Is India the next great convergence story?

India has been a favourite of emerging market investors for many years. In fact, according to survey data, a majority of mutual fund managers have favoured India more or less since the global financial crisis.

Underlying the many short-term reasons why asset managers might want to own Indian assets is the idea that India is the next great convergence story after China. A relatively poor country with a growing and large workforce is just the thing to get the world economy growing again. In a world starved of investment and development, India is the great hope.

This paper assesses India’s prospects of becoming a classic convergence trade. India is a big and complicated country. Can it just follow the Asian export model to success?

Our research suggests that India is not on this path, and is not pursuing it actively. Indeed, it is not clear whether this path is even available. But India is not alone in having an imperfect economic structure for convergence. China, South Korea and Japan all had issues before they began their rise.

We highlight the alternatives for India, review how it might overcome some of its existing challenges, namely a lack of investment and the labour market, and explain why Indian equities still offer attractive opportunities for investors.

What do we mean by convergence?

While the link between economic growth and stock market performance may not be as strong as sometimes thought, it should not be dismissed. Indeed, many investors are actively attracted to emerging markets by the idea that their economic growth inevitably converges with that of developed markets.

Convergence theory, which has its origins in the Solow growth model, suggests that economies can benefit from “catch-up growth”. This may be through a combination of an initial phase of capital stock accumulation, and as the benefits of additional capital/savings diminish, through technological advancement.

For example, if a poorer country gains access to technology from richer economies, its production capabilities should improve, supporting higher returns on capital, creating a virtuous circle that attracts more capital to fund further capital growth.

India’s macroeconomy

India has been talked about as an economy on the edge of explosive growth for many years. But it has made little relative advance on the developed world. As this chart shows, Indian GDP per capita relative to the US has more than doubled since the 1990s. However, this pales in comparison to China.


The comparison between the two countries merely tells us that the structure of the Indian economy is not the same as the structure of the Chinese economy - hardly a revelation. An assessment of the structure of the Indian economy is key to uncovering what is preventing it from achieving Chinese style growth.

One notable aspect we review is investment. Given the low level of complexity in India’s exports and hence industry, is India investing enough? The next chart shows total fixed asset formation as a percentage of GDP compared with other major economies.


India is above the US. Given that the US is a country at or near the technological frontier, we would expect it to have lower investment levels and we would expect India to be substantially higher. To gauge the sort of investment levels that India should be aiming for we can use the examples of South Korea, Japan and China; all countries which have experienced rapid growth in the past under the Asian export model. During their periods of high growth these countries had investment above 30% of GDP for substantial periods of time (although the data is not in this chart, the Japanese rate was high throughout the 1960s as well).

India has only managed a brief period of high investment in the mid 2000s. It is fair to say that, given its level of development, India is substantially underinvesting.

The microeconomic picture – some sectoral analysis

One of the most important things to understand about India is its huge regional differences. The macroeconomic analysis is an amalgam of diverse circumstances at a state level. This does not invalidate the analysis, but it does complicate the implementation of any remedies.


A key constraint on many developing economies is access to energy. In this, as in other things, India presents a very mixed picture. Power availability is still a problem for rural communities, but it is relatively cheap and accessible for business.

India cannot grow its GDP per capita substantially without a good deal more energy use per capita; there are no instances of countries with high GDP per capita and low energy use per capita. Can India improve its energy penetration at the same time as increasing energy usage substantially?

As the next charts show, the majority of India’s current energy mix comes from coal. These figures do not capture rural fuel sources, or for those without connection to the electricity grid or transport links to get bottled liquid petroleum gas (LPG)s. The International Energy Agency estimates these fuel sources to be worth about 20% of formal fuel sources. India needs to replace these energy sources with electric power or gas. And it will need to grow.

BP’s estimates for India’s energy mix in 2040 project a big increase in the renewable energy share. However, India is still assumed to be using 48% coal. Given that overall energy use is going to increase by over 2.5 times, that is going to be a substantial increase in coal use. India is already home to 15 of the top 20 most polluted cities in the world according to the World Health Organization.


The BP forecast is unlikely to come true. But if not coal then what? India lacks a proper gas infrastructure. Domestic gas pipelines do not exist in any size in India – indeed a portion of India’s oil use is for refining into LPG gas which is transported in bottles all over the country. Considerable investment is likely to be needed if India is to avoid restricting energy capacity and hence limiting growth potential.

As we discuss in the paper, further pressure is likely to come from global warming. Although India is the lowest per capita CO2  emitter among the world’s largest economies, on a total basis it is the third largest emitter behind China and the US. If India is to enjoy an industrial revolution in the style of China, it would likely quadruple its CO2 production. That would generate significant pushback from the rest of the world, regardless of how unfair it would appear to Indians. Indeed, given how many parts of India could be directly affected by global warming, it may not even appear that unfair to Indians. This reinforces the point made in regard to particulate pollution. The BP forecast looks untenable. India will need to find other solutions.

India’s power system is not ready or capable of coping with a surge in industrial production. India could be the first country that is seeking to massively increase its electricity usage at the same time as trying to improve energy mix away from hydrocarbons. It remains to be seen whether this is possible.

Labour force

A key argument made by proponents of India is that it is due a substantial demographic dividend. This is certainly true versus China. India has a significant structural weakness though. The female participation rate  is shockingly low.


India is not on the convergence path; but there are alternatives

India has a huge population, is relatively stable, operates under the rule of law and is relatively poor. You can see why investors think (or hope) that there is a substantial convergence trade possible. The evidence, however, is that India is not on this path, and is not pursuing it actively. Indeed, it is not clear whether this path is even available.

There seems little need for another huge exporter to provide more manufactured objects to the world as the cost of manufacturing drops relentlessly anyway. But there are alternatives for India. Even if it does not, or cannot pursue an export-led model, it can build out manufacturing capacity to satisfy its own demand. Providing reasonable housing and basic household goods to Indians would still require manufacturing capacity and have global implications.

To do this India needs to confront two main problems. First, a lack of investment, notably in power and electrification. This is now particularly difficult, since the assumed route of a decade ago – intensive coal fired power stations –looks to be closed off. The second issue that needs addressing is education and the quality of the workforce, specifically female education and workforce participation.

What does this mean for investors?

To our mind, India is not likely to see convergence style growth in the near future. We will be watching carefully to see if policy moves and industrial trends shift India in this direction. But rapid, export-led, convergence is not the only way forward. India is still capable of strong growth rates and, in any case economic growth does not solely determine the success of an investment. India has a large varied economy represented in the stock market across most sectors. It will continue to provide investment opportunities depending on industry dynamics, economic cycles interest rates, and other of the “usual” factors.

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Is India the next great convergence story? 24 pages | 2,206 kb