India States: The India Within India
The vastness and diversity of India lends to many interpretations. The temptation to see one India simply because it is one country leads to a shallow analysis of the opportunities and risks. It also leads to poor politics and poor economics. Headline economic performance statistics about India, regardless of whether GDP is growing at 4% or 10%, tell an incomplete economic story. As anyone who has travelled to the country can attest, India is an incredibly diverse continent-like country with many different languages, cultures and religions. However, it is often overlooked that India is also extremely heterogeneous from an economic perspective: its richest state has a per capita income over ten times higher than its poorest state. Indeed, parts of India are much more wealthy and developed than the overall numbers for India (c.US$1500 per capita income) would ever lead one to believe. Large metros and city-centric states like New Delhi, Mumbai, Kolkata, Chennai, Bangalore, Ahmedabad, Pune and Goa have per capita incomes of c.US$3000-5500 (similar to China in 2008-2011). At the same time, a quarter of the population lives in India two poorest states, Uttar Pradesh (“UP”) and Bihar, where the per capita income is US$500-700, a level that Sub-Saharan Africa crossed in 2003-2005. This stark difference has significant implications from both a policy and investment perspective. Just as one would not deploy the same development policy or investment strategy for China and Sub-Saharan Africa, it is not advisable to look at India in broad strokes when considering policy and investment decisions. Indeed, a close analysis of each of the Indian states, as if they were standalone economies, reveals other significant differences in terms of demographics, risk profiles, local policies, productivity and industrial composition. Understanding the nature of these differences and the complex local factors underlying their causation is critical for successful investment and business decisions, as well as for policy solutions to India’s development challenges.
India: A Continent, not just a Country
Through many lenses, the diversity of India’s regions makes it more like a continent like Africa, Europe or South America as opposed to a single country. While other large heterogeneous economies like China, the US and the Eurozone also have significant variations between their wealthier and poorer regions, the gap between India’s richest and poorest regions is starker by a large margin (see table below for a comparison). While the US, Eurozone and China have a 2-4x difference between their richest and poorest regions, the difference between India’s richest and poorest state is over 10x. On many other metrics, the gap between India’s regions is similarly wide. For example, the human development indicator (HDI) index for Indian states varies from 35.8 to 79.0 vs. a range of 56.9 to 82.1 for mainland China’s various provinces; average GDP growth over the last five years has varied from as low as 4.4% (in Orissa) to 11.8% (in Goa) while the average rate of inflation has ranged from 2.6% to 10.1% in spite of a common monetary policy and the same cost of capital across the country. Some of the differences are extremely counterintuitive and point to large underlying structural differences between the states. For example, Bihar, India’s poorest state, is the second least urbanised state yet has the highest population density whereas Maharashtra has close to half its population living in urban areas yet has an overall population density a third of Bihar’s level.
Comparison of Richest and Poorest Regions of US, Europe, China and India
Key Drivers of India’s Regional Economic Disparities: Demographics, Urbanisation and Governance
Although this difference in the economic profile of India’s states is due to a wide range of structural factors, the most basic driving force is different rates of demographic growth and urbanisation (see chart). While many analysts have written about India’s ‘demographic dividend’, its large and growing young population, it is easy to overlook that a big portion of this population growth is concentrated in India’s poorest states. Bihar, Madhya Pradesh, Rajasthan, and Uttar Pradesh (UP) (collectively known as the “BIMARU” states) along with Jharkhand and Chattisgarh account for almost c.50% of India’s incremental population. These states are amongst the least urbanised, the most dependent on agriculture and have only c.10% of India’s registered companies. On the other hand, several Indian states, particularly in South India, have already had their demographic boom and population growth has slowed down to c.1.0% and lower. The urbanisation of India’s population is also at vastly different stages: the poorer states have 11-22% of their populations living in urban areas compared to 45-55% in wealthier states such as Maharashtra, Gujarat, Karnataka, Tamilnadu and Kerala. Urbanisation is of course directly linked to the emergence of the non-agricultural economy; therefore the more urbanised states are minimally dependent on agriculture, which accounts for 7-13% of their GDP unlike the poorer states where agriculture still makes up 20-30% of the state economy.
