Weekend Long Read: Can India Become the World’s Next Manufacturing Powerhouse?

04 Sep 2024

I. Can India become a manufacturing powerhouse like China?

In the past couple of years, the economic fortunes and outlook for China and India have diverged. After the pandemic, China’s economic recovery has been weak while India’s has been strong. China is also facing many structural challenges: the country’s labor costs have risen sharply while its working age population and total population are declining; recently, foreign direct investment (FDI) has shrunk to low levels, national security concerns are hurting China’s trade and investment links; and local governments are facing fiscal difficulties in sustaining infrastructure investment. In contrast, India has a relatively young and rising labor force, the government has been improving infrastructure and the business environment, foreign investors are interested in coming to India, and it faces a far friendlier external environment than China.

Many investors ask whether India can become the world’s next manufacturing powerhouse. To be clear, when we discuss India potentially becoming a manufacturing powerhouse, we are not talking about it replacing China as the world’s factory now or soon. That is not feasible as China currently accounts for roughly one-third of global manufacturing while India is only about 3%. The real question is whether India has the fundamentals to set forth rapid manufacturing development going forward and increase its share of global exports along the lines of what China has done since the start of this century.

Since 2000, China’s GDP per capita almost quadrupled as the country became the factory of the world. Such economic performance was led by both exports and property heavy urbanization. China’s rise as a manufacturing powerhouse was driven by its competitiveness in global markets after the country’s World Trade Organization (WTO) entry in 2001 and domestic demand for consumption and investment goods. In this process, China’s abundant cheap labor sufficiently educated for manufacturing, relatively good infrastructure, opening up to international markets, and ability to attract FDI have been cited as the key factors behind its success. In addition, rapid growth of private enterprises also helped to reduce the relative importance of state-owned enterprises in manufacturing, helping to improve efficiencies and competitiveness. India’s per capita GDP in 2023 was about the same as China’s was in 2000 measured in constant USD terms (around $2,300 in 2015 USD, versus $12,000 for China in 2023), according to the World Bank. To explore whether and how India’s future economic development, specifically manufacturing growth, might resemble China’s path, we think it is useful to compare India’s economic features now with those of China’s at the turn of the century.

A smaller role for manufacturing

A notable difference between India and China is their economic structure, in particular the importance of manufacturing. China’s economy was already more manufacturing based at the turn of the century. Manufacturing was about 32% of China’s GDP in 2000, while services accounted for only 40%. India traditionally has been a much more services-based economy, and its manufacturing is about 13% of GDP today, while services account for over 50%. China’s manufacturing employment was about 110-115 million back in 2000, according to our estimate, and India’s is now about half of that, 55-60 million, while the two countries are roughly the same size in population.

As such, the roles of manufacturing in China and India in the global landscape are also different. We estimate China accounted for 6% of global manufacturing value added in the year 2000, rising to 9% in 2004, three years after it joined the WTO, to almost 30% today. India accounts for 3% of global manufacturing value added now, half of where China was in 2000. India, on the other hand, is doing well in services exports and accounted for 4.4% of global services exports in 2022, compared to China’s 4.6% in 2000.

Notwithstanding the difference in manufacturing’s starting position, how does India compare to China in some key factors commonly recognized as having driven the latter’s manufacturing sector growth?

A young, cheap labor force

Favorable demographics have often been cited as an important reason for India’s future growth, just as the abundance of young and cheap labor boosted China’s manufacturing competitiveness two decades ago.

In 2000, China had a population of 1.26 billion, with a median age of 29 years, while India today has 1.4 billion people and a median age of 28.2 years old, making its population bigger and slightly younger than China’s back then. Measured by overall population dependency ratio – ratio of non-working age people vs working age (15-64 years old) population, China started at 43% in 2000 (declining to 34% in 2010 before rising to 47% now), while India today is about 47%, also similar. However, China’s total employment was 720 million in 2000, while India’s is only about 550 million today, due to the low participation of women in India’s labor force. This, plus the lower share of manufacturing in the overall economy, means India’s manufacturing employment, at 55-60 million, is only half of what China’s was back in 2000, although it is still by far the second-largest manufacturing labor pool globally. This also means that India’s potential manufacturing employment could expand notably should female labor market participation rise significantly.

