumption must be coupled with continued liberalization of the country's markets. The reform agenda must focus on eight areas.

Product market reform. Having picked the low-hanging fruit, India must find the resolve to deregulate politically sensitive sectors—particularly retailing, banking, the news media, and defense. Exposing the retailing sector to world-class scale, skills, technology, and capital, for example, wouldn't lead to greater unemployment, as some claim. Rather, it would help workers to find jobs that add more value: for instance, jobs with distributors (delivering goods to retail outlets) and with intermediaries such as transport agents (delivering goods from manufacturers to wholesalers). Consumers would also benefit from better quality and lower prices. As reform spreads, other industries will experience similar outcomes.

Infrastructure. The government has invested in India's infrastructure and upgraded ports, telecommunications, and highways. But several important areas, such as power, water and sewerage, railways, and airports, remain troublesome, in part because intransigent state governments often block progress. Disputes over water-sharing rights, for instance, have slowed a $150 billion project that would link a number of India's rivers (the Brahmaputra, the Ganga, the Godavari, the Krishna, and the Yamuna) with a system of waterways. If completed, these canals would provide much-needed water to millions of Indians and boost agricultural productivity.

Meanwhile, the Electricity Act of 2003 aims to provide businesses with uninterrupted, low-cost power. The act permits the delicensing of power plants and provides for open access to generation, transmission, and distribution while phasing out cross-subsidies. So far, however, only eight state electricity boards have unbundled power generation, transmission, and distribution—a necessary step for implementing the measure. For this landmark effort, state regulators must also clarify myriad other details, such as the rules and access charges for third parties that supply industrial power and a clear definition of the contractual obligations of the generating companies. While these kinds of initiatives have failed to gain traction in the past, the central government has recently shown remarkable creativity in getting the states to play along.

Land reform. One of the greatest problems plaguing India today is confusion over land titles. Because of high stamp duties, property owners have long avoided registering transactions and instead transfer land through other means, such as powers of attorney. As a result, many titles do not correspond to the people actually in possession of the properties. Stamp duties must be reduced to international levels, and the government must streamline the registration system by establishing fast-track courts and implementing electronic record-keeping systems. Andhra Pradesh's progress in this area should encourage other states to follow its lead.

Urban renewal. Since India's independence, its urban population has grown fivefold, leading to overburdened facilities and greater numbers of urban poor. The central government has budgeted an initial $1 billion to finance its National Urban Renewal Mission, but states must also do their part. Measures that state governments ought to adopt include increasing usage charges such as property taxes and water and sewerage fees, improving collection rates for fees and taxes, enhancing the efficiency of municipal corporations, and making better use of assets in and around cities. In Mumbai, for instance, where terrible flooding recently underscored the need for quick progress, we estimate that the state could immediately finance about $10 billion in infrastructure improvements through measures such as reforming the property tax regime and improving collections from their current minimal levels. Public investments of this kind could attract an additional $40 billion in private funding. All told, these investments could greatly improve the quality of life for Mumbai's population.

Asset recovery. The government must continue to expedite the recovery of assets from bankrupt companies. To address the new market realities and to sustain the economy's long-term health, it should bolster recent measures that help lenders recover dishonored checks and assets from indebted companies. In particular, the government should clarify the mandate of the Asset Reconstruction Company of India, established recently by a consortium of banks, by giving the company a more active role in debt restructuring and recovery. Foreign institutions must also be allowed to invest in such ventures. Moreover, the government should encourage the sale of nonperforming loans by allowing foreign banks to purchase them and by making these transactions exempt from stamp duty.

Enforce measures protecting intellectual property. Over the past decade, the evolution of knowledge sectors such as pharmaceuticals, biotech, and IT services has been phenomenal. The patent law passed earlier this year will augment their growth. Now the government should enforce IP protection measures effectively and expeditiously; only then can India promote creativity and innovation and sustain its cultural, scientific, and technological development. To improve the protection of IP, India should also align its patent regime with global standards in order to prevent the sharing of proprietary information in areas such as data exclusivity and to improve the overall capacity and quality of the infrastructure and resources in the country's patent offices.

