Morgan Stanley: India Urgently Needs to Boost Manufacturing to Resolve Medium-Term Dilemma

Overview

This report explores the balance of payments pressure and medium-term growth bottlenecks currently facing India. Morgan Stanley believes that although measures introduced recently by the Indian government and central bank to attract capital inflows can alleviate financing pressure in the short term, to fundamentally solve the medium-term funding gap, cope with the impact of AI on service exports, and create sufficient jobs, India must shift its strategic focus to boosting manufacturing competitiveness. The report analyzes in detail why manufacturing is the key to solving India's 'impossible trinity' and proposes systematic policy recommendations containing five pillars based on China's experience.

Core views

Balance of payments pressure stems from a double squeeze of capital outflows and trade deficits. Since Q4 2024, foreign investors have recorded net outflows in five out of six quarters, and private equity exits have put pressure on FDI inflows. Meanwhile, rising oil prices and shrinking exports to the Middle East have widened the trade deficit. From December 2024 to March 2026, India's cumulative balance of payments deficit reached $52 billion, far exceeding the $25 billion during the same period in 2011-2013. The Real Effective Exchange Rate (REER) has fallen to 3.7 standard deviations below the ten-year mean, reflecting the severity of external imbalance. Short-term countermeasures have been implemented, but medium-term structural reforms are still needed. The government has attracted foreign investment by abolishing capital gains tax on government bonds, expanding the scope of FAR eligible securities, increasing overseas individual investment limits, and providing temporary ECB incentives, which is expected to marginally alleviate rupee pressure. However, relying solely on falling oil prices is insufficient to bridge the funding gap. The current account deficit is expected to widen to 1.8% of GDP in fiscal year F27 and narrow to 1.2% in F28. To fundamentally solve the problem, the domestic savings rate must be increased, which depends on employment and income growth driven by manufacturing. Manufacturing is the only key to cracking the medium-term dilemma, based mainly on three logics. First, Asia is in a capital expenditure super cycle driven by AI infrastructure, energy transition, defense, and supply chain reshoring. India needs to seize the opportunity but faces constraints of domestic savings insufficient to cover investment (F26 savings rate 34% vs investment rate 35%). Second, AI is disrupting the service export model India relies on. IT service export growth is expected to slow from an annual average of 9.8% over the past five years to 4.4%, forcing India to find new sources of foreign exchange. Finally, employment challenges are becoming increasingly severe. 85 million people will join the labor market in the next decade. Even without considering hidden unemployment, maintaining real GDP growth of over 7.4% is needed to fully absorb new employment; if solving hidden unemployment is considered, high growth of 12-14% is needed, which can only be achieved by relying on manufacturing exports with higher employment elasticity and stronger multiplier effects. At the policy level, a systematic approach is needed rather than scattered measures. The report suggests India draw on China's successful experience and implement five key initiatives: First, precisely position high-growth industries (such as EVs, batteries, robots, etc.), utilize the successful experience of the PLI scheme and expand to more fields; Second, build an integrated supply chain ecosystem, extend from assembly to localized production of components, and actively introduce multinational corporate cooperation; Third, adjust the financial system to support strategic goals, expand the scale of priority sector lending; Fourth, significantly increase R&D investment. Currently, India's R&D share of GDP is only 0.6-0.7%, far lower than China's 2.8% and the OECD average; Fifth, strengthen skills training. Although the proportion of STEM graduates is acceptable, higher education enrollment rates and vocational training levels still need improvement. In addition, coordinated execution between the central and state governments is crucial, especially regarding infrastructure 'last mile' connectivity.

Analysis framework

The report adopts an analysis framework of 'problem-oriented + structural decomposition + cross-country benchmarking'. First, starting from the Balance of Payments (BoP), it decomposes external pressure into two dimensions: current account (trade deficit) and capital account (foreign capital outflow), and combines relative valuation and earnings growth data to explain the deep reasons for capital outflows. Second, it uses the macro identity (Savings - Investment = Current Account) to derive medium-term solutions, demonstrating the unsustainability of relying solely on external financing or service exports. Third, it introduces the concepts of 'employment elasticity' and 'export multiplier', quantitatively comparing the efficiency differences between manufacturing and services in solving employment and generating foreign exchange. Finally, it adopts a horizontal benchmarking method, comparing India's current status with the historical path of China's manufacturing rise, extracting replicable policy elements to make recommendations more actionable.

