Sajith Pai Unpacks the 2024 Indus Valley Annual Report and the Changing Indian Consumer

SHRUTI RAJAGOPALAN: Welcome to Ideas of India, where we examine the academic ideas that can propel India forward. My name is Shruti Rajagopalan, and I am a senior research fellow at the Mercatus Center at George Mason University.

Today my guest is Sajith Pai, who is a partner at Blume Ventures and he is a long-time media executive turned VC. At Blume, Sajith supports investments in media, ed tech and e-commerce, while simultaneously helping Blume building a research and knowledge platform.

We spoke about the 2024 Indus Valley Annual Report. written by Sajith and his co-authors, Anurag Pagaria, Nachammai Savithiri both at Blume Ventures; the many countries that make up the country of India; bifurcated between India1, 2, and 3; gross fixed capital formation, fintechs, the consumption led boom that India is experiencing, the space industry, and much more.

For a full transcript of this conversation, including helpful links of all the references mentioned, click the link in the show notes or visit mercatus.org/podcasts.

Sajith, so good to have you here. Thank you for joining us. We have very few people who come on a second time. I’m very happy that now we have had enough episodes in the past that that number is growing, and we have some frequent repeat guests. Sajith Pai, again, welcome to the show. 

I want to start with the 2024 Indus Valley Annual Report. I feel like this is when I really speak with you. This report is co-authored this year with Anurag Pagaria and Nachammai Savithiri. Am I saying her name correctly?

SAJITH PAI: Savithiri, yes.

Sizing India1, 2, and 3

RAJAGOPALAN: Savithiri. Okay, perfect. One major difference between when we spoke last year about last year’s report and this year is basically that the size of India2, as you characterize it, has changed, right?

PAI: Yes.

RAJAGOPALAN: Just to get our listeners caught up, you sort of bifurcate India into India1, India2, India3. Each of these segments has a further bifurcation. India1 is still about the same size, about 120 million people. You call it a Mexico within India because it’s about that GDP per capital level, and that kind of spending. 

India2, which last year, you had characterized at about 100 million people, has now grown to 300 million people. The description has changed from a Philippines within India to an Indonesia within India, though, of course, this Indonesia is at a per capita level of about Nigeria, but that’s where we’re at.

India3 is still very large, a billion people, but unfortunately, still at sub-Saharan levels. This genuinely excited me and surprised me. 

When I first started reading, I was like, “Wow, has India’s middle class grown?” What I noticed was that a lot of this is not economic-growth or income-growth-driven, but a lot of it is about consumption-driven and especially the changing patterns of consumption.

If I had to summarize this year’s report, it is that there’s some room for maneuvering amongst the different segments: India1, 2, 3. Especially when it comes to changing attitudes, especially when it comes to marketing, consumption, consumption using digital spending and so on. But without strong economic growth, we’re going to hit a concrete ceiling very quickly. Is that a good way to think about this report? Because it’s 130-plus pages, so I want you to give the TL;DR before we really get into it.

PAI: You got it right, Shruti. But before that, delighted to be here. It’s always a pleasure to be here with you. 

You caught on to something which not too many have caught on, that we did change the India2 sizing. The fundamental reason for that, Shruti, is my audience is fundamentally the startup founder in a way. That’s really the core founder and reader persona I’m aiming at.

One of the ways in which I want the report to be useful for them is for market sizing. When I look at the consumption data, like you rightly said, when I look at the spends, for instance, when I look at the subscription patterns and YouTube data, as well as the data on apps like ShareChat, et cetera, I felt I couldn’t defend the previous number of 100 million.

Even though I had a very neat Philippines equivalent, and now I don’t have such an elegant construct, I felt I had to increase the base, because the base of consumers, albeit their per capita income is not changed—if anything, I have to drop it a little bit because you have to expand it—but they are relevant consumers now. Albeit not paying users to the degree, but they are beginning to spend.

Dream11, for instance, is one app where they spend. They’re beginning to spend on apps such as ShareChat. We’re beginning to see some spends from India2, so their consumption can be unlocked a bit. But fundamentally, I think you put it very well, the TL;DR is that India1 is becoming a powerful engine for growth.

Those 30 million households, 130 million people, 9%-10% of India is the economic engine that really drives the Indian economy forward. The second-order effects of that are beginning to be seen now in how they’re propelling the financial markets forward. Finally, there is a limit we’re hitting that we can only grow so much as India1 allows us to. Unless you keep moving India2, at least India2.1, the upper echelons of India2 into India1, we’re not going to get the kind of growth that China saw. Far from it. I think you’ve summarized it quite well. I think the TL;DR is exactly as you put it.

RAJAGOPALAN: I don’t think you should apologize for the change in categorization, because if I remember our previous conversation correctly, you almost predicted this. Because you were talking about sachetization, you were talking about how startups are now slowly changing not just their overall attitudes and values, but also the way they understand the Indian market to know that you can’t just build whatever is being built in Europe and United States for India. You can’t just build DoorDash for India. Now, we’re building for Indians.

A very large part of building for Indians is to understand what market actually pays, how much is their paying capacity, that they end up paying a lot in tiny sums of money, as opposed to one large lump sum. There is a very large aspirational class that is passively viewing or consuming the products of the digital marketplace that’s watching what’s happening that actually wants to enter this area. When I read it, I felt like you had called it absolutely right in last year’s report, and now you’re seeing that in the expansion of the India2 category.

PAI: Yes. When we spoke last year, there were a few trends that I spoke about like sachetization. That’s really the startup world saying, “We’ve got to adapt our revenue/economic model to fit what India2 can pay.” But there have been very powerful underlying infrastructural developments, not the least UPI. How UPI has made it easy for people to pay three rupees, four rupees. I think there is behavioral economics at work here when you’re paying digitally, you don’t feel like you’re paying, as opposed to taking it out of your wallet and paying for it.

Every customer is used to now paying X rupees. Especially the India2 customer is now used to paying cash for microtransactions, as they call it. One of the trends we’re seeing is, for example, ShareChat thought they could monetize India2 via advertising and they failed, because fundamentally, those eyeballs aren’t as lucrative as our (India1) eyeballs, but they’re willing to pay. They’re willing to pay two rupees.

The big finding for me was when Harsh Jain of Dream11 said that, “Hey, we can’t get India2 to pay 300 rupees a month. We can get them to pay 10 rupees every day for 30 days.” Apps, which are able to unlock this behavior pattern, this spending pattern, will become the new winners. Really, I think it’s these two trends. 

From the supply side, you have all of this technology and the behavioral manifestations of that. On the demand side, founders are saying, “Hey, we’ve got all this technology. Hey, we know how it works. We’ve seen some of the pioneers in the industry show how to make it work. Let’s do that.”

I would say this is really—coming of age is not the right way to put it—but I would say, all of the demand side and supply side coming to the fore and saying, “Hey, these are the patterns of unlock, and let’s go out and exploit them.”

Private Consumption and Fixed Capital Formation

RAJAGOPALAN: One of the things that you highlight in the report is a little bit alarming. But at the same time, it’s very good news for the Indus Valley as you have it, which is that India’s economy is so private consumption-driven or private consumption-heavy. This is relative to most of the other large economies, especially compared to China. Private consumption is really the engine that’s powering everything. It’s powering, of course, what’s going on with the startups and the types of products that get launched. It’s also powering government behavior.

The government of India relies heavily on consumption taxes because it is very difficult to escape that tax, relatively speaking, and which ends up making our tax base more of the poor people. It’s a very regressive way to raise taxes. Direct taxes, corporate and income tax, have just sort of hovered around somewhere between the 2.5% to 3.5% of GDP mark. The tax-to-GDP ratio is low, but it’s really being bolstered by this consumption. I want you to unpack this a little bit from the startup founders, and also the venture point of view. How do you think of this trend of the engine for the economy being this kind of private consumption and its growth?

