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India Rising, China Slowing Doesn’t Mean Modi Wins

India is poised to top China in population and economic growth. That's no guarantee Narendra Modi’s pro-business push will beat Xi Jinping’s consumption-heavy makeover in a regional contest with global consequences.

Jim O’Neill still vividly recalls a 2006 road trip he made from India’s capital, New Delhi, to a new industrial city named Gurgaon. On a two-lane road jammed with cars, motorcycles, rickshaws, and animals, it took O’Neill, then chief economist at Goldman Sachs, two and a half hours to travel 30 kilometers, Bloomberg Markets magazine reports in its July/August issue. “It was insane,” he says.

O’Neill, who’s now a British government minister, repeated the journey in February. This time, the drive, on a new highway to what’s now more of a suburb, was less than an hour. Even better, the hotel car provided free Wi-Fi—the first time he’d encountered this perk anywhere in the world. “It sort of sums up the changes in India,” he says.

Prime Minister Narendra Modi won the nation’s biggest election victory in 30 years in May 2014 by insisting India is capable of such advances on a grand scale. He pledged to lift the lumbering democracy—held back by red tape and weakened by corruption—into a global superpower with “minimum government, maximum governance.” He promised modern cities, improved manufacturing, and 100 million new jobs by 2022. Investors bought into the vision of the country’s first overtly business-oriented leader, pouring a record $42 billion into Indian stocks and bonds last year.

This story appears in the July/August

special Rivalry Issue of Bloomberg Markets magazine.

Christopher Wood is a believer. The chief strategist at brokerage CLSA in Hong Kong had more than tripled the percentage of Indian shares in his Asia-Pacific portfolio, which excludes Japan, to 20 percent as of mid-May from just 6 percent in October 2013. Wood’s 20 percent also tops the 6.2 percent weighting for India in the benchmark MSCI AC Asia Pacific Index, which also excludes Japan. “India is the most promising story in Asia on a five- to 10-year view,” he says. “Mr. Modi is the most pro-business, pro-investment political leader in the world.”

That’s some statement in a region where China’s shadow eclipses India in almost every conceivable way. China is bigger, with 1.37 billion people to India’s 1.25 billion. Economic reforms have lifted 500 million Chinese citizens out of poverty since 1978, the World Bank says. In India, 175 million have escaped poverty from 1993 through 2011, the closest comparison the bank offers. Modi, 64, and Chinese President Xi Jinping, 62, are political strongmen who profess mutual respect. But their politics are poles apart. India is the world’s largest democracy; China, a totalitarian communist state. And they compete for everything—investment and trade dollars; coal, gas, and oil; and even territory along their 4,000-kilometer (2,485-mile) border.‘

So far, China has had the upper hand. Its economy and stock market capitalization are each more than five times those of India, largely the result of then-leader Deng Xiaoping’s unlikely embrace of a market economy and foreign investment in 1978, 13 years before India opened some of its industries to outside investment. “China’s reforms were far more comprehensive, and it’s already an economic miracle,” says Ruchir Sharma, who oversees more than $25 billion as New York–based head of emerging markets at Morgan Stanley Investment Management. “India is still aspiring to be an economic miracle.”

India may be overreaching as it races to catch China. Its statistics ministry in January revised how it calculates gross domestic product and said the economy grew 6.9 percent in the year that ended in March 2014, up from the reported 4.7 percent. Finance Minister Arun Jaitley said a month later that the country can achieve double-digit growth, “wiping every tear from every eye.” Sharma, for one, isn’t buying the revised numbers, saying they’re “just wrong.”

As the controversy brews, China may not even be paying attention. “I really don’t think China cares about how India is doing because it has moved on,” Sharma says. “China’s strategic game is much bigger.”