Labor reform. To increase exports of manufactured goods rapidly, the government must permit the free use of contract labor for all work and repeal a law forcing companies with more than 100 workers to obtain state approval before cutting jobs. In tandem, India's labor benefits should be extended to all workers, not just those in the organized sector.3 Reform legislation should also consider establishing safety nets and policies that ease the retraining of workers. Simplifying labor laws could unleash unprecedented levels of foreign direct investment and foster brisk growth in light-manufacturing industries, such as toys, leather, shoes, textiles, and apparel, where India's cost advantage and skilled workforce should help it become a strong global presence.

Privatization. In India as in other countries, selling state assets is controversial, but the government must build on its success in privatizing Indian Petrochemicals, Hindustan Zinc, Bharat Aluminium, and the international telecommunications service provider Videsh Sanchar Nigam, among others. To manage political opposition, the government might consider creating a trust or special-purpose vehicle to act as a holding entity, much as Singapore's Temasek does. After the assets have been transferred, the holding company could be taken public, effectively diluting the state's share in the companies (without privatizing them) and releasing them from statutes applying to the public sector. As long as these companies, representing 60 percent of the country's capital stock, remain in the state's hands, their full potential will not be realized. Proceeds from the sales could also be used to bring down the public deficit.

After more than four decades as a closed economy and 14 years of reform, India has ascended the world stage and laid the groundwork for rapid growth. Low interest rates have also provided a lift for the economy. If policy makers continue on the path of economic reform—with a focus on increasing demand and competition—the flow of foreign direct investment to India will most likely increase, helping it to harness the immense potential of its young and educated workers. The foundation is in place for the economy to grow by 10 percent a year, but further effort and unwavering commitment are needed for India to emerge as an undisputed global economic leader.

About the Authors
Ranjit Pandit is a director in McKinsey's Mumbai office.

Notes
1The value-added-tax regime covers all manufactured goods and services, with proceeds shared between the central and state governments in a 68:32 ratio. The system is being implemented in three phases: the consolidation and unification of state taxes, the consolidation and unification of central taxes, and the equalization of tax rates for all manufactured goods and services.

2Or approximately 14 percent on retail prices.

3The organized sector essentially consists of companies that employ more than ten people.

Making India a global hub - McKinsey Quarterly, 2005 Special Edition: Fulfilling India's promise

Making India a global hub
India could be a global leader in education and financial services, to name just two possibilities, asserts the IMF's chief economist—but not until it opens up to the world.

Raghuram G. Rajan

The McKinsey Quarterly, 2005 Special Edition: Fulfilling India's promise


India fever is spreading in the world's investment community. The Western press rarely mentions that certified growth miracle, that leviathan of global trade—China—without adding "and India." In an admittedly unscientific test, a Google search reveals over 10 times more references linking "India" and "China" than "India" and "tiger" and 100 times more than "India" and "maharaja." But amid all the hoopla, it is well worth asking whether India is really ready to play a central role in the global economy. Instead of going through the familiar litany of strengths and weaknesses, it would be useful to pose the question in a different way: does India have the mind-set it needs to be a player in a globally integrated economy?

Mind-set is a difficult concept, and even more so when we speak of a nation's mind-set. But it does seem that there are times when a nation feels confident that it can take on the world, meet any challenge, and achieve any dream. If properly channeled, this spirit can be an enormous aid to growth. In fact, some sociologists argue that such a spirit, a national atma vishwas,1 so to speak, has been critical to the kind of explosive growth seen in Japan in the 1950s and 1960s, in South Korea in the 1970s, and in China today.2 It is the spirit that transformed South Korea from a country with a per-capita income on par with India's into a member of the Organisation for Economic Co-operation and Development (OECD) in just four decades, that built a sleek futuristic city in the Pudong district of Shanghai in what was largely farmland just a decade ago, and that is currently responsible for the development of the world standard, on-time New Delhi Metro. It is the spirit that asks "why not?" instead of "why?"

One reason such a mind-set is important is that it creates an intolerance for laziness, for shoddy products, for open corruption, and for the usual excuses. When people have a strong conviction that they can achieve the possibilities of the future, they become less tolerant of impediments and more willing to sacrifice their present happiness for the opportunities that they can see are being created for their children.

This mind-set can be important today for another reason as well: it gives a country the confidence to open itself up to the world, to take advantage of outside opportunities no matter where they arise, to use the cheapest resources no matter where they are produced, to hire the best people no matter where they were born, and to face the fiercest competitors no matter where they originated. Such confidence will be necessary if India is to become a hub for the global economy. Clearly, some segments of Indian society possess this mind-set. But does India have it as a nation and, if not, what must India do to get it?

