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The Missing Piece in India's Economic Growth Story: Robust Infrastructure

I ndia's ambition of sustaining its relatively high growth depends on one important factor: infrastructure. The country, however, is plagued with a weak infrastructure incapable of meeting the needs of a growing economy and growing population. S&P Global Ratings projects India's GDP to grow around 8% for the next three fiscal years, among the fastest in large, growing economies. The government also aims to significantly boost the manufacturing sector to contribute an all-time high of about 25% of GDP by 2025, from below 16% currently.

India is striving to improve its manufacturing competitiveness at a time when manufacturing powerhouse China is shifting toward consumption-led growth. China now faces the risk of overcapacity in segments such as port and power. For India, on the other hand, its road to sustainably higher growth and a competitive manufacturing sector goes through robust and reliable national infrastructure, especially in power and transportation.

Overview

  • Infrastructure development is critical for improving India's manufacturing competitiveness and achieving higher growth.
  • Timely execution of projects within budgeted costs will be the key challenge, even if funding is available for economically viable projects.
  • Power generation and transmission are improving, but transportation infrastructure capacity constraints continue to limit corporate performance and investments.
  • Successful infrastructure development can provide a boost to many sectors, including steel, cement, auto, real estate, and others.

Despite India's significant infrastructure investments (about 35% of GDP), the government estimates that it requires US$1.5 trillion in infrastructure investments over the next decade. But even this would likely only help bridge the infrastructure deficit rather than create room for future growth. We believe, for India, investments in infrastructure equal to 1% of GDP will result in GDP growth of at least 2% as infrastructure has a "multiplier effect" on economic growth across sectors.

Lacking Infrastructure Hampers Growth And Investments

In our view, poor infrastructure is among the biggest hurdles facing the Indian government's ambitious program, called "Make in India," which aims to improve the nation's manufacturing capabilities and support higher growth for generating employment. We believe corporate growth and investments can be hampered if the government fails to close the infrastructure deficit, which some experts estimate costs about 4%-5% of GDP due to inefficiencies. Infrastructure development can not only help remove some of these inefficiencies contributing immediately to economic expansion but also support stronger long-term growth.

India's power infrastructure, traditionally a weakness, seems to be turning a corner, but transportation infrastructure still faces overwhelming capacity constraints. We believe execution capability will remain the biggest challenge for transportation infrastructure projects based on lessons learned from the power sector. The government has to lead by example by spending first and demonstrating the ability to execute projects. Sustained policy improvements, confidence in sustainability of economic growth, and infrastructure development will be essential to attract otherwise muted private sector investments.

We believe adequate funding should be available for commercially viable projects as contractors' financial health improves, capital markets gain greater confidence in the contractors' execution capabilities, and banks improve capital adequacy and appetite for infrastructure lending. We believe careful project selection and appropriate risk premiums by developers and financiers to build in healthy skepticism on secular growth (even if India appears to be the fastest growing large economy--for now) would be essential for sustained infrastructure development. Infrastructure may yet again be India's stumbling block, or if done right, it could be the key to achieving the country's economic potential.

Infrastructure Development Can In Turn Support Demand For Other Industrial Sectors

S&P Global Ratings sees clear economic benefits and positive credit impact from infrastructure spending, with the so-called "multiplier effect" of spending 1% of real GDP likely to boost India's GDP by at least double that amount.

The Effects Of An Increase In Spending Of 1% Of GDP
(Ranked by multiplier effect, highest to lowest)
Multiplier effect (2015-2017) Projected job gains (maximum above baseline)
U.K. 2.5 343,000
Brazil 2.5 418,000
China 2.2 2,400,000
India 2 1,360,000
Argentina 1.8 68,000
U.S. 1.7 730,000
Japan 1.5 211,000
Canada 1.4 61,000
Italy 1.4 136,000
France 1.3 109,000
Mexico 1.3 193,000
South Korea 1.3 95,400
Germany 1.2 157,000
Indonesia 1 320,000
Australia 1 38,680
Eurozone 1.4 627,000
Source: S&P Global Ratings.

If successful, higher infrastructure development will have a long-term positive impact on all sectors. However, in the short to medium term, the impact will vary for different sectors.

Impact Of Infrastructure Improvements On Various Industries In India
Sector Impact Nature of Impact Probable Change in Sector Outlook Rationale
Cement Very high Direct--immediate Stable to positive Growth comes from direct input in infrastructure
Steel Very high Direct--immediate Negative to stable Absorb excess capacity and generate growth from direct input in infrastructure
Automobiles-commercial vehicles High Direct--short term Stable to positive Generates growth from direct use in construction and transportation activities
Real estate Medium Direct--medium term Negative to stable Helps generate demand for unsold inventories, improves connectivity, and supports land prices
Capital goods Medium Indirect--medium term Negative to stable Results in new capital orders (but with a lag), if manufacturing demand picks up due to infrastructure improvements
Automobiles-passenger vehicles Medium Indirect--medium term Stable Decongestion of roads to support car demand, infrastructure development will still be inadequate to replace private transport
Consumers Low Indirect--medium term Stable Higher economic activity likely to result from uptick in consumer spending
Utilities Low Indirect--medium term Stable Higher economic growth would support demand
Oil and gas Low Indirect--long term Stable Growth from higher industrial demand
Metals and mining Low Indirect--long term Negative Growth from higher industrial demand

