India's Next Engine of Growth?

Over the next decade, India’s growth could hit nearly 7% a year, perhaps overtaking China as the big engine of the global economy. That may turn on whether this behemoth of South Asia can restore—indeed, reengineer—a relic of its industrial and colonial past: some 65 thousand kilometers of railroads.

For all of the vaunted virtualization of the New Economy, the real world still needs pistons and crankshaft infrastructure to move products and people. Rails and trains remain among the most cost-effective modes of transport and logistics for such a geographically vast nation.

In a not-so-tacit mea culpa, India has promised to nearly quadruple its investment in rail infrastructure to $132 billion, from 2014-19—not just to fix what’s derailed or broken, but to add capacity, build efficiency and deliver speed. In Morgan Stanley Research’s latest installment of its “Next India” series, analysts argue that this renaissance rooted in steel, steam and gears is exactly the kind of catalyst for growth that India needs and its investors have been waiting for. By investing in its railroads, India can route growth to far-flung stations of the country, offering opportunities, creating jobs, distributing capital. Government and private companies alike can ride rail re-industrialization to greater global competitive advantage.

Not too long ago, India’s railroads—which were more than twice the length of China's in 1951—were the envy of Asia. After all, rails tend to be the preferred mode of moving people and cargo: cheaper, faster and more predictable compared to roads. Over the next 60 years, however, China caught up, then left India far behind, especially over the past 20 years, during which China added high-speed lines. These connect coastal boomtowns with inland regions, and manufacturing centers in the south with financial, administrative and political hubs in Shanghai and Beijing.

India, on the other hand, not only stalled, but seemed to slip backward. Freight trains, for example, are charging much higher rates, yet they travel at half the speed of passenger trains, for which fares remain low. This pushes freight away from the rail system, and “places Indian manufacturing firms in a position of major competitive disadvantage versus Indian companies in the service sector and competitors abroad," says Akshay Soni, Morgan Stanley's India industrials analyst. 

India's spending on transportation infrastructure, roughly one-eighth of China’s, pales beside that of other economic powerhouses. Of that budget, roads account for five times more annual spending than do rails. Yet, logistical costs in India are two to three times current global benchmarks, according to the World Bank, a distinct disadvantage for manufacturers. “The key reason for this is the underinvestment in Indian railways, with the budget allocation to railroads versus roads significantly lower than global standards," Soni says.

India's new Railway Minister, Suresh Prabhu, has promised a 285% increase in railroad spending over the next four years, as part of Prime Minister Narendra Modi’s economic reforms. This renewed political support combined with earmarked funds and new funding models has the potential to spur real change, accelerating the growth of India's manufacturing sector and benefiting the country's entire economy.

The move couldn’t come too soon. “Not only does India need to up spending to stay in place, on a competitiveness scale, with the other economies—it needs to outspend them to catch up," says Soni.

Manufacturers stand to be the biggest winners in the medium to long term. According to the World Bank, reducing transportation costs by 20% to 30% could boost profit in key manufacturing sectors by 2% to 3%, “helping India return to a path of high growth and enabling job creation," says Soni. In addition, the World Bank notes that a mere 0.5% decrease in logistics costs could result in a 2% increase in trade and 40% increase in the range of exported products.

This is just the lead car of a long economic train. Spending on rail infrastructure would create demand for commodities, such as iron and steel, as well as services such as engineering and construction. Rail improvements would boost logistical efficiency, while lowering costs, which could help cut prices for raw materials. Other added benefits: Passenger rail volumes could increase as trains remain a cheaper, safer and faster mode of long-distance travel, compared to roads, improving regional mobility, boosting tourism, while reducing road congestion.

Bottom line: If India meets spending targets, rail improvements could account for 20% of total incremental economic growth through 2019, Morgan Stanley economists estimate.

In the past, when it comes to infrastructure, India has been “high on promise and low on delivery," Soni says. What makes this time around any different? Soni cites three major factors: the focus on delivering speed rather than just more capacity; the reformist credentials of the new minister, who has already begun to deliver on many of his initial promises; as well as new innovative approaches to funding, including raising money through the Life Insurance Corp. of India, and issuing “masala” bonds to raise money from foreign investors, making it easier and more attractive for lenders and investors interested in the opportunities in this sector.

Morgan Stanley Research has written a series of reports on “The Next India,” the latest installment of which is “Industrials – The Return of the Transportation Behemoth” (Nov 25, 2015). Contact your Morgan Stanley representative or Financial Advisor for the full report. Read previous stories in this series on reform and growth and the Internet boom in India. Plus, more Ideas.