PAI: I must say that as opposed to private consumption being 60%—and it’s not so much private consumption that’s driving it as much as the lack of fixed capital formation, right? It’s 60% because it’s 29% here, right? If that was a little higher, it (private consumption share) would be in the early ’50s, which probably is the more realistic one. India has underperformed on gross fixed capital formation. I’ve seen data in the last 24 years, and it’s never been (higher than) about 33%, which hit in 2010 I think.

RAJAGOPALAN: Since ’11, it’s been in secular decline. I think it just started an uptick in 2021/22 fiscal year.

PAI: Correct. You’re right. Some of it is path dependence. Historically, we’ve had low fixed capital formation, because it’s just been hard to get the private sector to invest. A, we’ve had a crippled corporate debt market. Again, is it the chicken or the egg? Is corporate debt market small because the private sector does not invest, or is it the other way around? That’s been expensive. Capital has been expensive.

The lack of land reforms haven’t helped. It’s hard to get land to buy on a large scale. A multitude of factors leading to it. I would say that the trend on taxation isn’t helping much. For a long time, I think it was 14%, a few years back, now it’s 17%, which is the tax-to-GDP ratio. Of which, 6% is direct taxation and 11% is indirect taxation. You’d expect it to be the other way around—

RAJAGOPALAN: Exactly.

PAI: —in India. I think a dangerous territory for me to go into, but I think there’s a sort of a Faustian bargain. Like for the U.S., for instance, it was kind of no taxation without representation. In India, it’s almost no representation for no taxation, right?

RAJAGOPALAN: I love that phrasing of it.

PAI: I’ve heard this consistently come up on your podcast. It was one with Rohini Nilekani, where she spoke about the inimical effects of not having local taxes. You alluded to it in the podcast with Karthik Muralidharan. 

What we have really done in India is to create a national overarching tax where, at the ground level, there is virtually no taxation, no property tax, hence no representation. If I’m not charged property tax, how do I go out and demand services? As a result, there’s a complete decoupling of the elite from any of the public market (goods). We all have our own private everything, right?

RAJAGOPALAN: Enclaves.

PAI: Enclaves, yes. I would say for the startup community, it’s really the second-order effects. We benefit from that. The one point is that it’s very hard for the startup community to do anything at the GFCF [Gross Fixed Capital Formation] level. It’s hard for them to do it. Finally, it is up to the large industry, the large private sector investors to put money in, the infrastructure players, et cetera. I think we are happy beneficiaries of consumption and consumption’s growth.

Shruti, I think, predominantly, I think the challenge has been that consumption is really the top end consumption, really. It’s not really gone beyond. We’re seeing some signs of economic models which take advantage of, I would say, India2 wider consumption, but it’s fundamentally, really India1 consumption that’s driving.

I think the challenge that I see, and I think we can cover it at some point, is that the capital that’s going in doesn’t always take into account that there is a very small base of power-spenders who are driving this forward. That is what I think the startup world has to keep in mind, like the famous quote goes, “never has so much been owed to so few,” and all of that.

Gross Fixed Capital Formation

RAJAGOPALAN: I want to get into the gross fixed capital formation part. Now, in your report, you actually start with it, which was such a pleasant surprise to me because I feel like no one pays attention to this one very important data point more generally, but especially the fact that the decline started in 2011/2012. I think most economists have now started agreeing that the decline at least started because of the Vodafone retroactive taxation, all the corruption scams, the corporate India part and the foreign investors suddenly put their breaks on because of so much regime uncertainty.

After that, you point out some of the reasons, which is the NPA crisis, the twin balance sheet problem, because of which, private borrowing just shrank. The more private borrowing shrinks, the more government starts entering that space, which means it’s further crowding out the private sector. These are just very standard problems that we’ve been seeing in India for more than a decade.

Now, my question is we saw a huge influx of capital in 2020 to 2022 from foreign investors, right? That’s when the VC market was ridiculously hot. We talked about it last time. It was actually unnaturally hot. All that has now calmed down. There’s been a big correction. But why are foreign investors so nervous about putting any money in startups that involve manufacturing, deep tech, space tech? Anything that would involve capital formation? Even something more than capital formation of building a new office for a startup. We are just not entering that space.

Same with ed tech, is very much on the online front. It is not online coupled with a warehousing model or a schooling plus library model. It’s a very odd way in which the foreign investor VC money has come into India. What do you think is driving that? I understand the domestic reasons why Indian corporates are not contributing to capital formation or investment rate, but why are the foreigners not doing it either?

PAI: I don’t have data on all of the different investment sectors. I think I’ll only be able to speak for venture. I think venture, historically, we have relied a lot on software. Hardware, for instance, is really coming to the fore now. We have a company called Ethereal Machines. They do manufacturing as a service and they launched in 2018, and it was one of the first investments I saw when I joined Blume. For the next four or five years, they were in the wilderness. They took a long time to get the product going, but even after the product went out, the demand was very weak. Finally, they pivoted, and then they pivoted again and now they’re red hot. 

Peak XV, which was Sequoia, now led a large round in it recently, and interestingly, we are beginning to see a huge appetite for manufacturing. Now, at the early stage amongst VCs—and many of these VCs also have access to foreign capital. If you look at our base (of investors), it’s largely institutional, and a lot of them are abroad; 70%, 75% of our capital base is international.

In a way, we are a proxy, Blume, that is, where I work is a proxy for international (investors). To that, I would say one reason you’re not seeing a lot of money, Shruti, is the action has just started now. If the action starts now, whether it’s manufacturing, whether it’s deep tech, whether it’s space tech, et cetera, it’s only in a few years that you will start seeing big money come into it.

For instance, if you look at the venture funding scenario two years back, it was about $40 billion, of which three-fourths was what’s called growth capital, which is capital about like $15, $20 million at a go. That has actually collapsed now, but still is two-thirds. Seed, where Blume operates, is not even $1 billion, and we’re less than 10% of the overall market, and growth capital is really two-thirds, but growth lags seed. It takes 18 months for growth to catch up in the sense that growth says, first, get to early growth, then we’ll come to growth.

I feel if we are going to do this in 2027, then we might actually see a slightly different thing because there’s some exciting plays coming out of India. We are beginning to see that largely at the seed stage. Some of the discussion we’ve had on, do VCs not invest in very technologically advanced startups, et cetera, that’s beginning to change. There is an appetite for innovative, interesting place in space tech, climate tech, manufacturing/deep tech, nanotech, all of that.

We’re beginning to see that. We’ve had a fair amount of new hires, and all of them are coming in that group, really the deep tech/climate tech group. I sort of represent the old economy group, and we have intentionally not grown that too much. I would say that’s been one of the most positive signs, the ambition of Indian founders. I dare say, you’ve got a point there, but I think we are reaching the point where, in a couple of years, we are going to prove you wrong, hopefully.

RAJAGOPALAN: No, and this also shows the maturing, not just of Indian deep tech manufacturing, but also the maturing of the Indian VCs, including Blume, because you need to have a portfolio that’s diversified enough in all the other areas that now you can say, “Okay, a large enough chunk will be deep tech.” So that’s one.

The second, I think, also going back to our previous conversation, is now we have finally started seeing a relay race formula for deep tech where you can pass on to the next person and the next person. And there is some exit, maybe not as quickly as SaaS companies that end up coming to fruition, but there is some kind of exit plan even with deep tech and space tech. Space tech, of course, is much more driven by government and government funding and contracts, but even in other places. I do see what you mean about this is now a new area, and maybe it’ll start contributing to fixed capital formation in three, four or five years. At least that would be my hope.

PAI: Yes. Numbers will be much smaller. We are a very tiny part. We, of course, overindex on innovation and new technology. But really, I think the big spending and the big lift will have to come from the Reliances and Adanis of the world.

