Cocky overconfidence, bloated government and crony capitalism may be India's undoing.

India stands just about a 50% chance of coming good as one of the emerging miracle economies. In a new book, Ruchir Sharma explains why cocky overconfidence, bloated government and crony capitalism may be its undoing. 

In the late 1800s, the story of a startling magic trick emerged from India and spread. In its fullblown version, the story describes a street performer who begins to play his flute over a coiled rope, which climbs dancing like a cobra to a great height. The boy assistant scrambles to the top of the rope and disappears. 

The magician calls for the boy, grows impatient, grabs a large knife and scrambles up the rope, vanishing too. Then limbs, a torso, and a head fall out of the sky. The magician reappears, reassembles and covers the body parts, and from under a bloody sheet the boy reappears, grinning. It would be one hundred years before "the great Indian rope trick" was fully exposed as a hoax: a composite pasted together in the imagination of Western visitors from the full menu of tricks performed by Indian street magicians. Magic societies offered rewards, but no one ever performed "the world's greatest illusion." 

In recent years visitors have been returning from India in a similar state of awe, overwhelmingly impressed by the nation that perhaps has been most deeply transformed by the emerging-market levitation act of the last decade. But India now risks falling for its own hype, based largely on the assumption that it is repeating a trick pioneered by China - a seemingly endless stretch of 8 to 9 percent growth - and is therefore destined to be the fastest-growing economy over the next decade. 

At least until the last months of 2011, when growth forecasts dipped below 7 percent and rattled investor confidence, the Indian elite seemed more focused on how to spend the boom's windfall than on working to make sure the rapid growth actually happens. 

The best example of this rosy thinking was the way the ongoing baby boom in India has been transformed from a "population time bomb" into a "demographic dividend". Until the 1990s the Indian government was still working hard to rally the nation against the dangers of overpopulation, but that fear has melted away, based on the argument that a baby-boom generation of newworkers helped fuel China's rise and will do the same for India. 

India's confidence ignores the postwar experience of many countries in Africa and the Middle East, where a flood of young people into the labor market produced unemployment, unrest, and more mouths to feed. I put the probability of India's continuing its journey as a breakout nation this decade at closer to 50 percent, owing to a whole series of risks that are underappreciated, including bloated government, crony capitalism, falling turnover among the rich and powerful, and a disturbing tendency of farmers to stay on the farm. 

The next decade is full of bright spots, but you can't find them by looking back at the nations that got the most hype in the last decade, and hope they will hit new highs going forward. The stars of this decade will be the breakout nations, by which I mean the nations that can sustain rapid growth, beating or at least matching high expectations and the average growth rates of their income class; for the richer emerging markets with average incomes of $20,000 to $25,000 (like the Czech Republic or South Korea) breaking out will mean 3 to 4 percent growth in GDP, while for China, in the class of $5,000 and less, anything less than 6 to 7 percent will feel like a recession. 

Similarly, it makes no sense to think of India ($1,500 per capita income, with a high-growth population) in the same way as Russia ($13,000, with a shrinking population ). 

The richer the country the tougher the growth challenge. The growth game is above all about expectations. People are always asking me, "So what if India slows from 9 percent to 6 to 7 percent - that is still three times faster than growth in the West, right?" 

Well, for India that slip would initially feel like a recession, because it is one of the poorer nations in the low-income group - the economies with per capita income under $5,000 - and every Indian has come to enjoy the levitating sensation of rising fast from a low base. 

Last year, New Delhi built its budget based on the revenue it could expect at 9 percent growth, and the prices in the Mumbai stock market were based on what Indian companies would be worth down the road if the economy continued to grow at a pace of at least 8 percent. In 2011, therefore, a growth rate of 7 percent was enough to trigger a bear market in Indian stocks. 

India's 'Silent Cal' 

Signs of an unraveling have begun to emerge under the administration of Prime Minister Manmohan Singh, but not really because of it. When Singh was tapped to become prime minister in 2004, many hoped that he could continue to push reform, but in reality he became more of a figurehead, presiding over an economic boom unleashed by global rather than local forces, particularly the tide of easy money that was flooding out of the United States, stirring an unprecedented boom across all emerging markets. 

Singh could not force reform on a political class and culture that had grown deeply complacent, and he now reminds me of US President Calvin Coolidge, the nondescript leader who was in office during the boom of the 1920s but did not use his power to correct fault lines that would bring down the U.S. economy in the 1930s. A man of few words, Coolidge earned the moniker "Silent Cal," and Singh too is known for keeping his mouth shut.. 

Brazil, Not China 

China is not the only possible model for India. Culturally and politically India has far more in common with the confusion of modern Brazil than with the command-and-control environment that defines China. 

Both India and Brazil are "highcontext" societies, a term popularized by the anthropologist Edward Hall to describe cultures in which people are noisy, quick to make promises that cannot always be relied on, and a bit casual about meeting deadlines. These societies tend to be built on close ties built over long periods of time, creating an environment in which a lot goes unsaid-or is said very briefly-because much is implicitly understood from context. 

The spoken word is often flowery and vague; apologies are long and formal. Such societies believe deeply in tradition, history, and favoring the in-group, whether it is one's family or business circle, and thus they are vulnerable to corruption. 