In some ways, India is well prepared to be a global hub. It has a multicultural, multiethnic society with a vibrant democracy and a free press that readily exposes its shortcomings. The country's highest elected office is open to anyone who consciously opts for Indian citizenship, not just to those who are born into it. All this reflects a willingness to assimilate and to work with foreign influences in the broadest sense of the term.

Some of India's corporations also demonstrate this willingness. The global expansion of the Tata Group reflects the emergence of Indian multinationals. But it isn't just large corporations that are spanning borders—technology has made it possible for small firms to do so as well. HeyMath! is a Chennai company that provides assistance with mathematics homework to students and lesson plans to teachers over the Internet. Schools in Singapore were the company's initial target market, but after successfully developing and selling its product there the company is now expanding elsewhere, including India. HeyMath! is small but truly multinational, with consultants from Cambridge University and IIT Madras, managers born in India but trained in the West, employees from Chennai, a knowledge base informed by the math curriculums of a number of countries, and customers around the world.

Despite these examples, as an economy India is still not as open to foreign goods and services, labor, or knowledge as it should be. On the International Monetary Fund's trade restrictiveness index, India has a score of 8 out of 10, which places it among the most restrictive countries; in 2004, it accounted for 1.62 percent of the global GDP but for only 1.07 percent of world trade.3 Moreover, India holds the dubious distinction of having instigated the largest number of antidumping cases under the World Trade Organization from 1995 to 2004.4 India's capital account is still relatively closed. The country restricts foreign entry and participation in various areas of the economy—even those that have few implications for national defense. And it is extremely wary of advice from foreigners.

Why is India so closed? The facile explanation is that Indians still remember the colonial experience; indeed, some see the process of opening up as a new colonialism by foreign multinationals assisted by a fifth column of neoliberal Indian economists. Yet there is a big difference between a monopolist colonial power and multinational companies: competition, which keeps any single multinational from getting overly powerful, either economically or politically. Although I do not want to imply that, individually, the multinationals have all been without blemish, there is no credible evidence that they have conspired to exploit India or misbehaved any more than their similarly placed Indian counterparts have. And in that most revealing of markets—the Indian marriage market—a job in a multinational has always been seen as a plus, almost on par with a place in the elite Indian Administrative Services. This would not be true if multinationals were suspected of dark and dire deeds.

My sense is that India's failure to open its economy reflects fears other than a dislike or mistrust of foreigners. This is, in some ways, good news, since it would be far harder for India to become a hub of globalization if the country were intrinsically xenophobic. But what else could explain how closed India remains?

Indian companies, when challenged to improve their productivity, found that the country had unique sources of comparative advantage
One explanation is the lack of confidence among India's entrepreneurs. Until recently, shielded by protection against domestic and foreign entry, they felt that they simply couldn't compete against foreign companies. Protection not only renders its beneficiaries lazy and inefficient but also gives them less incentive to rectify the system's distortions and inefficiencies. Because the costs could be passed on to consumers, India's corporations couldn't have cared less that finance was so costly during the License Permit Raj—the highly bureaucratic government system of allotting permits for business undertakings. But when the talk turned to liberalization, the same companies argued that they couldn't compete against foreigners with access to much cheaper finance. And Indians are not unique in making such complaints. An analysis of attitudes around the world toward competition shows that entrepreneurs are far more likely to oppose liberalization when the financial system is relatively underdeveloped.

Two things have been particularly important, I believe, in helping Indians break out of this vicious cycle in which a lack of competition has bred corporate indifference to the efficient provision of factors of production, such as power and finance, while the resulting inefficiency in turn has reinforced resistance to liberalization. First, software companies such as Infosys, Tata Consultancy Services, and Wipro Technologies showed that Indian firms could compete effectively on the world stage and that the profits from doing so were enormous. Second, creeping liberalization—initiated by crisis but then gaining a momentum of its own—forced competition on to other parts of the economy. Indian companies, when challenged to improve their productivity, found that despite the inefficiencies of the system, India had unique sources of comparative advantage, even in manufacturing. A few years ago, Indians feared that Chinese imports would swamp the motorcycle market. Today, Bajaj Auto sells more than 1,000,000 motorcycles annually and expects to export 160,000 this year. India's corporations have come a long way, and many are ready to make India a hub of globalization.

