Among emerging economic powerhouses, India represents an untapped market potential that is ranked second only to China's (Exhibit 1). Not only is it the fifth largest economy in the world, and home to over 870 million people, but it has also set in motion a process of economic liberalization that—despite progressing in fits and starts—is clearly inexorable.

Until recently, the Indian economy was one of the most inward-looking and inefficient in the world. Mired for years in an elaborate "license raj," companies had to seek permission from bureaucrats to open, close, and even expand their units. Exports were paltry, amounting to a few barter deals with the countries of the former Soviet bloc. Tariffs ran as high as 150 percent, effectively keeping imports out. To many Western companies, India just wasn't worth the effort. Not surprisingly, foreign direct investment in the 1980s was a puny $100 million a year, less than 2 percent of the figure for China.

But since the launch of an IMF-prompted austerity program and a policy of radical liberalization introduced in June 1991, India's economy has begun to cast off its isolationist image. This transformation, achieved through a mixture of such macroeconomic measures as curtailing wasteful government spending, slashing tariffs and excise duties, floating the rupee on foreign exchanges, and overhauling the financial system, has already yielded the desired results. The annual inflation rate has been reined back to 7 percent from a high of 17 percent in 1991; the budget deficit is expected to fall, despite the revenue shortfall from lower tariffs, to 4.5 percent of GDP; and economic growth, estimated at above 4 percent for the fiscal year to March 1993, is expected to rise above 5 percent next year—breaking the 3.5 percent rate at which India had settled so enduringly in the 1970s and early 1980s that economists called it the "Hindu rate" of growth.

India's current move—away from a planned economic model inspired by British socialism and driven by import substitution, with its distorted market structure—isn't its first attempt; for several decades it has wavered on the edge of economic liberalization, as the historical survey in Exhibit 2 shows. But it certainly is the first serious, systematic, and potentially irreversible attempt—as witnessed by the fact that the institutions and controls of the old model are being not just dismantled, but replaced with new ones that support an efficient market economy. Given the size of India's economy (see Exhibit 3), the effects are likely to be dramatic.

Foreign direct investment

Every threshold economy has something distinct to offer. China has a burgeoning consumer market; Eastern Europe, the industrial capacity formerly tied up in its military and industrial complexes; and India, not just the biggest democracy in the world and a huge consumer base, but, more importantly, the skills, systems, and processes associated with a Western-style market. Business is conducted in English, for example, and Indian universities model their curricula—particularly in science, engineering, and business—on those of Western universities, often with their collaboration.

Foreign direct investments are rising—fast. In 1992, India attracted over $1.4 billion, compared with $230 million the previous year (Exhibit 4). The United States had a 30.5 percent share of investment, followed by Switzerland with 18.5 percent, and Japan with 16.4 percent (Exhibit 5).

All the same, in comparison with other developing countries, India lags far behind. Recognizing the problem, the government has taken steps to attract more investment. As well as relaxing its terms—for instance, by allowing foreign investors to hold a majority 51 percent stake in a venture—the government has in recent months offered such inducements as a five-year "tax holiday" for new projects in the power sector, and a reduction—from 65 to 30 percent—in the short-term capital gains tax levied on foreign investors. Gains on stocks held for longer than a year are taxed at 10 percent. Most important of all, the administrative procedures for direct foreign investment are beginning to be simplified.

Such measures have already had an impact. It took PepsiCo close to five years before its proposal to enter the Indian market was finally approved in 1990. Coca-Cola, by contrast, had to wait only three months to get its re-entry application through just two years later.¹ Around the end of 1992, the government announced it was ready to approve $2 billion worth of foreign direct investments, in addition to the $1.5 billion it had cleared since the liberalization policy of 1991. Together these amounted to more than the entire foreign investment over the previous ten years.

In the twelve months following the launch of its liberalization program, the government approved close to 1,000 foreign collaborations—double the previous year's total. Foreign portfolio investments in India's 22 stock markets are also on the rise. With a market capitalization of $75 billion, more than four times the comparable figure for China or Indonesia, the Bombay stock market, which was founded in 1875, has already attracted registrations from several foreign financial institutions.

