With China’s status as the “workshop of the world” marred by rising political risks, slowing growth, and increasingly untenable “zero COVID” policies, no country seems more poised to benefit than India. In May, The Economist ran a cover story about India, asking whether this was the country’s moment—and concluded that yes, it probably was. More recently, Stanford economist and Nobel laureate Michael Spence declared that “India is the outstanding performer now,” noting that the country “remains the most preferred investment destination.” And in November, Chetan Ahya, Morgan Stanley’s chief Asia economist, predicted that the Indian economy will account for one-fifth of global growth over the next decade.

Without a doubt, India could be on the cusp of a historic boom—if it manages to increase private investment, including by attracting large numbers of global firms from China. But will New Delhi be able to seize this opportunity? The answer is not obvious. Back in 2021, we provided a sobering assessment of India’s prospects in Foreign Affairs. We pointed out that popular assumptions about a booming economy were inaccurate. In fact, the country’s economic rise had faltered after the 2008 global financial crisis and stalled completely after 2018. And we argued that the reason for this slowdown lay deep in India’s economic framework: its emphasis on self-reliance and the defects in its policymaking process—“software bugs,” as we called them.

One year later, despite the exuberant press, India’s economic environment remains largely unchanged. As a result, we continue to believe that radical policy changes are needed before India can revive domestic investment, much less convince large numbers of global businesses to move their production there. An important lesson for policymakers is that there is no inevitability, no straight line of causation, from the decline of China to the rise of India.

In some ways, India looks like a promised land for global companies. It has structural advantages, its potential rivals have serious drawbacks, and the government is offering large investment incentives.

Start with the structural advantages. Commanding a territory that is nine times larger than Germany and a population that will soon overtake China’s as the world’s largest, India is one of the few countries that is big enough to house many large-scale industries, producing initially for global markets and ultimately for the burgeoning domestic market. Moreover, it is an established democracy with a long legal tradition and a notably young, talented, and English-speaking work force. And India also has some considerable achievements to its credit: its physical infrastructure has improved dramatically in recent years, while its digital infrastructure—particularly its financial payments system—has in some ways surpassed that of the United States.

Beyond these advantages, there is the matter of alternatives. If international firms do not go to India, where else might they go? A few years ago, other South Asian countries might have been considered attractive candidates. But that has changed. Over the past year, Sri Lanka has experienced an epochal social, political, and economic crisis. Pakistan has been ravaged by an environmental shock that has aggravated its perennial macroeconomic vulnerability and political instability. Even Bangladesh, long a development darling, has been forced to borrow from the International Monetary Fund after Russia’s invasion of Ukraine caused commodity prices to soar, depleting the country’s foreign exchange reserves. Amid this South Asian “polycrisis,” as the economic historian Adam Tooze has called it, India stands out as a haven of stability.

More significant still is the comparison with China, India’s most obvious economic competitor. Over the past year, Chinese President Xi Jinping’s regime has been buffeted by multiple challenges, including slow economic growth and a looming demographic decline. The Chinese Communist Party’s draconian COVID-19 lockdowns and assault on the private sector have only made things worse. In recent weeks, Beijing has confronted an increasingly restive population, including the most widespread antigovernment protests the country has witnessed in decades. The country’s turn toward authoritarianism at home and aggression abroad—and the inept governance that has taken the sheen off the fabled “China model”—have made democratic India look even more inviting.

Finally, India has taken steps that, on paper, should sweeten the deal for international firms. In early 2021, the government introduced its Production-Linked Incentives scheme to provide economic inducements to both foreign and domestic manufacturing firms who “Make in India.” Since then, the PLI initiative—which offers significant subsidies to manufacturers in advanced sectors such as telecom, electronics, and medical devices—has had a few notable successes. In September 2022, for example, Apple announced that it plans to produce between five and ten percent of its new iPhone 14 models in India; and in November, Foxconn said it plans to build a $20 billion semiconductor plant in the country in conjunction with a domestic partner.

RHETORIC VS. REALITY

If India really is the promised land, however, these examples should be joined by many others. International firms should be lining up to shift their production to the subcontinent, while domestic firms boost their investments to cash in on the boom. Yet there is little sign that either of these things is happening. By many measures, the economy is still struggling to regain its pre-pandemic footing.

Take India’s GDP. It is true—as enthusiastic commentators never cease to point out—that growth over the past two years has been exceptionally rapid, higher than any other major country. But this is largely a statistical illusion. Left out is that during the first year of the pandemic, India suffered the worst contraction in output of any large developing country. Measured relative to 2019, GDP today is just 7.6 percent larger, compared with 13.1 percent in China and 4.6 percent in the slow-growing United States. In effect, India’s annual growth rate over the past three years has been just two and a half percent, far short of the seven percent annual rate that the country considers to be its growth potential. The performance of the industrial sector has been weaker still.

And forward-looking indicators are hardly more encouraging. Announcements of new projects (as measured by the Center for the Monitoring of the Indian Economy) have again fallen off after a brief post-pandemic rebound, remaining far below the levels achieved during the boom in the early years of this century. Even more striking, there is not much evidence that foreign firms are relocating production to India. Despite all the talk about India as the investment destination of choice, overall foreign direct investment has stagnated for the past decade, remaining around two percent of GDP. For every firm that has embraced the India opportunity, many more have had unsuccessful experiences in India, including Google, Walmart, Vodafone, and General Motors. Even Amazon has struggled, announcing in late November that it was shutting three of its Indian ventures, in fields as diverse as food delivery, education, and wholesale e-commerce.