The other key reason for the inter-state economic disparities is the quality of economic governance. In India’s federal governance structure, a large number of key laws, including most business, labour and environmental regulations are under the strict control of the state government. Moreover, the state government is a key driver of the local business environment as it administers indirect taxes, provides clearances and approvals for projects and helps drive the development of infrastructure in both urban and rural areas. Therefore stable and economically progressive state governments that drive structural and economic reforms at a state level have a disproportionate impact on growth. For example, the state of Gujarat, which was led by Prime Minister Modi for ten years before he was elected last year to lead the country, managed to significantly streamline the regulatory environment for businesses and ranks the highest in the Cato Institute’s rankings of Economic Freedom Index (EFI) of Indian states. This has helped Gujarat achieve an average GDP growth rate of 9.3% between FY05-FY14 compared to a pan-India average GDP growth rate of 7.6% during the same period. On the other end of the spectrum, Bihar which has long been a far less developed state, under the leadership of Nitish Kumar who was elected in 2005, managed to provide a stable law and order regime and significantly improve its EFI rating, while rapidly building road connectivity across the state, and thereby accelerated its GDP growth to an average rate of 10.8% since FY07. Meanwhile, the neighbouring state of UP has seen frequent changes in the state government and has been unable to put in place state-level reforms at the same pace, with a flat EFI rating and grown at an average rate of only 6.6% during the same period despite a low economic base similar to Bihar.
Analysing India’s Regional Economic Differences: A Quantitative Perspective
In order to put these economic differences into a broader context of factors, we have analysed each of India’s state economies across a wide range of metrics including economic growth, inflation, demographics, urbanisation, literacy and human development indicators, EFI ratings, fiscal performance and state-level debt, amongst others. We have organised these metrics to form three indices which measure the following for each state: (i) the relative market size, (ii) the relative growth opportunity and (iii) the relative risk profile. When plotted out on a chart (see below), a clearer picture emerges of India.
Based on this risk-reward matrix, India’s states can be divided into four categories:
i. “The Outperformers” (the I-5). These are the large, higher-growth, lower-risk states which are major drivers of India’s overall economic development. Together they account for c.24% of the total population, c.36% of the urban population and 40% of India’s GDP. 57% of India’s companies are based in just these five states and collectively, they have grown at an average growth rate of 9.2% over the last decade, 1.5% higher than the overall Indian economy. These states all have favourable demographics, are predominantly urbanised and agriculture makes up a relatively small share of their economies. They are led by relatively stable state governments which have put in place liberal economic policies to attract investment both from India and abroad across a wide range of sectors and have managed their finances well with relatively low levels of debt. These states also rank high on literacy and human development indicators, indicating that their workforce can be leveraged for both the industrial and service sectors.
ii. “The New Frontiers”. These are states which are growing rapidly, however, they are at an earlier stage of development and have higher risk profiles for businesses and investors compared to the I-5 in that their economic growth is more volatile and uncertain and the business conditions on the ground are generally more difficult. These four states account for 18% of the total population, 11% of the urban population and only 10% of India’s GDP. Less than 4% of India’s companies are based in these states, nevertheless they have demonstrated robust growth, collectively growing at 8.7% over the last decade and accelerating to 9.4% over the last five years (2.7% higher than India’s overall GDP growth during this period). This category consists primarily of poorer states that have managed to partially reform their economic policies and have thereby significantly accelerated growth, albeit from a much lower base. While these states are growing rapidly, they are still in the early stages of the reforms process with large agricultural economies and lower HDI and EFI rankings, and are therefore riskier and essentially similar to some of the rapidly growing sub-Saharan African frontier economies.