"Low context," in contrast, describes societies like the United States and Germany in which people are individual oriented, care about privacy, and are more likely to stick to timelines and their word. People tend to be on the move, to have many brief relationships, and thus rely on simple, open communications and codified rules to guide behavior. 

The most popular soap opera in Brazil in recent times has been A Passage to India, a Brazilian-Indian love story filmed in the Indian cities of Agra and Jodhpur in which Brazilian actors play the Indian roles and pass easily for North Indians. 

To Indians who have seen it, the show is a dead ringer, in terms of look and mood, for the style of the Indian producer Ekta Kapoor, who has turned out some of the most popular serial dramas in Indian TV history. 

In politics there is also a distinct Indo-Brazilian connection: a desire for state protection from life's risks - social welfare for the nation as one big in-group-to a degree rarely found in other highcontext societies. 

The political elites of India and Brazil are fond of welfare-state liberalism, and both populations demand high levels of income support even though the economies do not yet generate the revenue to support a welfare state. Per capita income is about $12,000 in Brazil and $1,500 in India. 

It was easy for India to increase spending in the midst of a global boom, but the spending has continued to rise in the post-crisis period. If this continues, India may meet the same fate as Brazil in the late 1970s, when excessive government spending set off hyperinflation and crowded out private investment, ending the country's economic boom. 

Crony Capitalism 

Crony capitalism is a cancer that undermines competition and slows economic growth. That is why the United States moved to take down the robber barons by passing anti-trust laws in the 1920s. Ever since, the American economy has seen constant change in its ranks of the rich and powerful, including both people and companies. 

On average, the Dow index of the top-thirty US industrial companies replaces half its members every fifteen years. India's market used to generate heavy turnover too, but in late 2011, twenty-seven - 90 percent - of the top-thirty companies tracked by the benchmark Sensex index were holdovers from 2006. 

Back in 2006 the comparable figure was just 68 percent . Further, the top-ten stocks on the Sensex now account for twothirds of the total value, while the top ten on the Dow account for just half the total value, showing a higher concentration of corporate wealth in India. 

Like most emerging nations India celebrates when its companies "go global," but this is not necessarily a good sign. To hit its 8 to 9 percent growth target India needs its businesses to reinvest at home, but they are looking abroad. Investment by Indian businesses has declined from 17 percent of GDP in 2008 to 13 percent now. Overseas operations of all Indian companies now account for more than 10 percent of overall corporate profitability, compared with just 2 percent five years ago. Given the boom in the Indian middle class, Indian companies should see huge opportunity at home: they are leaving because of the growing resentment against the domestic operating environment. 

In the global media India is closely associated with its dynamic technology entrepreneurs, who often grace the covers of international magazines. But this misses the retreat inward, the high-context side of India. 

Lately the enterprising moguls are getting replaced on the billionaire list by a new group: provincial tycoons who have built fortunes based on sweetheart deals with state governments to corner the market in location-based industries like mining and real estate. India has always been top-heavy with billionaires, which is partly a function of the way ingroups work to horde the economic pie for themselves. 

Political Chameleon 

India's boom has also sparked a rise in inequality, which to some extent is natural in the early stages of economic development; however, inequality can stall growth if it goes unchecked. Over the last decade, consumption levels have grown dramatically for all Indians, but 6 percentage points faster per year for the richest 10 percent than for the poorest 10 percent. 

Political leaders have been working to contain social tensions, mainly by increasing government handouts rather than by widening business and job opportunities. The Gandhi family has continued to show its trademark sensitivity to the poor, but in ways that may backfire against economic growth by running up deficits. 

This habit - deficit spending in good times as well as bad - was a major contributor to the current debt problems in the United States and Western Europe, and India can ill afford it. What's more, welfare schemes such as the rural employment guarantees create a perverse incentive for villagers to stay on the farm. 

China was able to convert its growing labor force into an economic miracle by encouraging a rapid mass migration of inland farmers to the more productive coastal cities. Over the past decade the share of the Chinese population living in urban areas rose from 35 to 46 percent. During the same period India's urban population grew much more slowly-from 26 percent to 30 percent of the whole. 

Why It Is 50-50 

No other large economy has so many stars aligned in its favor, from its demographic profile to its entrepreneurial energy and, perhaps most important, an annual per capita income that is only onefourth of China's. But Indian policy makers cannot assume that demographics will triumph and that problems such as rising crony capitalism and increased welfare spending are just sideshows instead of major challenges. These are exactly the factors that have prematurely choked growth in other emerging markets. 

The wild card for India is its freewheeling democracy, an environment in which the zeitgeist can change very quickly. It was only in the last decade that India came to see itself as the next China, and came to see its growing population as a competitive advantage rather than as a threat. The recent case of national overconfidence could give way just as fast to a healthy sense of urgency, with new state-level leaders who see the complex picture of India for what it is. 

The great Indian rope trick may be impossible, in its mythical form, but Indian leaders don't need to come up with something that dazzling. An economy with low per capita income is relatively easy to levitate. And lesser versions of the rope trick - with no one disappearing into the sky and no falling body parts - are still impressive enough to keep audiences riveted to the show. 

(Excerpts from Ruchir Sharma's new book, Breakout Nations: In Pursuit of the Next Economic Miracles, published by Allen Lane/Penguin. The author is head of Emerging Markets and Global Macro at Morgan Stanley Investment Management)