Weak Infrastructure Is A Key Impediment To Improving Manufacturing Competitiveness

India's infrastructure bottleneck is a primary constraint to improving (or even maintaining) its global competitiveness, as measured by The World Economic Forum's study on Global Competitiveness Report for 2015-2016. India is ranked at No. 55 out of about 140 countries. Its relatively poor quality power and transportation infrastructure contribute to that weaker position compared to Asian peers like China (No. 28), Thailand (32) and Indonesia (37). However, quality of infrastructure is also a relative weakness for China.

In India, key urban centers and manufacturing hubs also often struggle with capacity constraints, which directly affects competitiveness. By comparison, in China, eastern and coastal manufacturing hubs with an export focus benefit from strong infrastructure and limited need for inland transport, so it doesn't hurt export competitiveness. However, the rural areas away from China's manufacturing hubs do suffer from some connectivity issues.

Logistic costs in India (about 15% of GDP) and China (18%-20%) are both well above the average for developed economies (5%-10%). For China, we consider toll collections, fuel taxes, and inter-province protectionism as the key reasons for the higher costs. In India, they likely reflect inadequate transportation infrastructure and a multitude of taxes across states, which results in costly and inefficient movement of goods. We believe the proposed uniform goods and service tax (GST) in India, which aims to remove the cascading effect and inefficiencies created by different layers of taxes across states and the central government, can significantly benefit manufacturing competiveness. While the GST should be favorable for most sectors, we expect the logistics and manufacturing sectors to be among the biggest beneficiaries.

Power Infrastructure Is Improving But Distribution Remains A Weakness

India's electricity generation and transmission sector is turning a corner. India expects to have its first-ever power surplus in 2016-2017 after being plagued with double-digit peak demand deficits for much of last decade. However, quality and stability of supply still need significant improvement, given brown-outs that affect the industrial sector.

We believe the increased pace of power project completion and commissioning will help protect the credit profiles of key electric utilities like the government-owned NTPC Ltd. (BBB-/Stable) and Power Grid Corp. of India Ltd. (BBB-/Stable), despite higher capital expenditures (capex). We expect rising economic growth and a pickup in industrial activity to help absorb significant planned generation capacity additions.

The transmission sector is also witnessing strong commissioning activity and increasing private participation (projects of US$15 billion are being awarded by the government on competitive bidding). Underpinning these investments is a supportive regulatory framework that ensures adequate returns on completed projects.

The domestic coal supply has also improved significantly with adequate supply from Coal India Limited (unrated), which reduces dependence on costlier imports. We expect these factors to continue over the medium to long term and support the power sector's credit quality.

India will, however, need to carefully manage capacity additions to remain in line with demand and avoid overcapacities like China has seen in recent years due to its economic slowdown. Large capex needs to be executed with discipline because significant lead time for completing projects and land-related issues could create problems as returns on invested capital flow only after a plant is commissioned. The power sector has successfully attracted significant private sector investments, particularly in the fast-growing transmission and renewable sector recently, though competitive bidding could squeeze returns.

We believe the government's UDAY scheme (for Ujwal Discom Assurance Yojana, which aims to improve financial health and operational efficiency for state-owned distribution companies) is a practical approach to bolster perennially weak state distribution utilities, which have accumulated losses of over US$55 billion as of March 2015. Some states are realizing benefits of cheaper funding with state government support. However, reducing aggregate technical and commercial losses, distribution losses, continuing budget discipline from states, and banks' readiness to lend at lower rates in the future will determine whether UDAY ultimately succeeds in fixing the weakest link in India's energy chain, the distribution sector.

Key Opportunities And Challenges For Each Sector In Power Utilities
Sector Key Opportunities Key Challenges
Generation Stable regulations support adequate returns on investment. Growing demand expected to support PLF. Increase in domestic coal availability. Plant load factor (PLF) has been falling. Thermal plants face risks from renewable power getting dispatch priority and getting closer to price-parity.
Transmission Commissioning of projects at all-time high, with a large pipeline for the next three to four years. Increasing private sector investments. Improving grid stability with resolution of key transmission shortages. Execution needs to be managed as significant investments are being made; including from new players. Competitive bidding can squeeze returns.
Distribution UDAY reforms. Improvement in liquidity of some distribution companies. Weak financial health of most state distribution companies. Inefficiencies leading to continuing T&D (transmission and distribution) losses of 15%-18% (compared to 5.8% in China and an 8% global average).

Transportation Infrastructure Faces Capacity Constraints Across Segments

India's congested road transport, inordinate delays in railway freight movement, inefficient and long turnaround time at ports, and fast-growing but highly concentrated airport sector all add up to significant capacity constraints. Land acquisition issues often result in significant time and cost overruns for railways, roads, ports and airport developers, which puts them at high risk.