iii. “The Old Economy”. These are primarily south Indian states like Karnataka, Kerala and Andhra Pradesh that have a longer history of development but whose economies have grown slower than the overall Indian growth in the last five years. These states account for 17% of the total population, 20% of the urban population and 20% of India’s GDP. These states grew largely in line with the overall Indian economy over the last decade at 7.7%, however over the last five years have slowed down to 6.3% average GDP growth (c. 0.4% slower than overall GDP growth). Although growth is relatively slower in these states partly due to lower population growth and partly due to having already industrialised, they are relatively stable and business-friendly from a policy perspective and have strong literacy and human development indicators. While they will continue to grow slower than the I-5 on an overall basis, they have a number of mature industry sectors.
iv. “The Laggards”. These are the states which have so far failed to participate fully in India’s economic growth. They are poorer with higher risk profiles similar to the “New Frontiers”, however have not managed to grow even in line with the overall economy. They account for almost 40% of the total population and 27% of GDP. With 22% of India’s companies, these states ought to be able to grow faster than the “New Frontiers”, however due to a range of issues, have managed only a collective average GDP growth rate of 6.9% over the last decade, slowing further to 6.5% over the last five years. This category consists primarily of poorer states that are comparatively less urbanised and dependent on agriculture. Despite their low base, these states have largely failed to put in place economic policy reforms to attract investment and therefore rank relatively lower in terms of ease of doing business and economic freedom, as well as literacy and human development indicators.
The last five years have seen the Indian economy slow substantially from the high rates of growth in the previous decade with overall growth slowing from an average of 8.4% in FY05-FY09 to 6.7% in FY10-FY14. In the last two years growth fell off significantly to 4.5% in FY13 and 4.7% in FY14. Excluding the (historically volatile) agricultural sector, growth slowed to 4.9% in the last two years primarily driven by a sharp slowdown in the ‘“Old Economy”’ and the ‘Laggard’ states while ‘I-5’ and the ‘“New Frontiers”’ regions demonstrated strong resilience, with non-agricultural GDP growth of 7.5% and 8.6% respectively. This is because the ‘I-5’ and ‘“New Frontiers”’ states have reformed and established a strong baseline level of 9-10% growth (and in the case of the “New Frontiers”, have a low starting base), therefore, even in the worst years for the Indian economy, their industrial and service sectors continued to grow at 7.5-8.6%. The ‘Laggard’ and ‘“Old Economy”’ states, on the other hand, have a lower baseline, more agriculturally dependent and inherently less resilient economies and therefore were the biggest drivers of the overall macro slowdown in India.
The map below summarises the position of the various states on the categories above:
The good news, especially for the “Laggards”, is that the matrix is dynamic and the relative position of states is constantly evolving as they undergo structural, political and macroeconomic policy changes. Madhya Pradesh and Jharkhand, for example, have significantly accelerated their economic growth in the last two to three years moving their position from the “Laggards” category to the “New Frontiers”. The “I-5” states however have been relatively stable, consistently outperforming the other states on risk-adjusted growth over the last 5-10 years and have become the driving force of the Indian economy (see table below). This is due to the fact that these states have been able to create broad-based economies with multiple growth engines including a robust services sector, industrial growth and strong agricultural performance by creating a business-friendly local policy environment to enable investment. These states have also focused on specialising and leveraging their core competitive advantages to create domestically and globally-competitive industrial and services clusters. For example, Gujarat has used its large coastline to develop leading major ports and emerged as one of India’s major industrial hubs for sectors including automobiles and chemicals. Tamilnadu too has built a large automotive industrial cluster and leveraged its capital Chennai’s educated labour force to create an IT hub to rival Bangalore. Delhi and Gurgaon (which is in the state of Haryana) have emerged as a hub for several sectors such as telecommunications and infrastructure that require close coordination with the central government. Maharashtra has not only leveraged Mumbai’s position as India’s financial capital, but simultaneously build industrial and services hubs out of its other major metros like Pune, Nashik and Nagpur. The “Old Economy” and New Frontier states too have leveraged their large cities and other assets to create some clusters such as the IT and e-commerce hub in Bangalore, an infrastructure services hub in Hyderabad and a tourism hub in Kerala, however, they have not been able to diversify into other industries to the same extent as the I-5. The “Laggards” on the other hand have largely failed to build any significant clusters.
