Lehman Brothers: India - Everything to play for

Lehman Brothers has had a long association with India - both through its own presence in the country, and through the many Indian nationals who work for us, including the 2000 staff we have in our knowledge center in Powai. But, as India's impressive economic expansion gained momentum, the question naturally arose whether our presence in India was of sufficient scale, or whether we should raise it by a quantum leap.

Such a decision is never to be taken lightly; and certainly we did not. First and foremost, we had to decide whether India's recent growth upsurge was likely to prove temporary, as some commentators at the time were suggesting, or whether it had a chance of becoming self-sustaining.

Accordingly, we embarked on a detailed and lengthy evaluation of the prospects for India's economy, Indian financial markets, and Indian governance. We were encouraged by what we found. India's rapid growth of the past several years, we concluded, bears all the hallmarks of the sort of economic take-off that, in earlier decades, had taken place elsewhere in Asia, and stunned a world that until then had thought that single-digit growth was the most that any economy could achieve.

In short, we concluded that India's growth could not, and should not, be dismissed as a flash in the pan. But our research also led us to conclude that a continuation of recent fast growth is not automatically guaranteed: just as this growth is the result of important structural policy reform, so will future growth be shaped, in respect both of its rate and its quality.

Impressive though its economic transition has been, we judge that India could grow sustainably even faster than at present, and faster than most other studies have suggested, i.e. at 10% or so per annum over the coming decade. This judgement is contingent on India continuing to actively pursue structural economic reforms.

Naturally, a sharp global economic downturn is a risk to India's near-term economic growth. While India is one of the least vulnerable economies, it is not immune. Conversely, a period of demand running ahead of supply cannot be ruled out, raising risks of short-term overheating.

But more important than the ups and downs of the economic cycle are the structural changes behind India's growth acceleration, contributing to capital deepening and rising productivity. They include the development of the financial system, trade and capital account liberalisation, and more prudent macro management.

Conventional static "growth accounting" analysis gauges the contributions of labour, capital and multi-factor productivity to GDP growth. We believe that this approach fails to take adequate account of dynamic interactions in an economy, especially a developing one which has reached take-off. That is the basic reason why our estimate of India's potential rate of growth is higher than that of other studies.

We find clear evidence that India's rapid economic development, high growth and reforms have started to interact positively with each other "� the economy appears to be taking on many of the characteristics exhibited by other large Asian economies during the early stages of economic take-off.

While business continues to prove impressively adept at working round systemic and structural challenges, sustaining higher growth in the medium term will require continuing structural reform. For example, we estimate that further financial sector reforms could add 1 to 1½ percentage points to India's long-term GDP growth.

Even larger economic gains could flow from removing constraints such as weak (soft and hard) infrastructure, bureaucracy, and labour market rigidities. Breaking down these barriers is key to enabling business to achieve increasing returns to scale by capitalising on its global comparative advantages in labour-intensive manufactured and agricultural exports. We estimate that India's trade-to-GDP ratio could double over the coming decade, also adding 1½ points to GDP growth.

However, pushing through structural reform will remain a political challenge in the face of headwinds from vested interest and coalition politics. That said, there should be a new window for reform after the next general election due in 2009.

Given the powerful trends of demography and urbanisation, India needs "a faster and a more inclusive" growth strategy to correct its inter- and intra-regional imbalances and avoid social unrest. The social and economic costs of not pursuing inclusive growth are potentially enormous.

Inclusive growth can be facilitated by further easing the shackles on business, by making education and health available to all of society and by developing the rural sector, which employs nearly 60% of the total workforce. Labour market reforms to spur the necessary job creation over the next decade will be a key challenge.

India's growing economic clout is encouraging a more proactive regional policy and greater engagement on the global stage, for example in trade liberalisation and the climate change debate, which also stand to boost economic growth.

In short, given that there is still much growth potential to be unlocked, India has "everything to play for."

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