The average monthly wage in India’s manufacturing sector was about $196 around 2023, significantly lower than some large ASEAN economies, and a fraction of China’s. It is largely comparable to China’s manufacturing wage back in 2000.

In terms of the education level of the labor force, India has an adult literacy rate of 76% as of 2022, although the youth literacy rate is much higher at 97%. These compared with 91% and 99%, respectively, for China in 2000. The average years of schooling for India’s working age population is 7.8, slightly lower than China’s 8.4 back in 2000. About 25% of India’s working age population has intermediate or secondary education (according to the International Labor Organization), higher than China’s 14% back in 2000 (World Bank data). The OECD estimates that 24.5% of people aged 25-64 in China had at least an upper secondary education in 2010 and 37% in 2020.

Improving infrastructure

While infrastructure has been a long-standing challenge in India, the country has been consistently investing in transport and related areas in the past 10-15 years. According to the Economist (2024), India’s spending on transport more than tripled as a share of GDP between 2014 and 2023. While there is no aggregate data on infrastructure spending, UBS estimates that total infrastructure spending (including spending in communication and broadcasting sectors) is running at about 7% of GDP. If we exclude investment in communications, then India was spending about 5.8% of GDP in 2023 (including 2.3% of GDP on construction) on infrastructure, while China spent about 10% in 2003 (not including construction).

Reflecting the continued investments in upgrading infrastructure, India’s logistics performance index (compiled by the World Bank) has continued to improve since 2010. It is now ranked 38th with a score of 3.4, from 46th a decade ago (2012). Back in 2007 (the earliest available data), China was ranked 30 with an average score of 3.3. It has continued to improve and now ranks 19th, with an average score of 3.7.

India also improved on the World Bank’s measure of ease of doing business index. This indicator compares an economy’s business environment with a measure of best practice for 10 “Doing Business” topics, including starting a business, dealing with construction permits, trading across borders, enforcing contracts, and resolving insolvency. Both India and China saw major improvements in the past decade, although the index has now been suspended. The latest data in 2019 showed India ranked 63, compared with China’s 31 in the same year, and 108 in 2005. For China, the government’s efforts in the mid-2010s to cut down approvals and streamline procedures in opening businesses and getting licenses helped to improve the ranking. For India, the government pushed through a series of reform measures with a focus on paying taxes, trade across borders and resolving insolvencies, aimed at attracting foreign investment and boosting the private sector under its “made in India” campaign.

Reforming labor regulations

China’s hukou system and rural-urban dual society nature meant that while labor regulations associated with the SOEs and the public sector were very rigid, the labor market for private and foreign businesses was very flexible around 2000. In contrast, one of the long-lasting complaints about doing business in India has been its cumbersome labor regulations – perceived to be rigid, with multiple laws at the national level and in various states. As many laws apply only when businesses have a certain number of workers, existing labor laws discourage the scaling up of manufacturing, which may inhibit economies of scale and productivity. According to the Annual Survey of Industries (ASI) 2021-22, two-thirds of the firms in India have under 50 employees but their output (or net-value add) share is just 11%.

Labor regulations in India have eased slightly over the past few years, with several states enacting legislation to ease the threshold for applying the labor law and increase working hours. In addition, the recent government regulation to subsume multiple labor laws into four codes is potentially a major reform that could bode well for scaling up manufacturing. The four labor codes are Code on Wages, Code on Industrial Relations, Code on Occupational Safety, Health and Working Conditions & Code on Social Security. We believe this could: 1) reduce compliance costs, making it easier to do business; 2) remove disincentives for small businesses to scale up (a structural issue); and 3) encourage formalization. These labor codes were approved by both houses of parliament in 2020 but have not been implemented yet. As per the recent Economic Survey, at least 31 states/Union Territories have framed rules across all four codes, but there remains scope to expedite the enactment of Labor Codes by the states. Under Modi’s third term, it is not clear how soon the labor law reforms will be implemented.