RAJAGOPALAN: Absolutely. They are going in the opposite direction. During COVID, et cetera, they were actually retiring a lot of their corporate debt. They were very nervous about how costly funds are to borrow in India, and how it’s only going to get exacerbated with this twin balance sheet problem. It seems to me, at least on the government and the public sector banks, that a lot of this has been cleaned up. 

Do you see private borrowing, corporate borrowing increasing over the next few years and contributing to this capital formation? Or do you think still they’re waiting for something to happen before they invest further?

PAI: I’m not an expert on this. I only read a lot of reports and try and put it together, but all of the reports that we looked at for Indus Valley 2024 say that we’ve sort of hit the bottom of the lack of borrowing. We are going to see an uptick in borrowing. Keep in mind that these are sell-side reports, so they have to sell a story. I don’t know if it’s entirely factual based and how much of it is marketing. I think a bulk of it will be fact based, but there is certainly a case being made for an infrastructure spending boom, infrastructure spending wave.

We are beginning to see the early signs of that, for example, in manufacturing, Dixon, people who benefited from PLI, and there is a case being made that we are going to see a fair amount of spends in India in the infrastructure area over the next few years. I don’t have the firsthand information of that, given where I sit. This is secondhand information, from consuming a lot of reports. I would agree with what you’re saying that we are likely to see that, but I don’t think I’ll be able to say that I have any information other than the secondary reports that I consume.

Regime Uncertainty

RAJAGOPALAN: Yes, my intuition is not just based on the reports. I’m sure we are reading some of the similar stuff, things that are put out by all the big banks and all those kinds of reports and surveys. One thing that really concerns me when it comes to private investment in fixed capital formation, which, of course, therefore, also is related to private borrowing for the same purpose, is regime uncertainty.

When I say regime uncertainty, I don’t mean governments collapsing or this is not the African dictatorship problem. This is more the problem of even with a stable government in parliament, we have no stability when it comes to taxation. We have no stability when it comes to tariffs. Indian manufacturing 3.0, which is basically what’s happening right now—Indian manufacturing 1.0 was in socialist times, 2.0 was post-liberalization. Now, we are trying to enter a world where we are trying to better integrate with global supply chains. This is very much Foxconn coming and setting up in India, and thinking about India as an export market.

For that to happen, tariffs need to be sensible such that it can effectively integrate with the global supply chain, and taxation and GST needs to be sensible. Since GST was introduced, there have been more than 550 rate changes. If these things keep happening—and already, we have seven non-zero GST rates. That worries me more because before putting a lot of money down in brick-and-mortar, you need to be certain about those things.

India’s already at a stage where we are not even utilizing existing capacity when it comes to manufacturing because we’re not that well integrated with the global supply chain. This seems to be shifting now; there’s a big push. But I am really holding my breath for GST and tariffs to get streamlined and stay stable for a few years before I see a big investment push coming in from the private sector.

PAI: Interesting. One way in which startups and the world of startups are playing in manufacturing is not by setting up factories, but aggregating factories. This aggregating a lot of factories, being a cloud manufacturer, really pioneered by Zetwerk, to whom a lot of credit should go, in that if they got an order for XT widgets, they went to six manufacturers and said, manufacturer one-sixth of XT widgets, and then we will do all the basic quality check. That led to a series of vertical plays, for example, Groyyo in textiles, which try to do this.

We’ve met a couple of startups which want to do more in specialty chemicals, and specialty manufacturing. One manufactured stuff for railways of Eastern Europe and stuff like that. I think one way in which startups are dealing with the uncertainty that you said is by saying, “We are not going to set everything ourselves, but we’re going to become this layer, software, plus, light hardware layer. At best we’ll choose to do some monitoring, et cetera.”

It’s an interesting model because there’s also a fair amount of SMB manufacturing base India has clustered across Pune, some parts of Delhi-NCR, in the south, et cetera. They are beginning to take advantage of that. I think with startups, I think you will not see any big, large bets. None of us have that kind of capital. The markets here, only $9 billion came into the Indian venture economy last year or was invested in the venture economy. $9 billion is not much. It’s not going to help you set up very large number of factories and stuff like that.

RAJAGOPALAN: In fact, I think it’ll be the reverse. I think startups won’t lead in this business. It is when the reforms start happening in other areas and people start investing in traditional manufacturing that the startups that are already set up for this kind of utilization for coordination will start seeing an uptick, and then more money will flow into that. That’s my expectation of how this will play out in the future.

PAI: I probably agree.

The Indian Consumer

RAJAGOPALAN: Yes. I want to talk to you a little bit about the Indian consumer. If I just read the report, at first glance, it looks like, wow, the Indian consumer has changed. Maybe the Indian consumer has not changed that much, because what I find is once you scratch below the surface of India1, necessities really dominate consumption. Discretionary spending is tiny. It’s growing, which is the nice green shoot that you point out, but it’s still pretty small, at about 13% to 21% is where it’s grown. One of the interesting things that you say in the report is there seems to be a limit to India’s consumption class. Right? That’s, I think, a direct quote from the report.

One question I have is, other than economic growth, what do you see driving the change in the size of the consumer class? Part two of that question is, is the Indian consumer fundamentally changing? Even within these India1, 2, 3 categories, is there a lot of churn? Are people’s attitudes, habits, preferences fundamentally changing? Or is this just a question of which area, state, demographic you look at at that point of time, and who has more ability to engage in discretionary spending?

PAI: Got it. One factor other than economic growth, which could drive consumption is, I think, remittances. There is this very famous exit, voice, loyalty framework.

RAJAGOPALAN: Yes. Hirschman. Yes, Albert Hirschman.

PAI: Yes. Hirschman. Yes. India, if you notice, its exit is led by two classes. One, I call the exit class, which is people, for example, Punjab to Canada is a classic exit class corridor. People who have seen farm productivity drop, who have other challenges. Kerala, for instance.

RAJAGOPALAN: There are no jobs.

PAI: Yes, Kerala, for instance. A very vocal, highly educated, awakened labor class means that manufacturers are very scared. Even though the human capital stock is much higher than on average, there isn’t so much manufacturing coming into Kerala, as opposed to say Tamil Nadu, for instance. Very similar kind of literacy levels. Maybe I’ll bet 5% lower, maybe. Kerala, for instance, is again, the classic exit corridor, which is to the Middle East. Kerala really is an economy propelled on the back of that remittance.

RAJAGOPALAN: Absolutely.

PAI: It’s a remittance superpower. We also have an English class, which is exiting. It’s something that might come into the next report. I’m fascinated by why are the elites migrating out, and so that’s fascinated me as well. The people are going to the U.S. There’s a recent report I was seeing anywhere from 3 to 5 million (Indian-origin) people in US, most-highest paid XYZ.

RAJAGOPALAN: Yes, Indians are supposed to be the model minority, as they call them. Have fewest in terms of high school dropouts, the fewest in terms of criminality, so on. The highest in terms of education, graduate degrees, income, within the subcategory of South Asians and Asians. Very much that group that you’re talking about, which is propelled by IT exports and things like that.

PAI: Absolutely. We’ve got some interesting data on remittances and found that 20% of India’s remittances come from U.S. Even though it’s just 4.5 million people out there and they account for like 20%, $20 billion or so of remittances. Yes, the model minority part is justified. I would say other than economic growth, I can only think of remittances as one driver.

As far as economic growth is concerned, my worry is that the India1 class is deepening, thanks to basically access to ownership of capital. When you own capital, whether it is capital as in cash or real estate, we’re seeing all of those assets, they own the assets, majority of the assets, and those assets are going up in value. One is asset led, other one is income. If you look at the formal economy, we have a very undersized formal economy.

