The new Indian government’s free market agenda is encouraging, but it is fraught with danger

Why investors should be cautious about India

May 29, 2014: 10:33 AM ET

The new Indian government’s free market agenda is encouraging, but it is fraught with danger.

By Sanjay Sanghoee

All hail Narendra Modi?

FORTUNE – Markets around the world rallied recently on Narendra Modi’s historic win as India’s new prime minister. Foreign investors are hopeful he will turn the economy around and have invested $16 billion in India’s markets in the last six months alone.

But while the world’s largest democracy is an important player on the world stage, India has never quite managed to achieve its full economic potential due to over-regulation, lack of national infrastructure, and political corruption. The prospect of free market reform under Modi is enticing for the investment community and could open the floodgates to a lot more capital, but before investors in the U.S. and elsewhere dive in too quickly, they should consider the risks still inherent in the Indian economic landscape as well as in Modi’s government more carefully.

India is a country with 1.2 billion people, of which 30% still live in poverty, and 56% of the workforce is engaged in agriculture even though it contributes only 18% of GDP.  Reforming India’s economy will therefore require more than just the relaxation of business regulations; it will require a massive reallocation of labor and the retraining of agrarian workers for other professions through better education and vocational training.  In addition, only 29% of women in India are in the workforce even though they comprise 50% of the population, which represents the severe underutilization of a valuable resource, and a barrier to progress.

Modi’s government will have to create an infrastructure to rectify these inefficiencies, but given the lack of official resources and India’s notorious bureaucratic lethargy, funding and support from the private sector will be crucial for success.  It is also important to note that the reorganization of India’s labor force will take years, if not decades, to yield results for the economy. All this can push returns down for investors in the short and medium term, and necessitate an upfront financial leap of faith in the country itself.

Another major challenge for India’s free market experiment will be the provincial foundation of the Bharatiya Janata Party (BJP), which has its roots in religious fundamentalism. Free market economics can’t work properly without a truly free society, and the conservative social and political philosophies of Modi’s party could prevent that from happening.  While the new prime minister has promised to be inclusive, getting rank and file BJP members, many of whom reside in villages and remain mired in traditional social structures such as the caste system, to follow suit will be extremely difficult.

The rural base of the BJP also poses another risk for Modi’s agenda. While India’s poor will certainly benefit from economic reform, they are also the most vulnerable to exploitation by corporate forces and may require state-sponsored welfare for subsistence.  This creates an obvious contradiction for Modi and a real free market in India. To lift the country economically, capitalist principles must be embraced, but without state control, India’s poor and middle class may be left behind.  The pseudo economic freedom of the past two decades, which allowed large Indian corporations and foreign companies to prosper, has buoyed India’s economy, but because of the narrow concentration of wealth, income inequality, and government corruption, done little to change the fortunes of the common man.

That should concern foreign investors because of the instability haphazard growth can cause. A widening prosperity gap in India will cause labor problems and political unrest, which can hamper the efforts of the Modi administration to direct even and systematic economic growth.It is tempting to imagine that free market principles can solve all problems but not if the spoils accrue disproportionately to a small segment of the population; and if the BJP fails to keep its promise of prosperity for everyone, they will be ousted as quickly as the left-leaning Congress party was.

There’s also the intractability of corruption in India. Such problems are not because of a lack of rules but because of a widespread disregard for those rules. To eradicate corruption, Modi’s administration will have to address it at a cultural and individual level in addition to an institutional one, which is much easier said than done. Ironically too, corruption is a tool for incumbent businesses to protect their hegemony in Indian markets by stifling competition, implying that Modi’s anti-corruption agenda could face opposition from powerful private-sector players as well (albeit in the shadows).

All this is not to say that the new prime minister does not stand a chance, but that the odds are stacked heavily against him, and if investors are depending on real or quick reform, they would be smart to hedge their bets.  The current market euphoria could turn out to be a bubble, and an expensive one.

Sanjay Sanghoee is a political and business commentator. He has worked at investment banks Lazard Freres and Dresdner Kleinwort Wasserstein, as well as at hedge fund Ramius. Sanghoee sits on the Board of Davidson Media Group, a mid-market radio station operator. He has an MBA from Columbia Business School and is also the author of two thriller novels. Follow him@sanghoee.