Foreign investment

Foreign investors seem to be voting with ample confidence in India. Foreign institutional investment (FII) flows into India’s equity market since 2019 amounted to $50 billion. As per NSE ownership tracker, FII ownership in Nifty 50 companies was 19% as of March 2024. Meanwhile, foreign direct investment into India has also been rising, partly due to the ongoing shift in global supply chains, and partly attracted by India’s large domestic market. Annual FDI in terms of fresh equity inflows to India reached $56 billion in FY2020-2022 from an average $41 billion in the past five years, although it slowed to $45 billion in FY2024, with manufacturing FDI accounting for over one-third in recent years. This compares with around $50 billion for China in the early 2000s, although manufacturing FDI accounted for about two-thirds of total FDI inflows. The difference in FDI into manufacturing between China 20 years ago and India now may lie in the different structure and size of manufacturing in the two economies.

The recent headline FDI decline was largely due to an uncertain global outlook and a rise in repatriation/disinvestment of existing investments (we estimate $40 billion vs an average $28 billion in FY2021-2023), and partly due to reduced venture capital funding at start-ups. According to the UNCTAD, India is among the top five recipients by the number of greenfield investment projects announced. We expect FDI equity inflows to pick up to $55 billion a year over the next two to three years, partly supported by new sectors including clean energy (renewables, hydrogen), electronics, AI, and electric vehicles, in addition to traditional ones.

Slow progress in land acquisition rules, but reforms may spur progress

In China’s development process, one key feature has been local governments supplying industrial land easily and cheaply, including through industrial zones. Local governments often acquired land first and added basic infrastructure before supplying it to businesses, especially foreign investors. What about India? According to the IMF, land reforms remain essential to facilitate and expedite infrastructure development. This is also an issue for the industrial sector. Land acquisition has been a politically sensitive issue over the past few years in India. The existing Land Acquisition Act 2013 has been perceived by industry as making land acquisition more difficult due to the requirement of 70-80% of the land holders’ consent in private or PPP projects, along with a mandatory social impact assessment. The government’s effort to amend the bill has led to political backlash in the past.

In recent years, both India’s central and state governments have been focusing on land reforms in the form of: 1) creating landbanks for easily identifiable industrial projects; and 2) moving the purchase process online (except for very large parcels) via a land information system, ensuring higher transparency and 3) digitization of land records. Eleven states have fast-tracked the land acquisition process, making it possible for industries and non-farmers to buy large parcels of agricultural land and put them to nonagricultural use. Six of these states have made the amendments in 2020/21.

Openness to international markets

China’s rise as a manufacturing powerhouse was helped by its opening to international markets and competition.

In the long run-up to China’s accession to the WTO, the country cut average import tariffs from above 40% to about 16%, and further lowered then to 9.8% in 2009 after eight years of transition. China’s exports already grew rapidly in the years before joining WTO and reached 21% of GDP in 2000. Export growth was further propelled by the country’s WTO entry in 2001 and reached 34% in 2007 before coming down subsequently. Within China’s merchandise exports, manufacturing products accounted for almost 90% around the time of its WTO entry (having increased from about 50% in the beginning of the 1980s).

India’s economy seems to be at a similar level of openness as China around the time of its WTO entry. Although India’s goods exports as a share of GDP is far smaller than China’s was, its share of total exports in GDP including services is about the same. Also, India’s imports as a share of GDP is higher than China’s was. India’s import tariffs average less than 10% despite the recent increase on selected products including electronic goods, which is lower than China’s average tariff level back in 2001. That said, it is not clear how India’s recent trend of increasing import tariffs to promote domestic manufacturing will impact its competitiveness.

Much smaller state ownership

China has had a large share of state-ownership in the economy, with the share higher at the turn of the century. In the industrial/manufacturing sector, SOEs accounted for 74% of assets and 65% of employment in the industrial sector around the year 2000, and almost half of China’s exports. Since China joined the WTO in 2001, foreign joint ventures and private companies have become increasingly more important in driving exports, while the less competitive SOEs lost ground, with the latter accounting for only 10% of exports in 2023. India’s SOEs have a smaller share in its industrial and manufacturing sectors, which may bode well for developing competitively.