Implications for Development Policy
Clearly, it would be an error to have one economic or political strategy for India as a whole. As India emerges as the world fastest growing major economy, the Modi government has the opportunity to develop a much more tailored development policy for each of the four categories of states. There are a number of lessons that the leadership, both at the central level and in the state governments of the other states, can draw from the I-5 too and there are many lessons to be drawn from the rest of the world. While there are clearly no ‘one size fits all solutions that can be applied across the country to recreate the “I-5”, there are nevertheless some important lessons from these states that policymakers in India need to absorb to emulate their success more broadly across the country.
There are a number of general lessons to draw from the success of the “I-5” that apply to all of India’s diverse regions today, as well as a specific actions each one will need to take. Among general lessons, firstly, there is an urgent need to focus on the development of cities because urbanisation is the key driver of the growth of industrial and service sectors. All the “I-5” states are effectively city-centric economies with large metros and a lot of mid and small sized towns which has helped them unleash economic opportunities outside the farm. Secondly, state governments outside the “I-5” need to focus on adapting the policies that have successfully driven investment and growth including increasing economic freedoms and the ease of doing business. China is exemplary in its successful implementation of policies that spread investment and growth from the prosperous coastal provinces to the inner provinces by setting simple metrics, establishing a cadre of successful leaders and rotating key leaders across the country. Thirdly, states need to focus on developing their human capital in order to unleash their demographic potential. An educated workforce helps states drive growth in industry and services while simultaneously reducing risk. At the same time, both the central and state governments need to create the conditions to ease intra-India migration in order to better balance growth across the states.
Additionally, every state, including the “I-5”, needs to focus on continuously leveraging their core strengths to build competitive advantages in specific industries and sectors which reflects their stage of development. This is critical to ensuring that each of the states is put on a customised path to economic success. Such a strategy would involve the following for each of the four categories outlined above:
- I-5 States: These states are at a similar level of development to coastal China a few years ago and hence, like China, should focus on diversifying their economies and moving them up the value chain. This will involve building competencies in Intellectual Property-led sectors such as pharmaceuticals and moving into higher-value-added manufacturing. Since these states have already achieved more than a decade of rapid growth, these states need to smoothly transition to a middle-income economy using South Korea’s or the other East Asian tigers as benchmarks.in order to avoid slipping into the “Old Economy” category of states unable to maintain continuing growth off a higher base.
- The New Frontiers: These states have provided the initial boost to their economies by providing a basic policy framework and infrastructure to unleash growth. However, since they are at a much earlier stage of development, they need to focus on investing in education, healthcare and urbanisation in order to make growth more broad-based and sustainable. The initial focus area for these states should be to leverage their low labour costs to build competitive advantage in lower-medium value manufacturing. The benchmark for these states is China in the early 1990s. FDI will have a major role to play in the transformation of the “New Frontiers”. Current levels of FDI per capita of US$1 (Madhya Pradesh) are still below those of US$14 that helped China transform itself and attracting foreign investment needs to be top priority for the leaders of these states.
- The “Old Economy”: These states, primarily in south India, have already had some economic success but are facing demographic challenges and have failed to diversify their economies and move up the value chain. Growth therefore has slipped behind the national average. To reverse this trend these states need to become magnets for talent from the rest of India and use this talent to build new industrial and service clusters, specifically through specialisation in specific high-value manufacturing and service industries. In a way, the challenge for these economies is similar to that faced by certain western European countries which also need to restructure significantly in order to drive economic growth in the face of demographic challenges. India will need to restructure its “Old Economy” states to become competitive internationally and form a core engine of India Inc.’s export story. Today, India’s level of exports as a percentage of GDP at 25% lags far behind China’s (currently decreasing) level of 26%. The “Old Economy” states will need to work hard to help close this gap.