If so, what keeps India relatively closed? One factor is the country's politicians, aided and abetted by the bureaucrats. Foreigners not only are much harder to control than locals are but also don't vote, so they are an appealing lot to discriminate against. But India isn't special in this regard: Nordic politicians resist the takeover of the region's banks by other European banks, French politicians try to create national champions, and US politicians complain about global outsourcing. Politicians the world over, with a few notable exceptions, find it convenient to rail against openness.

But politicians don't act in a vacuum; they are particularly effective when they cater to strong constituencies. With large corporations becoming more open minded, so to speak, could it be the people who are against competition? On average, and with the caveat that cross-country comparisons are fraught with difficulty, the answer is no. Of the countries included in the World Values Survey, India and China are among the most favorable toward competition.5

But averages conceal some important patterns. Across countries, and correcting for other factors, richer people are typically more strongly for competition. In India, however, they are not. Indian farmers and agricultural workers, especially those who are not owners, are yet another powerful political constituency against competition. Finally, though in most countries older people are much more favorable than the young are to competition—a contrast calling to mind Churchill's famous remark that "If you are not a liberal at 20, you have no heart; if you are not a conservative at 40, you have no head"—older people in India tend to be against it. This probably reflects the strength of India's socialist past rather than a lack of gray cells among the elderly. In addition, the fact that many of India's politicians are rich, from rural backgrounds, and relatively old makes these constituencies particularly influential.

But even here there is reason for hope. First, more and more of India's young reach working and voting age unencumbered by the baggage of the past, and they are sending their kind into Parliament. Perhaps of greater importance, education and, more generally, the spread of skills tend to make people tolerant of competition: human capital gives them a chance in a competitive world, and India is no exception. So a second reason to hope that attitudes will change is the likelihood that as the population becomes better educated and skilled, India will be more tolerant of competition in general and of openness in particular.

An enlightened government can follow policies for openness and liberalization that encourage and assist the constituencies. The more prepared people are to face competition, the more tolerant of it they will be. Therefore, three key steps are, first, expanding access to and improving the quality of education; second, improving access to finance; and, third, promoting ownership and building infrastructure in rural areas. It is heartening that the Indian government sees these three things as priorities, but it should resist the temptation to use discredited methods, such as pouring money into education without tackling difficult issues (such as teacher incentives and parental involvement) or mandating wider lending by public-sector banks without improving their incentives and systems for evaluating credit and recovering loans. The government could be particularly helpful if it took on an enabling role—setting standards and providing an adequate supervisory, legal, and regulatory infrastructure—while encouraging the competitive provision of financial and educational services by the private sector.

As the constituencies for competition grow, tariffs not only will fall naturally but also won't be replaced by hidden nontariff barriers. This isn't to say that direct policy changes will have no role. For many reforms, a key step is reducing the country's large fiscal deficit. If India is to be a global center in financial services, for example, it must ensure capital account convertibility: the freedom to change local financial assets into foreign financial assets, and vice versa, at market rates of exchange. But the country cannot open the capital account without risk until the deficit is contained—the government has come to rely on a captive domestic financial market to finance it, and the risk of crisis would rise considerably if domestic investors were allowed to invest abroad before it was curbed. Many other policies, such as reorienting bank credit away from the government and toward the private sector and developing effective monetary-policy tools, also hinge on containing the deficit, so the importance of doing so cannot be overemphasized.

Competition will mean greater volatility. The best way to prepare people for volatility is to let them experience it incrementally. At present, however, the government is the insurer of first rather than last resort, as shown by the rush to fix prices that move up rapidly, to shore up interest rates that fall "too far," to rescue nonviable companies with special "technology-enhancement" funds, and to bail out failing banks by merging them with healthy ones. And all too often, it is the vocal and the politically well connected rather than the truly needy who get the manna from government.

A better form of insurance is flexibility, which India must build into the economy so that it can react quickly to inevitable change. The country has too much preservation and too little creation or destruction. Interestingly, studies show that the way to create more new companies is to make it easier for them to enter and leave a business (or to go out of business entirely). This means reducing the many petty bureaucratic barriers to entry as well as enacting more flexible labor laws and a better (and more rapidly enforced) bankruptcy code.