Methodology notes

• Macroeconomic framework

  Balance of Payments Identity and Two-Gap Model

  The report is based on the macro accounting identity 'Savings - Investment = Current Account', pointing out that when domestic savings are insufficient to support investment, a current account deficit inevitably occurs, requiring reliance on capital inflows to compensate. This framework helps readers understand why simply attracting foreign capital is only a stopgap measure, and increasing the national savings rate is the fundamental solution.

• Industry/Industrial Analysis Framework

  Employment Elasticity and Export Multiplier Effect

  The report cites World Bank data pointing out that the employment elasticity of manufacturing exports is higher than that of services and domestic demand-oriented industries, and every manufacturing export job created can indirectly drive two related service jobs. This common knowledge explains why, against the background of AI impacting service exports, manufacturing has become the optimal solution to India's employment problem.

• Competition and Strategy Framework

  Path Benchmarking for Industrial Upgrading in Latecomer Countries

  The report systematically benchmarks India's current manufacturing development stage with China's successful experience over the past twenty years, identifying key success factors such as 'forward-looking layout of high-growth tracks', 'whole industry chain clusters', and 'policy financial support'. This cross-country historical benchmarking method provides a reference system for evaluating the effectiveness of Indian policies.

Key data

• Cumulative Balance of Payments Deficit$52 billionCumulative value from December 2024 to March 2026, doubled compared to the same period in 2011-2013
• IT Service Export Growth Forecast4.4%CAGR for the next five years under baseline scenario, significantly lower than 9.8% over the past five years
• Required GDP Growth (Absorbing New Employment Only)7.4%Minimum real growth rate required to absorb 85 million new labor force in the next decade, assuming labor participation rate remains unchanged
• R&D Expenditure as % of GDP0.6-0.7%India's current level, stagnant for a long time, far lower than China's 2.8% and OECD average of 2.7%
• Current Account Deficit Forecast (F27)1.8%Percentage of GDP, significantly expanded from 0.6% in F26
• 2026Q1 Corporate Earnings Growth ComparisonIndia 13% vs South Korea 171%BSE500 index component earnings growth significantly lags behind AI supply chain beneficiary economies

Impact & implications

For India, manufacturing revitalization is no longer just an economic growth issue, but a strategic imperative concerning external stability and social stability. If manufacturing competitiveness cannot be effectively enhanced, India may fall into the 'middle-income trap' risk: on one hand, service exports stall due to AI impact; on the other hand, capital continues to outflow due to declining relative returns, leading to intertwined exchange rate depreciation and inflationary pressure. Conversely, if the East Asian model is successfully replicated, it can not only improve the balance of payments but also release huge demographic dividends. For investors focusing on emerging markets, this means re-evaluating the pricing logic of Indian assets—shifting from a simple 'domestic consumption story' to a new narrative of 'manufacturing upgrade + export substitution', focusing on investment opportunities in policy-tilted areas such as electronics, semiconductors, new energy equipment, and infrastructure.

Risks

• AI impact on service exports is faster than expected, leading to earlier deterioration of the current account
• Insufficient execution by state governments or failure of central-local coordination, hindering the implementation of industrial policies
• Rising global protectionism limits the market space for Indian manufactured exports
• Slow increase in domestic savings rate, leading to investment funding gaps continuing to rely on unstable short-term capital inflows

What to watch

• Cross-departmental coordination progress and project implementation speed of the Gati Shakti National Master Plan platform
• Adjustments to the priority sector lending list and the actual flow of credit deployment
• Industry coverage and corporate participation in the new round of Production Linked Incentive (PLI) scheme
• Specific measures for business environment reform in each state and changes in the regional distribution of foreign direct investment
• Changes in IT service export order structure and output per capita, verifying the actual transmission path of AI impact