What can we learn from the above comparisons?

Compared to China, India’s manufacturing base is relatively small and it is hard to see the country replacing China or mounting serious challenges to China’s overall manufacturing position anytime soon. However, India has some potentially favorable conditions for rapid growth in manufacturing: it has abundant cheap labor educated at appropriate levels; infrastructure is improving with significant investment over the years; labor regulations are becoming less cumbersome; the authorities have implemented measures to attract foreign direct investment and foreign investors are enthusiastic about investing in India, with the country having a mostly favorable international image.

A very important factor and favorable condition for India’s manufacturing development is its large domestic market, which is now bigger than China’s back in 2000 in constant USD terms. Therefore, even though in the global market, India may face tough competition from China and ASEAN economies, its large domestic market is the key to rapid manufacturing growth in the years ahead. In this process, India stands a good chance of closing the gap with China in manufacturing and taking some market share away from China internationally.

II. How might India’s domestic consumption grow?

Along with its rapid economic growth, India’s household consumption doubled in the past decade to $2.1 trillion in 2023, with a compound annual growth rate (CAGR) of 7.2%. UBS expects India to overtake Japan in 2026 to be the third-largest consumer market. While India’s private consumption was only 30% of China’s total in FY2023, it is significantly higher than China’s when the latter was at a similar stage of development (measured in per capita GDP). India’s private consumption size is about the same as China’s in 2006-2007.

How might India’s consumption grow in the coming years? After all, having a large domestic market is one important factor that differentiates India from smaller emerging market economies in attracting foreign investors, especially given the uncertain global environment.

One thing is clear: if India’s consumption share of GDP does not decline and consumption continues to grow at a similar pace as its GDP, its domestic market size could reach China’s current level many years before its GDP does. This is because India’s household income as a share of GDP is far higher than China’s, which is why India’s consumption now is as large as China’s in 2006-2007, while India’s current per capita GDP is only at China’s 2000 levels in constant USD terms.

One of the key reasons behind China’s low household income share of GDP back around 2006 was the growth strategy and policy bias in favor of investment and industry. In addition, the household saving rate also rose sharply in the years before then, partly due to a rapid decline in the population dependency ratio. In India, consumption’s share of GDP fell between 2000 and 2010 and rose in the past decade. If India was to embark on a period of rapid growth and urbanization, it is not clear whether labor income and household consumption shares will decline again, as investment including infrastructure investment picks up. We think India is unlikely to see as great a decline in such shares as China given its more services-led growth, and less policy bias in favor of industry and investment versus households and consumption.

Despite China’s relatively low share of GDP, real private consumption expanded 7.7% a year since 2007, driven mainly by the country’s 7.1% per annum real GDP growth. In nominal USD terms, China’s private consumption grew by 11% a year. Also importantly, both the share of household income and consumption in GDP rose somewhat after 2011 due to the government’s “rebalancing” efforts. The rebalancing policies included expanding the pension and healthcare insurance coverage significantly, requiring state-owned companies to pay dividends, reducing energy subsidies to industry, increasing labor protection and raising minimum wages. Pension coverage expanded from 18% of the population in 2005 to 76% in recent years, while 95% of the population have some kind of basic healthcare insurance coverage now compared to below 20% in 2005. However, the social safety net and public services for rural and some of the urban population remain inadequate, which is partly why China’s household saving rate remains high.

For India, we look at the potential of household income growth by focusing on labor income, which in turn, is a function of wage and employment growth.

India’s urban wage growth, proxied by that of listed corporates’ salaries, has been about 10% a year in the decade before the pandemic (2011-2020, simple average), and growing now at around 14% in 2022. This is at a similar pace to China’s 15% around 2006. In the decade since 2006, China’s wage growth averaged 13% a year before slowing down in recent years.