Exports

Exports have been rising too, as Exhibit 6 shows—and especially to countries outside the former Soviet bloc, which represented India's major export market before the fall of Communism. Between April and December 1992, the overall value of exports rose by 3.4 percent, while those outside the former Soviet bloc jumped 11.4 percent.

However, export performance lags behind that of many newly industrialized countries in Southeast Asia. Turning this situation around will require an assessment of those sectors in which Indian producers are the most internationally competitive; the most promising appear to be textiles, chemicals, pharmaceuticals, leather products, gems and jewelry, and such knowledge-intensive areas as computer software.

Business environment

The rules of the game for businesses operating in the Indian environment are changing rapidly, presenting both challenges and opportunities. While considerable progress has already been made, a number of outstanding macro- and microeconomic issues still remain (Exhibit 7 and Exhibit 8). Items that need to be on the agenda include more stringent supervision of financial transactions; the creation of policies for both the closure of unviable state-owned enterprises and the restructuring and privatization of viable ones; and—despite the inviting "open for business" sign—much more work on relaxing the persistently cumbersome and bureaucratic procedures for approval of foreign investments. The financial scandal in the Bombay bourse further demonstrates a need for banking reform.

Although entry barriers to both domestic and foreign companies have been largely dismantled, exit policies still exist which prevent the closure of unprofitable enterprises (Exhibit 9). In many industries, the continuing inability of firms to reduce their workforce, coupled with the progressive lowering of entry barriers to prospective competitors, is likely to lead to overcapacity and increased price competition, eroding the profitability of existing and prospective players. The government has pledged to reform India's highly restrictive labor laws and to relax prohibitions on the closure of unprofitable units, but it faces stiff opposition from the politicized trade unions and many state governments.

Consumer market

With a large and complex market like India, looking at averages can be deceptive. The key is to disaggregate the information, since most official statistics about per capita income in India fail to reflect the real purchasing power of its inhabitants. India, in common with other developing nations, subsidizes many basic needs: housing, primary health care, education, power, and transportation. When such state support is taken into account, the 1992 figure for per capita income, $275 (derived on a market exchange rate basis), quadruples to $1,255 per capita (on a purchasing power parity basis).

The danger of taking official statistics at face value is illustrated also by their failure to cast light on regional imbalances in income. So great are these that incomes in the western and southern areas of India are comparable with those of such newly industrialized Asian countries as Malaysia and Indonesia.

Nor are incomes the only source of regional disparities. As Exhibit 10 shows, there are wide gaps between states when life expectancy, adult literacy, real GDP per capita, and human development are compared.

Comparative analyses aside, the magnitude of India's population—870 million—means that the size of its middle class is large in absolute terms: conservative estimates place it at about 150 million. Moreover, the middle class is expanding by about 20 million a year—more than the entire population of Malaysia.

From a survey of half a million people, the government-financed National Council of Applied Economic Research calculated that over 20 million households make upwards of $1,500 per annum on an exchange rate basis, yielding a purchasing power equivalent of about $4,000 in 1990; another 38 million households make between $750 and $1,500 (Exhibit 11). We have found that consumerism takes off in India beyond an income threshold of $2,000 on a purchasing power parity basis. Sales of consumer durables, for example, have skyrocketed in recent years. Exhibit 12 shows how production of certain items has risen; the corresponding consumption levels are likely to be, if anything, higher by the time imports have been taken into account.

Even surveys such as these tend to underestimate real incomes, failing as they do to include unreported "black" money, which is predominantly in the hands of the middle class and accounts for between 20 and 30 percent of GDP. The true wealth of Indian consumers, who have a savings rate of over 20 percent—a lot of it tied up in unproductive assets such as gold—is also missed by most statistical analyses. Some of this wealth is, however, invested in the domestic capital market. The country currently has some 20 million shareholders and investors in mutual funds—a figure that is expected to double over the next decade.

Many consumer goods companies have an eye on this lucrative market. In the five years between 1985 and 1990, the number of brands in several major categories proliferated, more than doubling in some (Exhibit 13). While per capita consumption of most branded consumer goods remains low, the absolute size of the market is attractive. The market for haircare products, for example, is estimated to be worth over $150 million, despite low average rates of consumption (Exhibit 14).