Data, this is very hard to come by, exact data. All the data points are like three, four years old. I wish I could have the latest data. The last data point I saw was about 550 to 600 million workers in India, of whom about 10% work in the formal economy. About 30% of this is thanks to IT. That is really the greatness of Mr. Narayana Murthy and his peers. In that 30% of the middle class owes itself to that industry, that one industry.

There’s 50 million people (in the formal economy). I remember reading “Poor Economics,” that wonderful book. What stayed with me was, they said that very few of the poor—and I think they said that the poor are poor because they don’t have visibility into their income streams. When you look at the ratio, the share of Indians who have predictable income streams so that we can invest in our kids’ education, we can buy a house, XYZ—

RAJAGOPALAN: Absolutely.

PAI: —it’s just 50, 60 million people. They’re about 30 million households, again, you’re coming back to that number, really. When you take a look at those 50-60 million people, unless that grows, Shruti, we’re not going to see India1 grow. For that to grow, and strangely, what we’ve had in India has been growth without necessarily the big increase in employment.

I’m not the best person to debate, but we’ve seen Mr. Raghuram Rajan and Rohit Lamba talk about their views on this. There’s a big debate there. I don’t want to contribute to that debate. What we’re beginning to see is really growth that doesn’t drive jobs as much. We are investors in a company called Smartstaff, which is in the business of staffing textile workers. That’s a big category.

Tremendous offtake, trespassers will be recruited kind of offtake, but the big challenge is skilling. Skilling is a fundamental challenge. The challenge they say is employers won’t pay for skilling. Okay, employers won’t pay for skilling. There are multiple reasons for that, again, chicken and egg, employers pay for skilling because workers quit immediately, and so on and so forth.

One of the big challenges that these folks have is that come Eid, come farming season, workers just head home. They’ve actually done a lot of research that finally got to a series of hacks through which they persuade people to come home, one of which is that tickets are given, et cetera. They even paid some of the workers, say, give them money saying, “Why are you going home for farming? Take the money, give it to your brother or uncle or father, and tell him to hire a worker.”

They’re saying they can’t hire workers because NREGA means the average wage level has gone up and social consciousness, backbreaking work farming, some of it is backbreaking work. Historically, we have had a certain set of castes and all who could be persuaded, for the lack of a better word, to do the stuff, and today they’re not willing to do it. They have to go back, and that means if you’re a factory, you’ve got to then say, “Oh, this is Eid season, this farming season, we are going to see a 20% drop in workers.” So it becomes very hard to plan in India.

Textile is interestingly the fastest—any other job, requires at least one year, auto, et cetera, electronics, CNC. CNC needs a technical degree to operate the CNC machines, but textile, you can do a sewing machine in three months, you can learn.

Really, I think the fundamental challenge for India is if you’re not going to invest in people, and people are doing the behavior which companies won’t invest in them, then you’re fundamentally stuck at two ends. You’re going to have a very elite class which works with machines and tells machines what to do. That’s people like us. Then you have this large semiskilled, unskilled class, which just can’t seem to break into. So these are, I think, the things that sometimes worry me about India, but it’s also fascinating, right?

Bottlenecks and Reforms

RAJAGOPALAN: Yes, the way I see it is, I feel like the Indian economy, because of its scale, a lot of the bottlenecks get hidden, because there’s always an untapped place where you can get a little bit more utilization, and I think now, 30 years after liberalization with the services sector being about as utilized as we can with IT export-led growth, which has led to urbanization, which has led to all the services, ancillary services that the very rich use, and so on.

Now, I think we have come close to that limit, and we really tested that during COVID when everyone went back, when that sector just shut down and these people couldn’t go out and spend. That service sector said, “Oh, we really need to rely on the networks back home and the agrarian networks and all.”

I think we’ve tested it, and now we have reached a point where it’s not that India could have gotten away without manufacturing growth ever in its trajectory, but we managed to get away with it for about as long as we could because of the scale of the service sector. Even though service is a small part of the economy, it just generates such a big number compared to another country. I think, now, we really need to get to that state-level, local-level structural reform. That is the bottleneck.

If people can’t sell their land back home, you’re always going to have a situation where the brother or the cousin or the unmarried daughter has to come back home to the village to help during harvest season or sowing season or whatever. I think now we are there. Until we have that next big stage of structural reforms, I’m afraid that even a startup, which is technically in the matching business, which has nothing to do with the agrarian economy or something else, it’s going to feel the ripple effects of that bottleneck. That’s where I think the next thing is. Unfortunately, none of this can be done by the union government. This can be done at a state level.

I think, as you rightly pointed out, Tamil Nadu has been the front-runner in this. It has a serious industrial activity and also industrial worker class, which has then spurred the rest of the economy further. I think the question for the rest of the states is, how do they get there? How do they get to a point where your service is led, but you also have the next class of 30%, 40% which can exit agriculture and go somewhere? Even in Tamil Nadu, now I realize the services, you go to a Adyar Ananda Bhavan, or you go to a Sangeeta, or Saravana Bhavan, I’m told that the back-end staff is all from Bihar and Odisha.

They spend three years in Tamil Nadu, they can also become front-end staff because they also start speaking Tamil. Because you can’t be selling idlis and taking down the chutney order if you don’t speak Tamil, no Tamilian would order from them. This is now happening, that now Tamil Nadu has become such a sophisticated state in terms of job creation, that the migrant pool has to come in, even for services, which was earlier not the case. The migrant pool only came for construction or this backbreaking work that no one else was willing to do. I see what you mean. This is not a problem startups can solve or scale. I think we are getting to the bottom of the bottleneck, where it is in the Indian economy.

PAI: Couldn’t agree more. I see this in Kerala, too, what you said about frontline staff from the northeast, specifically. One very interesting pattern I heard from Smartstaff, again, that what drives migration within India, and why Kerala and Tamil Nadu get a lot of people from Odisha to the northeast, is the rice and predominant animal protein diet here. Like, for example, they like to eat meat or fish.

RAJAGOPALAN: Yes, absolutely.

PAI: Whereas in the north, dairy is the predominant protein, and wheat is the predominant carbohydrate. Call it the milk line (which divides) the north and the west, where you don’t have lactose intolerance, and the south and the east, historically, there’s predominant—that is really the map of India which explains India. North and the west is where the BJP, for instance, rules. So much can be explained by that one map, really. I call it the milk line.

RAJAGOPALAN: Yes, the milk line and the rice line, right? Also, Alice Evans was talking about how pastoral versus rice-growing economies, there’s more female labor force participation in plantation economies and rice-growing economies. Actually, if you see a lot of the women who are leaving Odisha and the northeast, it’s the single women. Now, their families let them travel, especially from places like Odisha, because they think, “Okay, they’re not going to come back and work in the agrarian household, but at least if they work for three, four years, they can pay for their own wedding and their own dowry.”

PAI: That’s interesting.

RAJAGOPALAN: That is what we’re seeing in a lot of the electronics companies are fascinating because they have that hostel/dormitory model. There’s that special corridor, the Sriperumbudur corridor, where a lot of this industrial activity takes place. When you have that kind of a system with young people, it’s easier to have a single gender versus coed. For very heavy manufacturing, you will rely on men. This would be something like Asian Paints or auto parts or something like that.

For instance, electronics, where the shift is 12 hours—I have been told, I have no evidence for this, this is purely anecdotal—that women actually do better in a 12-hour shift than men do. Women do better in a seven-day week or a six-day week than men do because the expectation is that they have only three or four years to work. Then you can build out a women’s dormitory. Therefore, you can have much more stable workforce. You can have a doctor on call.

You can have all of those additional benefits, which become very complicated in a coed system. Plus the problem of complaints from family, if people fall in love and get married outside their caste and so on. You’re absolutely right, it’s becoming very interesting how the migration pattern’s going, especially when it comes to female labor. Female labor was never a migration category. Women migrated purely for marriage, and then post-liberalization, a little bit for education, but still predominantly marriage. Now, that seems to be changing, which again, gives me a lot of hope.