In terms of employment, while China’s total employment was largely flat in 2005-2007, rapid urbanization pushed up its urban employment, which grew by 3.4% a year in 2007-2017. In absolute terms, China’s urban employment expanded from 310 million in 2007 to 470 million in 2023. India’s non-farming employment growth accelerated after 2019, growing by 3.4% in the past five years (FY2017-2022), higher than the 1.7% in the previous five years, and rising to 316 million by 2022. Looking at India’s overall employment structure, 43% is in the agriculture sector, 24% in secondary sectors (of which manufacturing is 11%), and 34% in the services sector. Looking at how China’s farming employment declined sharply in the past more than two decades to less than 25%, there seems to be large potential for India to increase its employment share in secondary and services industries. Such a transfer of farming labor to more productive non-farming sectors would likely boost labor productivity and wage growth, supporting continued consumption growth.

Another important reason for China’s low consumption share in GDP is its high household saving rate. India’s household saving rate (as percentage of disposable income) is at 24%, while higher than in DM, it is similar to China’s was around 2006 according to the country’s household survey data. China’s flow of funds data suggests a much higher saving rate that has remained high. The fact that China’s household saving rate seemed to have remained high or even risen (household survey data) along with population aging and improvement in social safety net coverage is puzzling. How India’s household saving rate might evolve in the future is unclear.

In 2006, there was some expectation that as Chinese households’ access to consumer credit increased, consumption’s share of GDP would be boosted. At the time, China’s household debt accounted for 17% of GDP and 31% of disposable income (36% of adjusted disposable income). However, in the past decade, even though China’s household debt has risen sharply to 63% of GDP and 105% of disposable income (>110% adjusted), most of the debt is mortgage debt, and did little to push up consumption share.

India’s current household debt/GDP ratio is at 40% and household debt/disposable income is at 51%. These ratios have remained relatively stable throughout the more than past decade with a marginal increase last year. We estimate India’s household debt service obligations to rise to 7.6% of disposable income in FY2024. This compares with roughly 10% for the U.S. according to the U.S. Fed, and about 18% for Chinese urban households, according to the People’s Bank of China (PBoC). Compared to developed markets, we think India has the potential to see consumer credit picking up further in the years ahead, which could help support consumption growth.

However, we believe high-quality job creation would be critical to sustain India’s consumption growth in the medium-term. The relative weakness in consumption growth in the past couple of years likely partly reflects how the pandemic impacted lower income households (and lack of fiscal support to them), softening corporate wage growth and rise in food inflation.

As India grows, the number of people at income levels where they can afford modern durable consumer goods such as appliances and automobiles increases exponentially. Consumption patterns will likely significantly change along the way. In 2023, India had 119 million people (age 15+) that have an annual income over $5,000, accounting for 11% of the total population (age 15+), according to Euromonitor. This ratio rose from 4.3% in 2010 (37 million people), and is expected to rise further. China currently has a population of 806 mill ion (age 15+) that have income above $5,000, or 68% of its population, rising from a population of 83 million that had an equivalent income level back in 2005.

A major beneficiary in this process of income growth would be the automobile sector. China’s automobile penetration (passenger cars) climbed from 2% per hundred people in 2006 to over 20% in 2023, which corresponded with annual automobile sales going up from 5 million units in 2006 to 26 million units in 2023 (passenger cars). India’s automobile penetration is only about 3.1% per hundred people currently, similar to China’s level in 2008-2009. Although it went up from 1.2% in 2010, it certainly has much room to rise in the years ahead. Meanwhile, India’s 2W (two-wheel) penetration rose from 5.8% in 2009 to 14.3% in 2023.

III. Will India’s energy and commodity demand grow like China’s over the past two decades?

Arguably the most notable impact of China’s rise as an economic power on the world stage has been its enormous demand for energy and commodities in the past two decades, especially the rapid import growth in the few years before and after the U.S. subprime crisis. China’s total primary energy consumption rose from 42 exajoules in 2000 to 171 exajoules in 2023. By major energy categories, China’s coal consumption grew from 30 exajoules in 2000 to 92 exajoules in 2023, oil consumption grew from 4.7 million barrels per day (mbd) to 16.6mbd, and natural gas consumption grew over 600% since 2006.

