India’s Medium-Term Outlook Encouraging, Long-Term Prospects Look Promising

The perception about India has changed dramatically in recent months.  There was widespread disenchantment with the lackadaisical leadership of the previous government that lacked a coherent economic strategy and vision to reinvigorate growth.

The perception about India has changed dramatically in recent months.  There was widespread disenchantment with the lackadaisical leadership of the previous government that lacked a coherent economic strategy and vision to reinvigorate growth.

Political instability,  protracted  economic slowdown (with growth below 5% for two consecutive years) and policy paralysis has given way to rising confidence in the incumbent Prime Minister’s (Narendra Modi) decisive leadership and his government’s ability to revive the economy and pave the path for economic resurgence in 2015-2016, and political stability.

Soaring stock markets, rising business confidence and consumer confidence attest to such optimism about the economy.      

This government is amply demonstrating its pro-business, pro-reform, investor friendly and strong development agenda by trying to revive the flagging economy, improve the business climate and set the stage for bolder economic reforms (to put the Indian economy on a high growth trajectory of 7-8% in the medium term and even a higher growth rate in the long term).  Modi is wisely initiating consistent and steady ‘structural reforms’ (rather than rely on ‘big bang’ reforms to please markets) demonstrative of a sound long-term economic vision, eschewing populism and focusing on improved governance.  

Among the key reforms undertaken by the government are measures to address the supply side of the economy (such as deregulation of diesel prices (which will reduce India’s huge subsidy bill and its yawning fiscal deficit):

* Raising natural gas prices (required to bring in much needed energy investments and reduce the energy import bill) and commencement of the overhauling of India’s archaic labour laws are designed to boost the manufacturing sector (which currently accounts for only around 16% of GDP) – all taken within the last four to six weeks).

* Launching the ‘Make in India’ manufacturing initiative is designed to make India a global manufacturing hub.

* Undertaking initiatives to end government monopoly on coal mining.

* Raising foreign direct investment limits in manufacturing, defense and construction sectors.

* Slashing red tape for small-scale companies and other measures to make India an easier place to do business (India ranks an appalling 142 among 189 countries in World Bank’s latest “Ease of Doing Business Report”).

* Launching fiscal austerity measures in October (to reduce non-plan expenditure by 10%) – in order to promote fiscal discipline and attain the fiscal deficit target of 4.1% of GDP for 2014-2015.

* Expediting clearing of stalled projects to accelerate investment and capital formation; and, streamlining industrial licensing.

Fortunately, for the Indian economy, there was significant improvement in four key macroeconomic stability indicators in recent months.  Lower than expected inflation (CPI measure), a significant fall in current account deficit, relative exchange rate stability (largely due to superlative monetary policy management by the RBI) and sizeable increase in foreign exchange reserves – coupled with key reforms undertaken by the government – have stoked widespread expectations of an economic resurgence in 2015-2016. 

Stock markets soared in November (with the Sensex likely to cross 30,000 by the end of the year).  Rising business and consumer confidence (according to latest surveys) – which in turn is likely to lead to a meaningful rise in fresh business investment and consumer spending 6-9 months from now and consequently result in the Indian economy gaining momentum in the first half of the next fiscal (2015-2016).

Further, better than expected corporate earnings, rapid fall in crude prices (India’s imports around 80% of its oil), Bank of Japan’s increase in its quantitative easing programme and the unlikelihood of the Federal Reserve raising interest rates anytime soon (due to the dismal global economic scenario) are also adding to optimism about the Indian economy’s outlook.        

However, rapid economic growth is atleast 12-18 months away and contingent upon few quarters of sustained investment growth and whether the government is able to push through some of the boldest reforms and policy measures in the next few months – starting from the winter session of Parliament (November 24th) to the Budget in February 2014.

These reforms are amendment of the land acquisition law (that is seriously stifling growth of manufacturing and infrastructure in the country).  A constitutional amendment introduces a GST (goods and services tax) – a single unified tax that can boost GDP growth by 1-2% by increasing of foreign direct investment (FDI) in the insurance sector to 49% from 26%.

Reducing the government stake in public sector banks, disinvestment in public sector units and certain crucial policy measures to revive the investment cycle – including initiatives to remove infrastructure bottlenecks (particularly in the power sector).  

Given the political stability at the centre, mandate for change and the BJP (the ruling party) having recently won elections in two prominent states (Maharashtra and Haryana), the government has bolstered its position and consequently should be able to push through most of the previously mentioned reforms.

Critically required to usher the India economy into a high growth trajectory in the medium term, these set the stage for further economic reform over the next two years and secure the foundations of long-term sustainable growth. 

Despite the optimism about medium and long-term economic prospects, economic revival continues to be tentative and uneven.  After the Indian economy grew at its fastest pace year-on-year (5.7%) in more than two years in the quarter ended June 30, India’s GDP growth is expected to have moderated considerably (possibly to 5-5.2%) in the quarter ended September 30

A major reason being dismal industrial year-on-year growth in July and August; according to official data, industrial growth registered anemic growth of only 0.5% in both July and August.

Further, slowdown in export growth, tight monetary and fiscal policy and unfavourable kharif harvest are also important contributory factors responsible for expected moderation in GDP growth. However, better than expected industrial growth of 2.5% in September, according to official data (helped by a rebound in the capital goods sector – a key indicator of investment demand) point to a tentative economic recovery.

Moreover, more than expected fall in inflation on the CPI measure – from 6.46% in September to a record low of 5.52% in October 2014 (the fourth consecutive month of decline in inflation on the CPI measure in India) is likely to have a positive effect on consumer spending in the coming months that continue to be tepid.      

In such a scenario, there is increasing clamor for RBI to reduce its policy rate from 8% (which has remained unchanged since January 2014) to support growth. 

Despite the pressure, I do not envisage the RBI reducing its policy rate in its December monetary policy review, due to several reasons.

They may wait until clear indications emerge about decelerating inflation (particularly food inflation).  Uncertainty about whether the government will be able to meet its target fiscal deficit of 4.1% for this year (2014-2015).  The fiscal deficit in the April-September period touched 82.6% of the full year budget estimate.  Reining in of inflation expectations, uncertainty surrounding US monetary policy puts pressure on the Indian rupee because of a strong dollar.

In addition, existence of some uncertainty over achieving the RBI’s medium-term inflation target (January 2016) of 6%.  Upside risks to inflation due to certain geo-political risks could reverse the recent fall in global commodity prices, and the possibility of food prices and overall inflation rising again in early 2015 and beyond.

by Sher Mehta of the Macroeconomics School