BUGS IN THE SOFTWARE

Of the many risks to investing in India, two are particularly important. First, firms still lack the confidence that the policies in place when they invest will not be changed later, in ways that render their investments unprofitable. And even if the policy framework remains attractive on paper, firms cannot be sure that rules will be enforced impartially rather than in favor of “national champions”—the giant Indian conglomerates that the government has favored.

These problems have already had serious consequences. Telecom firms have seen their profits devastated by shifting policies. Energy providers have had difficulty passing on cost increases to consumers and collecting promised revenues from the State Electricity Boards. E-commerce firms have discovered that government rulings about allowable practices can be reversed after they have made large investments according to the original rules.

At the same time, national champions have prospered mightily. As of August 2022, nearly 80 percent of the $160 billion year-to-date increase in India’s stock market capitalization was accounted for by just one conglomerate, the Adani Group, whose founder has suddenly become the third richest person in the world. In other words, the playing field is tilted.

Nor can foreign firms reduce their risks by partnering with large domestic firms. Going into business with national champions is risky, as these groups are themselves seeking to dominate the same lucrative fields, such as e-commerce. And other domestic firms have no wish to tread in sectors dominated by groups that have received extensive regulatory favors from the government.

THE PRICE OF ENTRY

Apart from elevated risks, there are several other reasons why international firms are likely to remain gun-shy about India. One of the key elements of the PLI scheme, for example, is raising tariffs on foreign-made components. The idea is to encourage firms relocating to India to purchase inputs in the domestic market, but the approach significantly hinders most global enterprises, since advanced products in many sectors are typically made of hundreds or even thousands of parts sourced from the most competitive producers worldwide. By attaching high tariffs to these parts, New Delhi has provided a powerful disincentive for firms contemplating investment in the country.

For companies such as Apple that plan to sell their products in India, high import tariffs may be less of an issue. But these firms are few and far between, since India’s market of middle-class consumers remains surprisingly small—no more than $500 billion compared with a global market of some $30 trillion, according to a study by Shoumitro Chatterjee and one of us (Subramanian). Only 15 percent of the population can be considered middle class according to international definitions, while the rich who account for a large share of GDP tend to save a large share of their earnings. Both factors reduce middle-class consumption. For most firms, the risks of doing business in India outweigh the potential rewards.

Recognizing the growing tension between its protectionist policies and its goal of enhancing India’s global competitiveness, New Delhi has recently negotiated free trade agreements with Australia and the United Arab Emirates. But these initiatives—with economies that are smaller and less dynamic—pale beside those of India’s competitors in Asia. Vietnam, for example, has signed ten free trade agreements since 2010, including with China, the European Union, and the United Kingdom, as well as with its regional partners in the Association of Southeast Asian Nations (ASEAN).

DANGEROUS DEFICITS

In any country, a well-known prerequisite for economic takeoff is having key macroeconomic indicators in reasonable balance: fiscal and external trade deficits need to be low, as does inflation. But in India today, these indicators are off kilter. Since well before the pandemic began, inflation has been above the central bank’s legally mandated ceiling of six percent. Meanwhile, India’s current account deficit has doubled to about four percent of GDP in the third quarter of 2022, as it struggles to increase exports while its imports continue to grow.

Of course, many countries have macroeconomic problems, but India’s average of these three indicators is worse than in any other large economy, save the United States and Turkey. Most worrisome, India’s general government deficit, at around 10 percent of GDP, is one of the highest in the world, with interest payments alone accounting for more than 20 percent of the budget. (By comparison, debt payments account for just eight percent of the U.S. budget.) Aggravating the situation is the plight of India’s state-run electricity distribution companies, whose losses are now about 1.5 percent of GDP, over and above the fiscal deficits.

A final barrier to growth is a deep structural shift that has undermined the dynamism and competitiveness of private enterprise. India’s very large informal sector has been especially hard hit: first by the 2016 demonetization of large-denomination notes, which dealt a devastating blow to smaller firms that kept their working capital in cash; then by a new goods-and-services tax the following year; and finally by the COVID-19 pandemic. As a result, employment of low-skilled workers has fallen significantly, and real rural wages have actually declined, forcing India’s poor and low-income population to cut back their consumption.

These labor market vulnerabilities are a cautionary reminder that the country’s vaunted digital sector—whose promise does seem almost unbounded—employs high-skilled workers who constitute a small fraction of the workforce. As such, India’s rise as a digital powerhouse, no matter how successful, seems unlikely to generate sufficient economy-wide benefits to effect the broader structural transformation that the country needs.

INDIA’S CHOICE

In other words, India faces three major obstacles in its quest to become “the next China”: investment risks are too big, policy inwardness is too strong, and macroeconomic imbalances are too large. These obstacles need to be removed before global firms will invest, since they do have other alternatives. They can bring their operations back to ASEAN, which served as the world’s factory floor before that role shifted to China. They can bring them back home to advanced countries, which played that role before ASEAN countries. Or they can maintain them in China, accepting the risks on the grounds that the Indian alternative is no better.

If the Indian authorities are willing to change course and remove the obstacles to investment and growth, the rosy pronouncements of pundits could indeed come true. If not, however, India will continue to muddle along, with parts of the economy doing well but the country as a whole failing to reach its potential.

Indian policymakers may be tempted into believing that the decline of China ordains the dizzy resurgence of India. But, in the end, whether or not India turns into the next China is not merely a question of global economic forces or geopolitics. It is something that will require a dramatic policy shift by New Delhi itself.