The total detergents market will soon exceed 2 million tons, which represents a larger market in volume terms than that of any single country in Europe. Thanks to higher disposable incomes among middle-bracket consumers, some product categories are enjoying growing consumption levels. The government's Planning Commission estimates that food consumption jumped 35 percent between 1980 and 1989—almost twice the (19 percent) growth in population over the same period.

The rise of rural markets

Most of the focus on Indian consumers has so far been on urban markets, but it would be a mistake to neglect the much bigger, almost wholly untapped markets in rural areas, where over 70 percent of Indians live. Existing rural expenditure on packaged goods is about $700 million—itself the result of an annualized 23 percent growth rate (Exhibit 15)—which actually represents only 1 percent of rural income. Few consumer goods companies have achieved any substantial penetration in rural areas (Exhibit 16 and Exhibit 17). Reasons for such a poor reach include inefficient distribution, weak logistics, and a fragmented transportation infrastructure.

Heightening this sense of missed opportunity, disposable income in rural India has been steadily rising. Such recent benefits as the "green revolution," several years of good monsoons, improved agricultural and irrigation practices, debt relief for farmers, and better procurement prices have combined to create a rural middle class with few outlets for spending its money. The proportion of rural poor almost halved in the 1980s, from 54 to 28 percent of the population. Over India as a whole, a quarter of the population lives below the poverty line, many of them concentrated in the central and northeastern regions of Madhya Pradesh, Uttar Pradesh, and Bihar. The regions of northern India, especially Punjab, Haryana, and Himachal Pradesh, the coastal zone, starting from Gujarat and Maharashtra in the west to Tamil Nadu in the south, and increasingly even West Bengal in the east, are all witness to the growing rural affluence (Exhibit 18).

However, companies need to think of new ways of reaching rural consumers. Only just over half of India's villages can boast populations above 2,000 people and access by motorable roads. Distances between villages, and between villages and towns, can be vast. The lack of organized freight transportation often makes companies dependent on lower-quality third-party trucking operators. In response, some companies have created a two-pronged distribution chain: wholesalers in villages with over 2,000 people are served directly from regional warehouses; smaller villages are served by wholesalers in large villages (over 5,000 people). The wholesalers are generally small family-owned businesses which also tend to play a vital and intrinsic role in the social and cultural fabric of the village. Some companies have piggy-backed on the distribution networks created by other (non-competitive) companies. In essence, the key to success is the ability of companies to pioneer distribution networks and thereby create markets.

Aware that distribution costs can be prohibitively expensive, many companies are trying innovative methods of packaging² in the effort to bring overall costs down (Exhibit 19). Hindustan Lever penetrated rural markets by packaging shampoo in sachets; Colgate, by packaging toothpaste in aluminum foil laminates. Pan Masala, a branded betel leaf chewing mixture, achieved an increase in sales from $5 million in 1985 to $66 million in 1991 by switching from a 200g tin container to a 10g sachet.

Food processing

Given the dominance of food within household expenditure (Exhibit 20), it is predictable that the food industry should be poised for sustained growth. Food expenditure as a percentage of GDP does, admittedly, decline as living standards rise (Exhibit 21), but spending shifts toward higher-value-added "luxury" items such as complete ready-to-eat meals and frozen products. Interest in such goods is expected to be concentrated in urban areas, where dual-earner families are becoming more common.

Similar trends toward branded processed food have been frequently observed in other economies (Exhibit 22), though certain product categories have tended to do better than others in developing countries (Exhibit 23).

Overall growth of the processed food industry in India is expected to be between 9 and 12 percent (Exhibit 24), although far greater potential could be unlocked if the high costs of packaging and distribution were overcome. The ability to do so depends on a number of factors: increased investment in food processing, use of cheaper alternative packaging materials, catering to regional differences of taste, and the introduction of both refrigerated delivery vans and fridges at retail outlets.

Reaching India's vast market, especially the third that is most attractive to Western companies, entails making informed decisions about which products to sell, carefully implementing market entry strategies, selecting the regions on which to focus, considering what kinds of distribution channels to use (or to set up from scratch), choosing the packaging, and—finally—resolving all the standard issues related to market entry: partnerships and alliances, negotiations with government, supply chain development, and so on. The passage to India isn't an easy one, but for those with the will to persevere, the payoffs can be huge.