- The “Laggards”: This is a diverse category of states each with a unique set of challenges. The most common characteristic however is a failure of governance and a lack of the necessary state-level reforms to take advantage of their assets. The main focus for these state needs to be to provide the necessary level of business friendly policies, as well as law and order, in order to attract investment into the basic manufacturing sectors. Large states like UP can leverage their massive demographic advantage and low labour costs to easily establish competitive advantage in sectors like textiles (particularly with China ceding ground in some of these sectors) while others like Orissa and the North Eastern states can leverage their wealth of natural resources in order to provide a boost to industry. Many of these states have similar characteristics to the poorly governed countries in sub-Saharan Africa, hence strong leadership and governance is the first port of call for almost all of them, along with basic infrastructure investments. While overall infrastructure investment in India today is c.36% of GDP, (comparable to China’s level in 2000), this is largely driven by investments in the I-5 states, rather than in the “Laggards” where the need is among the greatest.
Conclusions: Implications for Businesses and Investors
For the many investors that PM Modi has been courting to come to India, the implications are clear: India cannot be looked at with a broad macro lens. It requires a deep understanding of the various states, the regional dynamic and the local factors at play in each. The scale of the inter-regional economic differences is such that the risk-reward nature of investments can vary significantly depending on the location, with each type of region suited for different profiles of investors:
- “I-5” States – Diversified Growth Investing. Investing in the “I-5” has distinct advantages in terms of accessing markets, which are growing at close to double digits and have a much lower degree of risk than the rest of the country, offering investor a wide range of potential investment strategies and opportunities. Given that these states offer the best ecosystem for business and innovation a disproportionate number of India’s high-value companies will likely come from the I-5, creating unique growth capital and venture opportunities in these regions, for both smaller innovator and more established companies seeking to access capital and expertise to move beyond India’s borders.
- “New Frontiers” – Scaled Bets and Higher Risk Ventures. The “New Frontiers” offer attractive opportunities for a set of industries that are mature and tried and tested in other developing economies. The regions are well suited for investors seeking to deploy long term investments in scaled manufacturing given that their significantly lower labour costs and demographic advantages should provide longer-term sustainability in terms of comparative advantage. The “New Frontiers” will also attract selected higher risk venture investments, focusing on an emerging tier of local entrepreneurs seeking to address needs in local or region markets. While these companies may not become the next Infosys, they can build differentiated and competitive businesses with a national footprint.
- “Old Economy’ States – Restructuring Investments. Investors seeking to deploy scaled capital in mature companies and restructurings will likely focus on the “Old Economy” states, which have built up a significant (for India) industrial base now facing the prospects of lower growth and increased competition from other regions. The restructuring, consolidation and rationalisation of sectors and clusters are an important investment need for these states regaining competitiveness and international investors could have an important role to play in this process.
- “Laggards” – Infrastructure Focused Investing. The “Laggard” states today lack some of the most basic types of investment, particularly around infrastructure, extraction of natural resources and basic mass employment industries. To date, these states, due to their policy and risk environments, have been unable to attract even minimal levels of private investment to create the basis for further growth. Provided that investors can secure basic investment protections and guarantees from regional and local governments, the “Laggards” should provide attractive opportunities for a wide range of infrastructure opportunities, whose volume and value will only growth with increasing economic activity.
PM Modi has visited 20 countries since securing the leadership of the country including the United States, China, Japan and Germany. Total capital inflows into India have increased over three times over the previous year, from US$24 billion to US$78 billion. However, 77% of these additional capital flows since the election have been into the equity markets (in the form of FII primarily into the liquid large cap stocks) and only 23% of the incremental capital has been FDI directly into businesses. Although the Modi government is in the early days of implementing its change programme, an analysis of the capital flows since the election suggests that investors are still waiting for a sign. Part of the hesitation is that India is complex and it is difficult for investors –sovereign, institutional and private – to know where to invest and in which form. The state analysis suggests that there are analogues to other countries, historic paths of development in other nations, understandable risk and return profiles and therefore there is a path that has been trodden elsewhere in the world and can be followed in India. The Modi government needs to make this simple and act as the guide that directs investors to the right places based on investors’ appetite for risk, return and sectors.
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