PAI: It’s interesting. I didn’t know about the female migration route. That’s interesting.

RAJAGOPALAN: I think it’ll grow. With Foxconn and Qualcomm, with all these guys coming in and having the new shifts—this is the South Korean and Chinese model which already had so much female labor force participation at the factory floor level—I would expect to see more of this if the government’s push to integrate to global supply chains to integrate to China Plus One becomes a bigger deal.

Mutual Funds Savings Model

One of the questions I wanted to ask you, just to move away from the service and consumer category, was about investments and savings. India has a low investment rate, but it’s not clear to me that the savings rate has changed dramatically at the individual or the household level. What we find actually is that it’s very mutual funds driven. It’s this SIP [systematic investment plan] model, which is a different kind of sachetization model, this time for saving and investment instead of directly buying stocks, we have the SIP model for mutual funds.

The big change that you point out has been that not only do mutual funds dominate, it’s really the domestic institutional investors and not the foreign institutional investors who are driving this crazy market growth and market capitalization that’s taking place in India. Two questions related to this. One, why does the Indian household prefer to save in this format? As opposed to maybe investing in their own ventures, maybe small entrepreneurship, maybe other ways of investing, maybe in property and so on. Why is it this SIP, mutual funds-led model? Second, what that means for startups, again, for the newer firms in the newer categories that we are discovering?

PAI: Two reasons for this. One is that a lot of the folks who are investing in mutual funds are India1 service-class employees. Keep in mind that all of these numbers neatly match, so 50, 60 million formal employees, which means, at two people, it’s 30 million households. Yes, of course, there are business households as well, and nothing will neatly match in that sense. But broadly, there’s a coherence between the numbers. Service class is the predominant investor in mutual funds.

What has happened, Shruti, is over the last few years, a series of supply-side and demand-side factors have led to the growth of the mutual fund industry. One is KYC; it used to be very arduous to do KYC checks, et cetera. Almost physical KYC checks had to be done, we had to go to the bank and submit a lot of documents. And now thanks to DigiLocker, it’s an API call away. That makes KYC easy, onboarding easier. Startups, for instance, Zerodha is not—

RAJAGOPALAN: Zerodha, exactly.

PAI: —it’s not venture-funded. A lot of VCs probably wish they could have funded it, but it’s a very well-run profitable company. But Groww, for instance, or Upstox, these are venture-funded companies. Groww, if anything is bigger than Zerodha in volume, in the number of people, and they’ve grown like a rocket of late. They have taken advantage of it. It’s also a very well-marketed category. If you go to a bank, each relationship manager as they are called—it’s not a private banker, but it’s a democratized version of that—they will try and push mutual funds because of the commissions and because of the incentives that they have. It’s a very well-marketed category. 

Really, fundamentally, Shruti, it is the deepening of India1 and basically the economic surplus that this constituency commands today. It’s driving something like $2.5 billion every month through the stock market, and the stock market typically gets about $5 billion every month. The rest comes from institutional investors, et cetera. This $5 billion that’s systematically going into a stock market, which is not as deep as the U.S. one, et cetera. For instance, we have about 4,500 stocks. It’s very similar to the U.S., I think, in that. When we did the calculation, we found that three-fourths of these 4,500 stocks had market capitalization less than $250 million.

Only 10% had something above $1 billion dollars in market cap. The other thing, Shruti, is the float is very small in India. Many companies have small floats. They’re promoter controlled. Because of the small float, what it means is that there has been a runaway growth in stock prices. More money comes in. There’s limited stuff to buy and the limited high-quality assets. You buy them, and because the float is so small, the prices go up. It’s like a self-fulfilling prophecy. That is one of the fundamental reasons why we have had this tremendous increase.

If you’ve looked at it, the Indian stock market, and it used to be a joke that sometimes historically people say that venture funds give any valuations, et cetera, which is not entirely true. There’s a reason in our logic. Around 2021, 2022 is when we would actually tell whoever asked us that look, you call us fanciful, but what about the public market? If anything, the public market’s in a league of its own. I think these are some of the factors that has driven and has encouraged more and more money to come in. It’s growing.

Path from Seed to IPO

RAJAGOPALAN: There are two things I see coming out of the stock market question. One is just, how do we think about the trajectory or the duration that startups take from, say, seed to IPO? Is this an opportunity to make that trajectory shorter? Is IPO in India stock market, and its investor, which is almost entirely mutual funds chasing after very few high-quality assets, is this now a group that we can go for even as a startup on its growth trajectory? Is this a valuable exit option for people who invest?

PAI: I do think that in India we will need startups to go IPO much earlier than their counterparts in the U.S. Primarily because there’s an upper cap on how big the consumption market in India is. Keep in mind that the U.S is a $23 trillion economy, very homogeneous. What works in Illinois will work in California. It’s not true in India. In India, there are 85 regions and 28 states. These sociocultural regions, many consumption patterns break. India is one of those places where there is scale break all the time. Given that, I think there are clear upper limits on how much certain companies can grow to.

I do think there are upper limits on how quickly companies can get big. I think that’s the thing. It’s not that companies can’t grow. They can compound in India over a long period of time. Whether it’s Unilever, there’s Asian Paints, there’s Castrol. There are so many wonderful examples of companies which have grown but they IPOed earlier. HDFC Bank is a compelling example. One year, or less than a year after they got the banking license, they went public and for the last 30-odd years they’ve been giving stellar returns. Really, it’s only now that they faltered a bit.

Historically, in India, we’ve had companies going IPO early and have compounded over a long period of time. In venture, you tend to invest in companies which you think are going to hyper scale, and there is so much capital that is available in the West. I genuinely feel that the Indian venture market has been shaped as much by the Western capital deployment folks as much as by Indian founders. Because in the West, they have gargantuan amounts of capital, and they have to invest that somewhere.

I call it the highest of the first-world problems where they have deployment targets and they’ve got to deploy it somewhere. They look at India and they say, “wow, I think this could do it.” I’m sure they’ve realized now but what we need to keep in mind is the kind of hyper scaling companies—I like to divide startups into two categories: hyperscalers and compounders. Hyperscalers are companies, for example, Zepto is a good enough example of that. Zomato is a decent example of that. These are companies where they broadly have India1, India2 and maybe upper ends of India3. Some of them, not all of them. Or at least have India1 and India2.1 clearly locked in. They have a much larger market to go after. They can continue to grow for a long period of time. They can absorb a lot of capital. 

A lot of the other Indian companies can’t absorb so much capital. I call them compounders. For compounders, I think they have to be very careful on how much capital they take in, and they should list early. In India, even in the U.S., suddenly, the debate on Twitter over the last few weeks is about this debate over how big should a company be before it goes IPO? There is this realization that, you don’t need to be $500 million revenue to go IPO. You could probably do it at $150 million too. Of course, Sarbanes–Oxley and some of those factors—

RAJAGOPALAN: It’s more regulatory driven, because the U.S. is so flushed with capital that if the regulatory problems or even a slight friction, you say, let’s delay the IPO so that we can do this privately a little bit longer, we can innovate without eyes and without quarterly reporting requirements a little bit longer.

PAI: Absolutely.

RAJAGOPALAN: India doesn’t have that similar constraint. Here, the constraint is the capital availability.

PAI: Capital availability.

RAJAGOPALAN: It ebbs and flows with U.S. interest rates. When the interest rates are low, then there’s huge influx of capital. When the interest rates are high in the U.S. like right now, suddenly everything disappears. It’s called a startup winter whatever, AI winter, crypto winter—pick your favorite winter. Here, I understand what you’re saying that it just makes much more sense, especially for the firms that are not going to have that kind of hyper growth. Not everything is a unicorn nor should it be. 