Statistics bear out China’s global dominance. Since Deng abandoned doctrinaire communism in 1978, growth has surged an average of 9.8 percent annually. Since 2001, China has overtaken Italy, the U.K., France, Germany, and Japan to become the world’s second-biggest economy. Its $10 trillion GDP dwarfs India’s $2 trillion. Not only has China built the world’s biggest stockpile of foreign reserves, at $3.7 trillion; the country also accounts for one-third of the global total and boasts 10 times India’s amount. Even O’Neill acknowledges the imbalance: “If India grows by 8 percent for the rest of this decade and China grows by 7 percent, China will still create another three Indias before the decade is over.”

The trouble is, China’s economy may slow even more sharply than that. Beijing’s rulers, who have successfully navigated both regional and global financial crises since Deng declared “to get rich is glorious,” are finally stumbling. One long-running strategy appears to have misfired badly: China’s single-child policy has left an aging, diminishing workforce. Labor, once bountiful and cheap, is less plentiful and more expensive. At the same time, the economy has become too dependent on low-priced exports and government spending on infrastructure. While such pump priming has helped China forge ahead—creating highways, railways, and airports India can only dream of—much of it has been wasteful. Today, the home to one-fifth of the world’s people is dotted with ghost cities and bridges to nowhere. Corruption and housing bubbles are rife. After China’s original capitalist reforms shattered what its people called the “iron rice bowl,” the cradle-to-grave welfare system of Mao Zedong’s communists, Chinese consumers were too worried about saving to help their nation by spending.

Now, Beijing is belatedly trying to create a more balanced economy driven by consumption and service industries. The transformation hasn’t been easy. Last year, growth slipped to 7.4 percent—the lowest rate in 24 years. This year, it will fall to 6.8 percent, the International Monetary Fund estimates. “It’s a very bumpy path that’s going to produce some very big losers,” says Patrick Chovanec, chief strategist at New York–based Silvercrest Asset Management Group, which oversees $18 billion.

The biggest losers may be investors who’ve helped Chinese stock markets more than double in the past year. On June 5, the Shanghai Composite Index topped 5,000 for the first time since 2008. India’s S&P BSE Sensex Index, by comparison, has risen 5.4 percent through June 15. “The perpetual hope that China will stimulate its economy and prop up growth is misplaced,” Chovanec says. “More easy money won’t solve China’s woes. Only real reform can do that, and that won’t be painless.”

Investors are especially concerned about China’s red ink. Total debt quadrupled to $28 trillion in 2014 from 2007, equivalent to 282 percent of GDP, says Satyajit Das, a risk consultant and author of Extreme Money: Masters of the Universe and the Cult of Risk, his 2011 book that examines how financial maneuvers generate bubbles of fake growth. “China has contributed to around one-third of the total increase in global debt since 2007,” he says. Japan in the late 1980s, South Korea in the 1990s, and the U.S. and the U.K. in the early 2000s saw rapid growth in credit, ending in financial crises, he says. “China has experienced a similar or even greater level of expansion in debt,” Das says.

Xi, who came to power in 2012, is committed to transforming China while not letting growth slip too far. That includes easing capital controls to make China’s currency, the yuan, more convertible and liberalizing interest rates. He wants to create economic corridors that track the ancient Silk Routes linking Asia to Europe. At home, he’s arrested 100,000 government officials in an anti-corruption drive. His medium-term aim: to double China’s $7,000-a-year per capita income by 2020.

All of this comes as India is hitting its stride. Its economy will expand by 7.5 percent in 2015, the IMF says, beating China for the first time since 1999. India will likely outpace its rival this decade and possibly for the next 20 years, O’Neill says. O’Neill, who, in 2001, coined the term BRIC to group emerging economies Brazil, Russia, India, and China, suggests that by 2030, India may be No. 3, after China and the U.S. “Under Modi, India’s got a better chance of getting closer to its potential than ever since I dreamt up BRIC,” he says.

Modi and Xi are political strongmen who profess mutual respect,

but their politics are poles apart.