India’s total primary energy consumption in 2023 was about 39 exajoules, similar to that of China’s in 1996 and 23% of China’s 2023 level. It also relies heavily on coal (22 exajoules in 2023), while its oil consumption was about 5.4mbd and natural gas consumption at 63 billion cubic meters in 2023.

Similar to China today, coal accounts for over half of its primary energy use, followed by oil (27%). Natural gas (6%), renewable (6%), hydro electric (4%) and nuclear (1%) together account for a quarter. Back in 2000, China was more heavily reliant on coal (70%) and oil (22%).

Could India’s energy demand grow as much in the future as China’s did in the past? We think it is unlikely.

First, India’s economic structure is different from China’s – industry as a share of GDP is now 25%, versus China’s 40% in 2000 and still 32% now. As a result, India’s economy is less energy intensive than China’s was, as the industrial sector has been the largest energy consumer in China. With India’s relatively higher share of services now than China’s 20 years ago, India’s energy intensity is about 4.2MJ per unit of GDP (as of 2021, in 2017 PPP GDP), while China’s was over 10.5MJ in the first part of the 2000s, and is still at 6.3MJ (2021).

Second, India’s growth is unlikely to be as capital- and energy-intensive as China’s has been. India in recent years has seen fast fixed investment growth, with its gross fixed capital formation (GFCF) accounting for 31% of GDP in 2023. This is quite similar to China’s 33% in 2000. However, China’s investment share in GDP rose to about 45% subsequently and remained high for over a decade (still above 40% currently). This extraordinary and persistent high level of investment share has been helped by China’s even higher national saving rate, and both are partly attributable to the country’s policy bias in favor of investment and industry, which is not obvious in India.

Moreover, China’s commodity- and energy-intensive property and infrastructure investment grew by 14% per annum since 2003, led by rapid urbanization, helped in part by China’s unique rural-urban land systems and local governments’ property policies. India’s urbanization has been and will likely remain different and hence, less commodity and energy intensive. In addition, China also became the largest exporter globally by around 2015, and accounted for over 30% of global manufacturing exports in recent years. This means that a significant share of China’s commodity and energy consumption was for exports. As discussed earlier, we do not expect India to grow its manufacturing exports in the coming years as China did in the past.

As one example reflecting its energy/commodity intensive growth of the past two decades, China’s crude steel production rose from 127 million tons in 2000 to 1.02 billion tons in 2023. Domestic demand arising from property construction was the most important driver of domestic steel demand, while machinery, infrastructure and automobiles were also important. India’s domestic steel production was 123 million tons in 2023, similar to China’s in 2000, but we think it is unlikely to reach China’s current output level, given our outlook on India’s economic growth pattern and urbanization.

On the energy front, India is already a large oil and coal importer, and its imports are unlikely to grow as fast as China’s did in the past. For example, China’s coal and lignite imports increased by 220 times from the 2000 level to 474 million tons in 2023 (while its total consumption was about 4.6 billion tons), and crude oil imports grew seven times to 564MMT. India imported 233MMT of crude oil in 2023, and 232m tons of coal in 2022. The latter is 20% of India’s domestic consumption of coal (1.1 billion tons).

For base metals, China’s imports of iron ore grew by 16 times to reach 1.2 billion tons in 2023, with imports increasingly replacing domestic produced ores. Its copper imports also rose 14 times to reach 28 billion tons in 2023. For India, it is a net exporter of iron ore –producing about 275MMT a year, of which about 17% exported in FY2023. India is also a copper producer and exporter. India’s own mineral resource availability, and its different economic structure, urbanization pattern, and likely lower reliance on investment and industry in future growth than China all mean that India’s base metal imports are unlikely to follow the path of China.

Both China and India are largely self-sufficient in agriculture, especially key grains. China is a net importer of agricultural products, the biggest imports being soybeans ($59 billion in 2023), which accounted for about a quarter of its total agricultural imports. India, on the other hand, is better endowed in arable land than China and is a net exporter of agricultural products. India’s largest agricultural imports are vegetable oil and largest export is rice. Given its relatively better agricultural endowment, India may not increase agricultural imports as much as China did in the past, although consumption upgrades and climate change may alter that general outlook in the future.