It also seems a little bit more democratic in a sense that we need more stakeholders in India’s startup growth culture. One kind of stakeholder comes from jobs, but that’s not where the startups are leading so far. The other kind comes from capital. Once the capital influx comes in, then they’ll just have a very long trajectory. They will be more founder-driven because they’re compounders. They’re not so much venture and PE-driven and so on. I don’t know. I somehow think of it as a positive thing. Do you think this is a positive thing or this is terrible that India is at this stage?

PAI: No, I think it’s a very positive thing. You alluded to capital availability. In India, one important factors of capital, absorbability.

RAJAGOPALAN: Absolutely.

PAI: We don’t have—

RAJAGOPALAN: Because of the size of the market basically.

PAI: Size of the market. As a market expands, there will be more hyperscalers. They will be able to unlock new revenue streams and certainly be able to absorb more capital. At this point, we are beginning to encourage our founders to go and list early and continue and grow. For example, one of our companies, E2E, we do sometimes wonder if we got them to list too early because they’ve really grown. They listed on the SME exchange, which is the exchange for the smaller companies.

RAJAGOPALAN: Smaller one.

PAI: They’ve upgraded now to the main boards, and they’re benefiting from the AI wave. They weren’t very—

RAJAGOPALAN: What do they do? Sorry, I’m not familiar with them.

PAI: They make GPUs available.

RAJAGOPALAN: Oh, nice.

PAI: It’s not like they manufacture it, but they help make it available for companies, and they’re riding that wave. I don’t have too much information. It’s not a company I track very well because it exited. If you’re going to look at the compounder category, the one learning we’ve had is that the SME exchange was very active last year. They accounted for 10% of the value of the main bourse.

The main bourse saw something like, I would say, $6 billion, and about $600 million was what the SME exchange accounted for in terms of listing, how much they were able to get. About 10% of that. It’s the highest it’s ever been. Can it last? Hope so, because it democratizes ownership and allows companies to list early and grow, and allows us to get an exit as well.

RAJAGOPALAN: Exactly. It’s the pipeline issue that we talked about last time, which is this major problem in India where you need a clean pipeline, where at each stage people can exit. IPO being one possible way is quite fantastic. The second part of this whole domestic investor and mutual funds, a part of that is I see that FDI is low and declining in India. Again, the same problem we have with gross fixed capital formation, we see a similar trend in FDI. Until recently when it started picking up, it was declining. FIIs are also low, relatively speaking. Your domestic institutional investor is dominating.

India’s Foreign Investors

Is India becoming less attractive to foreign investors? Is that how you read these data points? Or do you read these data points as, oh, the Indian domestic investor is actually coming into her own and driving the prices up, which make it less attractive for foreign investors, especially when interest rates are high in the developed part of the world and so on? How do you read this trend? 

PAI: Here’s where I think my lack of an economists’ toolbox handicaps me. I need a lot more understanding of the wider economy I think on foreign institutional investment, the last few years have been a little more complex: COVID, then the rate drops, then the rate increases.

RAJAGOPALAN: Sharp increases.

PAI: Sharp increases. It drops, and the rate increases since ’20. It’s hard for me to really understand because the Fed governor is a patron saint of the Indian capital market really. It’s really hard for me to parse on the FII front. There, I would say that the FII’s behavior has been hard for me to predict. There, I would probably say the domestic market’s really been a larger factor, is one.

On foreign private investment, I’m genuinely puzzled. I would have expected that to take off, especially with China Plus One, and a lot of those factors. I’m hopeful that we’ll see some of it changing in the coming few years. Again, because it’s so politically a treacherous space to wade into, I would say that I do feel that we are likely to see an offtake growth in FDI in the coming years, especially investments in manufacturing.

It will come but is not coming at the pace that we all expected it to come. You alluded to some of the reasons. These are both questions, FDI as well as FII behavior, as to why they have been so. While one, I can explain to an extent by some of the larger macroeconomic factors, the other has been a little harder for me to understand. What we’ve really seen is the China Plus One, India is not the overwhelming the same. Vietnam seems to be the big—

RAJAGOPALAN: Vietnam, Bangladesh, they seem to be getting that share.

PAI: Vietnam is largely Chinese manufacturers who’ve just set up there and they’ve just taken advantage of the China Plus One, or taken advantage, doing the best of what they can with the China Plus One rhetoric.

RAJAGOPALAN: They’re just better integrated. The way I see that trend, the Vietnam trend, as the China Plus One policies, they are part of all the regional trade agreements. At least they’ve adapted the institutional rules. Even something simple like labor law, do you mandate an 8-hour shift, do you mandate a 12-hour shift or do you not mandate at all? On these things, Vietnam seems to be much better poised to integrate to whatever the Chinese and South Korean manufacturing setup was, such that now the same supervisors can come and monitor the same shift, the same size, the same format.

Even the industrial activity in China was so templatized, and at such a high scale. That’s really what China gave the world. China and South Korea just templatized manufacturing. Anyone who can integrate into that template relatively easily, because of domestic policy, tariffs, VAT, everything, is just going to be the beneficiary of that. I think the ball is really in India’s court on whether we wish to reform, and reform in a way that we can integrate with that. Or are we going to march to our own beat, which is what we’ve been doing for 30 years?

PAI: The East Asian model which we saw in the Four Tigers, that’s really, I think, what you’re seeing in Vietnam to an extent. It’s laggard there in the sense that they’re trying to catch up, but if anything I think it’s far more on the East Asian model. I think, India, I see it as a weak East Asian growth model, a WEAGan model as we call it. It has some characteristics of East Asia, but not entirely. 

RAJAGOPALAN: Nowhere close.

PAI: Nowhere close. I remember reading about the 12-hour shift thing being reversed in India. It was in Tamil Nadu or Karnataka, one of the states.

RAJAGOPALAN: I think Karnataka first it was brought in, then it was reversed. Then I think the government gave the special exception or something like that. There was some back and forth going on. I think it’s Karnataka if I’m not wrong.

PAI: Got it.

RAJAGOPALAN: Those are the sorts of things. I think we are now realizing how well we integrated into services and exports when it came to IT. We really integrated well into the global supply chain. With manufacturing, there’re just more hiccups and we’re struggling and that reforms agenda.  Electricity, oh my God, our electricity situation is just bananas. Sorry, I don’t even have a coherent way of describing it like an economist. Our pricing is crazy. Our shortages are crazy. Our cross-subsidization is crazy. How we regulate captive pipelines, open access pipelines, crazy.

India’s Fintechs

One other last topic I wanted to touch when it came to the consumer, consumption savings that kind of triangulation you guys have come up with, is India’s fintechs are booming. Actually one trend that you point out, which is super interesting is even startups and companies that were traditionally not fintechs have entered the fintech zone in that they are now becoming de facto lenders. They’re all applying for licensing. They’re trying to figure out buy-now-pay-later models, and so on so forth. 

Having said that, the personal loans, it’s a small category, but it’s been increasing that you point out. It’s increased 12 times in volume, but only 3.5 times in value. The bigger problem is that about a quarter of them are now, I believe, nonperforming assets. When I look at this data that you’ve pointed out, there are two ways of thinking about it for me. One is, these are the people who used to go to friends and family and money lenders and so on. Now thanks to the DPI infrastructure that we have, this digital payments infrastructure, they’ve been plugged into the economy of formal credit. They may not know how to deal with it. 

Some of it might be an information/attitude issue. Some of it might just be credit crunch. Earlier, money lenders were charging crazy daily compounding and things like that for these kinds of small sums of money that were lent. The banks obviously don’t gouge like that, but that means the NPA start mounting. 

