Building new roads and other infrastructure is vital for India's growth

When Japan’s Prime Minister Shinzo Abe embraced his Indian counterpart Narendra Modi in Kyoto in August it was not just a sign of their strong personal relationship. It also reflected the potential for increased economic co-operation between Asia’s second and third largest economies.

Japan’s economy is more than twice the size of India’s, but the gap will disappear sooner rather than later. The two countries have increasingly complementary investment needs, underpinned by divergent demographic trends. India needs to tap into sources of foreign investment to unlock its vast potential and create jobs. Meanwhile, Japan is increasingly looking overseas for investment returns that can help fund the retirement needs of its ageing population.

India’s GDP has more than tripled since the turn of the century, yet the country doesn’t look quite like the economic dynamo that China is. For starters, it isn’t known as a place for production, even though it is home to the world’s second-largest labour force. In India, industry’s share of GDP is less than half that of services: 24.8 per cent versus 57 per cent, according to the World Bank. In China, they are much more evenly balanced. That partially explains why India’s share of world trade lags far behind China’s.

Increasing the contribution of labour-intensive manufacturing to the economy will be essential if India is to employ its booming population. According to HSBC Global Research, India’s workforce will expand by 1.5 per cent annually over the next five years, meaning the economy will need to grow by 7.5 per cent a year just to generate enough new jobs for the young.

Japanese institutional investors are seeking to export more capital to create the wealth required to fund the country’s ageing society

But to convince investors and businesses that the country is a suitable location for factories, India needs to improve its infrastructure. After a lengthy period of under-investment, building new roads, bridges, power stations and airports would have a significant impact on economic growth. India’s Planning Commission believes the country needs to invest around USD1 trillion in infrastructure during its current five-year plan – raising its investment rate from 30 per cent to 35-36 per cent of GDP.

The challenge lies in financing. India’s national savings rate was just under 30 per cent of GDP in 2013 and it cannot make up the shortfall on its own. Instead, it will need to look beyond its borders for funding – and Japan looks like a natural partner.

Faced with depressed yields at home, Japanese institutional investors are seeking to export more capital to create the wealth required to fund the country’s ageing society. In October, Japan’s Government Pension Investment Fund – the world’s largest state investor – announced portfolio reforms that will increase its holdings of overseas bonds and equities. HSBC analysts estimate that more than USD100 billion could flow onto the international bond market as a result.

Other Japanese investors have already begun to look abroad. In the first ten months of 2014, bond investment in emerging markets by Japanese investors reached USD10 billion, compared with USD4 billion in 2013.

But while India is attracting increased interest from Japanese and other international investors, it must also develop a more mature financial system to avoid becoming over-reliant on foreign capital for financing. Especially for long-term funding, India needs to move from a bank-dominated framework to a market-based one. Although India’s stock market is very open, its corporate bond market is tiny: only 3 per cent of GDP versus 9 per cent in China, 16 per cent in Japan and 36 per cent in the US, according to the Asia Securities Industry and Financial Markets Association.

The investment needs of India and Japan are increasingly complementary. Asia’s second and third largest economies should look to embrace each other – much like their prime ministers did back in August.