Increased corporate flexibility will inevitably force individuals to bear losses: for example, workers who lose their jobs as the economy changes. India should make it easier for workers to learn new skills, so it is all the more important to invest in education. But the country needs to find better ways to assist those who cannot adapt, especially because old social-support networks like the extended family and the village tend to erode in the modern market economy. As India modernizes, it has to create an explicit safety net—including unemployment insurance, pension schemes, and health care—targeted at individual workers to shield them from business cycle fluctuations. In doing so, India should learn from the experience of other countries to avoid killing incentives for work or expanding programs beyond the ability to pay for them.

Finally, people will be far more willing to accept competition if they have time to adjust and are convinced that the government will use this time to improve their ability to compete. A gradual phasing in of competition and phasing out of protections and subsidies may find far greater acceptance than shock treatment would.

Thus far, I have discussed what it will take for India to be more welcoming toward foreign businesses. But the government also needs to think about what will make foreign businesses more interested in India. Here again, the short-term approach would be to ply them with tax breaks and financial guarantees. These not only are addictive but also tend to discriminate against domestic companies, which then have perverse incentives to take capital abroad, have it ritually cleansed and certified as foreign, and then bring it back home to take advantage of the breaks.

A better way to draw in foreign investors would be to treat them as domestic ones are treated and to deal with all of the domestic investors' concerns. Foremost among them is policy uncertainty. All too often in the past, policies have been hatched by theorizing bureaucrats removed from the polluting influences of business reality. When a policy, with all its clauses and subclauses, is rolled out nationwide after much discussion within this small and out-of-touch elite, it quickly fails the market test. And because little effort has been made to build a consensus among business groups or political parties, there is immediate uncertainty about when and how much the policy will change.

Fortunately, the authorities are encouraging more open debate about policies before implementing them. It would also help to experiment with different approaches on a small scale to see what works or to avoid setting policies in stone before an initial rollout phase, when they can still be changed. Clearly, it will be less necessary to change policies that specify general principles rather than attempt to micromanage implementation.

Given the size and strength of India, it can afford to take the extra step to quell regional tensions
Foreign investors also value transparency in decision making—more so than large domestic investors do, because foreigners are less familiar with the corridors of power. Not everything can, or even should, be laid out in clear rules, but where discretion is relied upon the decision-making process should be seen as fair. Regulatory and supervisory bodies should be given more independence; a first step would be to staff them with attractively remunerated professionals rather than bureaucrats of proven loyalty.

And don't forget that most countries have their most significant business relationships with their neighbors. Given the size and strength of India, it can afford to take the extra step to quell regional tensions. The government's immediate offer of help to the country's neighbors and its coordination of regional relief efforts in the aftermath of the Indian Ocean tsunami are a silver lining in a heartrending tragedy. More proactive attitudes will help to draw in not just neighbors but also the larger world community.

To conclude, the stars are well aligned for India to become a hub of globalization, but the country is still some distance from that goal. The vote of confidence that foreign investors are giving India should not induce complacency; they are betting on the potential, not the reality. It is up to India to realize that potential. The country could well become a global financial center, for example: it is in the perfect time zone and has the necessary information technology, communications, and financial skills. All that is missing is a more sound regulatory environment and the conditions needed for introducing capital account convertibility. The country could also become a center for higher education: it has the core human capital, both in India and dispersed around the world, and a history of tolerance for ideas. All that is needed is a more welcoming environment for foreign educational institutions, faculty, and students, as well as a greater tolerance for market-clearing fees and salaries. Tourism, health care—I could go on, but the point should be clear. India's future is in Indian hands and will be what Indians make of it.

About the Authors
Raghuram Rajan is the economic counselor and the director of the research department at the International Monetary Fund.

This article is adapted from a speech, "India—A hub for globalization," given by the author on January 7, 2005, at the Pravasi Bharati Divas Conference, in New Delhi. The views expressed in the article are his own and are not meant to represent those of the International Monetary Fund, its board, its staff, or its member countries.

Notes
1Hindi for "self-confidence."

2Liah Greenfeld, The Spirit of Capitalism: Nationalism and Economic Growth, Cambridge, Massachusetts: Harvard University Press, 2003.

3This estimate is based on the International Monetary Fund's World Economic Outlook, April 2005, with data for 178 countries.

4Of the total number of cases initiated by the reporting countries during that period—2,646—India initiated 15.1 percent (400), well ahead of the United States (354 cases) and the European Union (303 cases).

5The survey, a global investigation of sociocultural and political change, is conducted by a network of social scientists at leading universities around the world.