Two parts here to this question. One is, do you see the fintech retail market turning into NBFCs and plugging in a particular kind of retail lending loan as a positive sign? That’s part one. Part two, are you worried that this NPA risk is going to turn into some kind of systemic risk that also starts infecting nonfintech companies? Because the RBI is very worried about this sector as far as I know. How do you see this space playing out?

PAI: Lots of questions there. I think the broader theme—

RAJAGOPALAN: Sorry about that.

PAI: No.

RAJAGOPALAN: It’s just the report is so rich. I must congratulate you and your co-authors. You guys triangulate in such an organized fashion.

PAI: Thank you. 

RAJAGOPALAN: It’s never one data point. It’s like 10 pages of data that help us get close to the truth in one sector before you move on to the next. That’s the reason for the long setup and the long questions, but sorry for interrupting you.

PAI: Thank you for that. When we look at the data, what data tells you first is that we are fundamentally underpenetrated on credit. A lot of what has been happening, like you rightly said, the digital public infrastructure removes the friction of onboarding the customer, et cetera. It makes it easier to lend, for sure, but there’s also appetite from the consumer. I think the challenge is that the growth now is largely coming from India2, and maybe even the bottom half of India2. We are beginning to see some of the numbers like about a quarter or just over a quarter of loans under 50,000 are NPAs now.

RAJAGOPALAN: That is, defaulted for more than 90 days.

PAI: Yes, which is 90-day plus. Then about 40% of personal loans are going to borrowers with five-plus loans. Typically, these are signs that what happened in the U.S. in 2005 to 2007 in the housing market, these are warning signs. The RBI, it clearly is worried. For instance, I remember a data point that it came in one of the RBI interviews that personal loans are 30% of bank advances, not corporate loans. The fastest growing is personal loans. 

Also now, something we couldn’t put in the report but heard from someone that the RBI is very worried about some of this going into the F&O, futures and options market. Which, if you know, India has the highest F&O volume and short-term volume. Where is this money going? Is it going for productive assets? Is it going for unproductive assets? Personal loans? I don’t know if it’s all productive entirely. I think the RBI, if anything, it’s the one institution, I would say—again, getting into controversial territory—one of the few institutions which has held its own and stands up to anyone. I do feel the RBI is coming at it in a very positive way. They really care that no Indian depositor should lose their money.

I think that’s what drives them. I think there is certainly worrying warning signs. For instance, we have invested in a company called DPDzero. The whole investment was born out of seeing—I normally don’t invest in fintech but when I saw all of this lending taking off, and I said, what is the second-order effect of this? Collections is going to be a nightmare. This is a company which focuses on better collections. They help lenders collect more. It’s actually doing very well. I get a lot of interesting information from them.

They’re fundamentally seeing that a lot of the advances have gone to customers with low CIBIL scores or credit scores, and they see strong patterns. The lower the CIBIL score, for example—and many people are rotating money between four, five loans, et cetera. Shruti, I do think overall we are underserved on credit. For instance, the entire credit market is about $2.25 trillion, of which banks are 90% of this. There is a lot of room to grow. I do feel that the growth has largely come from personal loans as one category. 

The real driver, you talked about a 12-times increase in the volume of personal loans. It grew from, I would say about 8 million to about 100 million loans, so that’s a 12-times increase over five years, 2018 to 2023. The real driver has been small-ticket personal loans which grew 31 times. It’s about 3 million loans (2018), they’re about 88 million. They’re almost 90% now of personal loans. That’s been the driver. Most of it is by NBFCs who are these nonbanks, for the listeners who are abroad, nonbanking financial corporations. A lot of them, these NBFCs, are powered by fintechs.

Fintechs are these new-age startups that we are funding, the venture economy has funded. One trend we’re certainly seeing is the fintechs today are saying we want to be more regulated, and we are happy to become NBFCs. They are picking up NBFC licenses. Many of them want to be banks. One of our fintechs has actually got a banking license called Slice. One of the few to get that license.

RAJAGOPALAN: Which is very hard to get. I’m very impressed they got it.

PAI: The journey is to get more regulated. I do see that these are the two broad things. One, there is more credit, but credit is not necessarily going into the most productive side. Will it change? Hopefully. We’re seeing a clear sign that the RBI’s regulation is beginning to impact. Certain areas like BNPL, for instance, India is stillborn because RBI came and said, you can’t do some of these things, and it just stopped. 

RAJAGOPALAN: Sorry, keep going.

PAI: For instance, the RBI’s regulation, they said what we are really seeing is fintechs are driving the products which they officially don’t have a license for, a credit card. They created a quasi credit card product, and the RBI came and said, you can’t do all of this. RBI is well meaning. To that extent, I understand. Fintechs will adapt, and they’ll move on.

RAJAGOPALAN: In India there’s this interesting tradeoff. You want a lot of financial inclusion, but that means if you overinclude, then credit worthiness goes down, and the overincluded low-credit worthiness is also the group that needs to borrow the most. Which means now what you are worried about is the tradeoff between overinclusion and systemic risk, because you don’t want them have the domino effect on all the other firms. I think startups are right at the heart of it. Going back to the head of our conversation, this is the India2, and the bottom half of the India2 that startups want to expand to.

This is also venture-driven, because venture wants to see certain kinds of numbers. The lack of credit worthiness and the overinclusion comes much later, which is a little bit different than the other companies. The other startups are cash-on-delivery models or something. They’re not exactly fintechs or buy-now-pay-later. Everyone will have to learn. It’s the startups, it’s the venture firms who are really pushing for growth, but maybe unstable. It’s the RBI trying to cap it from the other end, trying to worry about systemic risks. Water will find its own level is how I read the situation. It’s these three effects which are pushing and pulling.

PAI: I agree. There’s a realization, we alluded to it in one of the charts that the number of borrowers grew by 60% for the last five years. It was 250 million as a borrower base. If you actually look at the size of India1, India2, and add them together, that’s 100 million households, with two and a half adults, let’s say. It’s 250 million adults. We are almost at the—any mode you’re getting into really, the bottom of the barrel. Certainly I think the journey now is to go a little bit beyond small-ticket personal loans, and can we do more productive borrowings. I probably agree with what you say there.

Space Tech in India

RAJAGOPALAN: Exciting space. The last question I have is really about the space tech. Relative to last year’s report, this is one place has just taken off in India. It’s taken off for two different reasons. One, of course, the government liberalized the space sector. Second, the government had a lot of wins. The government’s able to do this ISRO “for very little money that goes a very long way,” no pun intended, to the moon, to Mars and so on. That was led on the government front, and on the venture front, there is a realization that India has excellent talent when it comes to deep tech.

Not just when it comes to IT tech, and we have people who can genuinely build this out. How do you see this going forward? Do you think of the space tech market very much as a—there’s a cap to it. There’s a government cap to it, because past a point, how do you commercialize this depends very much on military and government-aided projects. Which will, of course, determine how the venture capital comes in and how it exits. Or do you see a second-order effect of right now we are putting together drones, but very soon in India, we will start making the carbon fiber you need as the parts to make the drones?

Right now we import that, but as we go forward, if that part of the economy grows enough, maybe it will make sense in aerospace and the drone industry, the space industry, to start having the ancillary supply-side industry, and India could eventually be a powerhouse even in that. That’s, of course, 20 years down the line. How do you see this space moving forward?

PAI: You mentioned about defense. I must say that defence is only one part of the demand. A lot of the funded companies, larger ones, are not necessarily catering to defence. If anything, defence tech is seen as a little bit of a subsegment. We’ve got a colleague who looks at that space. It’s a little tricky because of payment and the way orders are given.

RAJAGOPALAN: How do you exit, basically? That’s the big question.

PAI: One big customer, and if that customer sneezes, then you got fever and pneumonia. If you look at space tech companies, for instance, take Pixxel. It’s a company we’ve invested in. Their customers—

RAJAGOPALAN: Congratulations. They’ve done very well.