Transportation infrastructure could significantly benefit from a stable regulatory environment with an independent regulator and supportive, comprehensive policies, in our opinion. These factors underpin the credit strength of the power generation and transmission sector. Tariff disputes and in some cases a lack of independent dispute-resolution mechanism have harmed the financial health of some transportation infrastructure developers. In contrast to the highly stable regulations for transportation infrastructure sector globally and in the Asia-Pacific region, we see such regulations as a relative weakness in India. This also creates higher volatility for the cash flows of Indian companies in a sector where cash flows generally demonstrate low volatility.

Key Opportunities And Challenges For Sectors In Transportation
Key opportunities Key challenges
Roads Government is leading spending to rebuild confidence. Some pickup in the pace of participation by private contractors (some as engineering, procurement and construction). High congestion. Roads carry 65% of freight and 80% of passenger traffic. Weak dispute-resolution mechanism. Contractors suffering poor financial health from past losses.
Railways Largely government-led spending, now focusing on improving infrastructure. Progress in development and funding of dedicated freight corridor. Inordinate delays keep railroads from being preferred despite being cheaper (China ferries over 3x freight for a similar route network). Tariff disputes for few PPP (public-private partnership) metro projects may discourage private investments.
Ports Some government investments for capacity expansion and modernization, such as the “Sagarmala” project. High growth and margins for private ports. Long lead time for overcoming capacity constraints at government- owned major ports. Last-mile connectivity issues and lack of inland waterways. Low containerization level. China's sixth-largest port has container traffic that's higher than India's total.
Airports Sustained high passenger traffic growth. Efforts to improve regional connectivity. High concentration, with Mumbai and Delhi accounting for more than 40% of national traffic. Weak financial health of many airlines, including government-owned Air India. Low freight traffic (China has 10x freight and 4.4x passenger traffic).

Infrastructure Investments Are Likely To Remain High

As in China and other developing nations, India's infrastructure systems and networks also need to keep pace with population growth to enhance economic expansion. Although India's gross fixed capital formation is healthy at 30%-35% of GDP, it has significantly lagged China's since 1990. China has an unusually high level of investment, which S&P Global Ratings expects to remain so, at above 40% of GDP, despite the Chinese government's move toward consumption-led growth.

Both India and China plan significant investments to improve infrastructure. India intends to invest over US$1.5 trillion in railways, roads, and other infrastructure over the next five to 10 years, while China is pumping about US$720 billion into transportation infrastructure over 2016-2018 alone. Although India's government is scaling up spending, its heavy debt burden could derail its ambitions to improve public infrastructure. It will thus need funds from private sector investments unlike China, which has largely state-funded infrastructure. China has also leveraged local government financing vehicles (LGFVs) to tap offshore markets to fund infrastructure projects for local governments.

China faced similar challenges regarding funding and contractual enforcement in the 1980s and 1990s as India has been facing for much of the last decade. The Chinese government was open and flexible, initially attracting private and foreign investors through innovative contracts and concessions that essentially guaranteed a return on investment. Subsequently, it increasingly shouldered the responsibility of infrastructure development with support from banks (largely state-owned).

India needs resolute commitment to infrastructure development, and in our opinion, that will require flexible policies and the ability to manage timely execution on an unprecedented scale. We believe private sector investments will flow as the government's willingness to make projects commercially viable and to share the risks of the projects (like land acquisition) becomes clearer. Otherwise, the private sector will be left to grapple with risks that it has been unable to manage or price appropriately in the past.

In addition, many experienced developers are still trying to overcome financial problems from earlier underperforming or stranded projects. Banks and capital markets will support financially viable projects but perhaps not immediately, given developers' weak financial position and banks' own problems stemming from rising nonperforming loans (including from the infrastructure and power sectors), tighter provisioning, and higher capital requirements.

Lower Labor Cost Alone Isn't Enough To Bolster Manufacturing Competitiveness

Infrastructure development in India is as much a prerequisite for maintaining current growth as it for driving higher future growth. Resolving land acquisition issues and implementing the GST are two big national reforms that could have significant positive impact on infrastructure development, economic growth and improvement in India's manufacturing competitiveness.

We believe lower labor costs alone aren't enough to bolster India's manufacturing competiveness. It will be sustainable only with adequate national infrastructure, which currently is lacking. A vibrant manufacturing sector supported by infrastructure development will be crucial if India is to reap the demographic dividends of gainfully employing the large young population. But, in our view, improving labor productivity and providing ample employment opportunities will be additional challenges.

India's domestic-focused economy is less vulnerable--though not immune--to global economic shocks, so we expect it to register relatively higher growth. Falling interest rates, benign commodity prices, and government rhetoric about improving the business climate are already generating interest from domestic and foreign investors. India remains an attractive investment destination given global economic sluggishness. Initial hesitation to invest can be allayed if the government can match its rhetoric with action and demonstrate an ability to execute much-needed infrastructure projects, provide stable and supportive policies, and--most important--focus on economically feasible projects.