Sheng Jiapeng/CNSPHOTO/ChinaFotoPress via Getty Images

Modi is paving the way for the growth he envisions. He’s allowed foreign investment in railways for the first time and raised the foreign ownership limit in the defense and insurance industries to 49 percent from 26 percent. He’s scrapped diesel subsidies and pledged to unclog transportation and build cities. Aided by the plunge in oil prices, inflation slowed to 4.87 percent in April from 8.33 percent in May 2014. The current-account deficit narrowed to 1.4 percent of GDP at the end of 2014 from 2.6 percent a year earlier. In response, Moody’s Investors Service in April raised India’s credit outlook to positive from stable.

Modi, like Xi, is tough on corruption. He supported a law that requires prison terms of up to 10 years for those who shift unreported assets abroad. Since last August, Indians have opened more than 132 million bank accounts, which may help curb illegal deposit taking that targets the poor. The government is expanding cash transfers into these accounts so the billions of dollars in subsidies it doles out every year go directly to the 59 percent of Indians who live on less than $2 a day.

Some big financial reforms have stalled. A uniform goods and services tax to replace local levies and an overhaul of land laws to make property acquisition easier for foreign companies are stuck in parliament. Plans to reduce nonperforming loans at state-owned banks have gone nowhere. “The first year is critical to impose the maximum number of reforms,” Morgan Stanley’s Sharma says. “What the Modi government has done is good but not great.”

One of India’s main assets propelling it forward is youth. India’s median age is 27, compared with China’s 36.7. India’s population will exceed China’s after 2028. And by 2030, its labor force may increase by 300 million, equal to the current number of workers in Germany, Spain, Italy, and France combined, O’Neill says.

Global companies, often frustrated by India’s labyrinth of labor and land laws, are redrawing their business maps to target the nation’s swelling young population. New Jersey–based Honeywell International, which makes jet parts and thermostats, has increased its number of employees in India to almost 13,000 from 1,000 in 2002. Companies must establish their presence now, “not 20 years from now,” CEO David Cote says.

Modi wants to make that easier by streamlining permits and building roads and ports. He’s fond of telling investors “a red carpet, not red tape,” awaits them. General Electric, which had been shut out of bids to modernize railways, opened a $200 million factory to produce locomotive components and jet engine parts in Pune in February.

The rivalry between China and India extends beyond competition for investment. Even the carefully choreographed bonhomie between their two leaders, on display in May when Xi entertained Modi in his birthplace of Xian, can’t veil the legacy of a border war the two nuclear-armed giants fought in 1962. In September, as the men were toasting each other at a dinner in Modi’s hometown of Ahmedabad, two incidents soured the lovefest. High in the Himalayan snows, Indian and Chinese troops confronted each other along their disputed frontier after what New Delhi claimed was an incursion by People’s Liberation Army soldiers. In the south, close to where India and Sri Lanka are separated by a 30-kilometer-wide strait, a Chinese submarine had docked silently a few days earlier in the Sri Lankan capital, Colombo—the first such visit.

China denied any border infiltration had occurred and brushed off the sub visit as a refueling stop. Yet even as China spoke of closer ties, was it reminding its rising rival of who calls the shots? “It’s not clear that Xi Jinping authorized these acts,” says Rory Medcalf, head of the National Security College at the Australian National University. “If he did, that shows a lack of good faith. If he didn’t, that’s at least as disturbing, because it shows no matter how hard Xi tries to improve the relationship, there’s a great degree of mistrust at the military level that China’s top leadership can’t control.”

At the end of the day, the China-India rivalry is no contest on most fronts. In economic clout, military might, geopolitical influence, literacy, health, life expectancy, and even sporting prowess (2012 Olympic medal count: China, 88; India, six), it will be an unequal competition for years to come.

Yet India’s rise presents one challenge China’s Communist Politburo may find impossible to match. “A degree of Indian success raises an enormous question mark over the Chinese political and development model,” Medcalf says. “India’s very existence is an example to third countries that they can be democracies and grow.”

This story appears in the July/August special Rivalry Issue of Bloomberg Markets magazine. With assistance from Kevin Hamlin and Unni Krishnan.

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