PAI: They’ve done well. Yes, they’ve done well. There’s two kids, no longer kids now, Awais and Kshitij out of an engineering college. They started in their engineering college, BITS Pilani. Shruti, their customers could be agriculture companies, like the large big ag, for instance, because they want to see patterns of cropping and stuff like that. What space companies have done is to figure out who the buyers are. Typically, many of the buyers are Indian or international companies. Fundamentally, they’re trying to sell data.

That’s one model. Some of them are basically helping other space companies, payload, getting it into space. Fundamentally, the end customer who’s driving this is someone who can buy data or someone who is paying for an intermediary step, the logistics of getting something into space. Sometimes there are component manufacturers and stuff like that, yes. 

Really, I think defence is a much, much smaller share than I would think, and the innovation level here is, I would say, of a much higher order. Pixxel, for instance, I think their innovation is on optics. Get that camera. It has to be of a certain size, make sure it works and all of that. 

This is one sector where we’ve seen some impressive plays out there. I would really say this is one of the, if you’re looking at the entire deep tech category, this is, I think, the crown jewel. For a large reason, they benefited from a very well-meaning—I don’t know what its role is. Is it a regulator? It is a big actor. They have been remarkably—

RAJAGOPALAN: It’s potentially also the biggest buyer.

PAI: Also the biggest buyer.

RAJAGOPALAN: I think that’s the interesting space with it. That’s why I said this is so government-driven and led so far. Pixxel, of course, is very interesting. There are other companies. On construction sides, there are these unmanned drones. There’s a question of, can they do surveillance when they are worried about fire hazard, cropping? There are so many potential commercialization avenues like that, which is very exciting.

PAI: Indeed. ISRO’s kind of support and I would say its stewardship of the sector has been a huge reason why we’ve seen this take off.

RAJAGOPALAN: Also, the brain drain is much more on the software side, less so on the hard engineering. Civil engineers, mechanical engineers tend to stay back. This will, I think, very much be a homegrown industry in that sense. I think the incubators at BITS and IIT are also quite good in terms of driving this stuff. IIT Madras is one of the best incubators for deep tech and space tech, and AgniKul and all the things that have come out of that. Exciting space. No pun intended again.

I somehow feel like India is nowhere close to having its own Boeing and Airbus. I see Indian engineers as potentially maybe in a matter of 15 years becoming excellent suppliers to Boeing and Airbus and the rest of the space and defence industry abroad. In India, I know there’s one big buyer and there are hiccups, and there’s always a question. But the potential is incredible here. If we don’t make any missteps and we don’t overregulate it, if you do it like IT, I feel like this has some fantastic possibilities. Plus, it’s by nature a sector that will add to capital formation and employ lots of people and so on. It’s a very different kind of innovation, deep tech.

PAI: I should think so, Shruti. I do agree with you.

What’s on Pai’s Bookshelf?

RAJAGOPALAN: Before I let you go, you have some of the most interesting reading habits of anyone I know. I want to pick your brain on what you’re reading right now. I follow your blog, so I know you write notes about the books that you’re reading and so on. If you can give some recommendations both in terms of the evergreens, what should people read, and also a couple of books that you’re reading right now, which you find exciting.

PAI: One book that I recently finished, it’s nothing to do with startups, was this very interesting book called—though somewhat disappointing because I went with certain expectations. It was a book called “Beyond Market Value” by a female VC. In fact, she was a pioneer VC, I would say. Had set up her own health tech firm called MedVenture Associates. Her name is Annette Campbell-White. It’s actually intriguing book. It’s about her memoirs, but also deals with book collecting because she was a big book collector. 

What disappointed me was that there wasn’t as much of the venture capital side as much as there was the book collecting side. It was a fascinating one. She seems to be an interesting character. I would like to have a chat with her one day. That was a book that I just finished, in fact, today morning. It’s interesting, which describes her collecting habits. It’s an addiction, almost, of buying books. She was buying modernist books like James Joyce, “Ulysses,” and the likes. That’s very interesting. I wish there would’ve been a little bit more on the venture side because I’m a venture nerd myself, and I like to know about these models. 

Before that, I read a book called “Write Useful Books.” That was the name of the book. That’s by a guy called Rob Fitzpatrick. That’s about how to write nonfiction, how to write high-quality nonfiction. It’s interesting as he divides nonfiction into two categories: the pleasure givers and the problem solvers. The pleasure givers are like a Malcolm Gladwell book, for instance. That’s a canonical pleasure giver, a nonfiction. He says all of the nonfiction advice is for pleasure givers, but you could write problem solvers, and which is really books like “The Lean Startup,” for instance.

Those were the last two books I read. For the life of me, I can’t seem to recall its name. The author’s name was Robert X. Cringely. Maybe once I give you the title, you can put it up there. That’s about the ’80s and the ’90s and the early history of tech, tech as in information technology. Very interesting pictures of Bill Gates, portraits of Bill Gates at the early days really. That was a fascinating one. “Accidental Empires,” that’s the name. “Accidental Empires.”

RAJAGOPALAN: “Accidental Empires.”

PAI: These were the books. One (reading) theme is venture history. Venture in tech history. The other theme is really, I think, India and industry. The next books on that theme are “Lilliput Land” by Rama Bijapurkar. I don’t know if you’ve had her as a guest, but that’s an interesting book.

RAJAGOPALAN: No. This is sitting on my table as we speak, so I’m yet to read it.

PAI: Same here. It’s sitting on my table too. That’s the next book. After that, I’d probably get down to Karthik Muralidharan on that series. These are the books. I’ve had to restrict my reading to these. The other one I read was a very interesting book called “Double Entry.” Although I didn’t complete it because it’s about bookkeeping, a little bit of history of bookkeeping.

RAJAGOPALAN: This is the Medicis and stuff, right?

PAI: That is right.

RAJAGOPALAN: I think I’ve read this book, or I’ve read some book on the history of double bookkeeping and the Medicis, which was fascinating.

PAI: It was fascinating. I enjoyed it. For some reason, the book is almost schizophrenic in the sense that at a certain stage it goes completely away from what it was and goes into a critique of capitalism. I found that very odd. Until then, it’s terrifically interesting. It’s about the rise of Venice. It’s about all of these interesting characters. Luca Pacioli’s friendship with da Vinci. It’s utterly interesting and fascinating. I really enjoyed that book until the part where she goes, sorry to say this, but a bit woke.

RAJAGOPALAN: I think it’s because it’s written by a historian. For me, that was expected that historians will be fantastic in their description and then land properly on the incorrect model of the world.

PAI: “India is Broken” by Ashoka Mody was another read. I found it interesting. I appreciated the fact that he skewers all the regimes equally well, and he is balanced in that. To read it is to really grit your teeth and get all enraged, because there were so many points at which India could have taken those steps. Only in ’91—and you’ve got that wonderful 1991 Project—it’s only in 1991 that we did anything that was sane. That was another book that I read. I can’t say enjoyed it because a lot of it is about the mistakes that we did  but I really found it interesting. I learned a lot from it.

RAJAGOPALAN: I got a lot out of it too.

PAI: That’s what I’ve been reading. 

RAJAGOPALAN: Huge congratulations to you and Anurag Pagaria, and Nachammai Savithiri for putting out this year’s report. It’s really fantastically done. Hopefully in future years, I hope that both the venture and the startup community my sincere hope is they realize that it can’t be a separate bubble.

It is so deeply integrated to the rest of the economy that I think this elite group has to start really pitching for reforms. It’s such an influential and elite group that I think people will listen. Whereas so far it’s all about oh, growth story, and things are so exciting and not really focused on the bottlenecks. That’s where I hope next few years go in terms of the literature that comes out of the venture world.

PAI: I couldn’t agree more, Shruti. I couldn’t agree more. Thank you for having me. This was a pleasure.