The first quarter of this year saw India’s economy grow a mere 5.3 percent, the slowest rate in nine years. The single biggest factor has been the hefty increase in benchmark interest rates by the Reserve Bank of India over the past two years—from 4.25 percent in January 2010 to 8.5 percent in January 2012. While the central bank’s motivation has been to keep inflation in check, a direct side effect of the interest rate hikes has been a rapid cool-down of the pace of investments in infrastructure and the manufacturing sector.
A second major factor has been India’s worsening trade deficit, caused primarily by a growing appetite for oil and coal coupled with an increase in the price of these commodities. During the fiscal year ended March 2012, India did extremely well as on the export front: Shipments grew by a stellar 21 percent to a record $322 billion. What hurt India, however, was that imports grew even more sharply—by a huge 32 percent, to $489 billion.
A third major factor has been misguided policies as well as policy flip-flops by the central government. The government’s proposal to impose a “retroactive” capital gains tax on indirect transfers of India-based assets between foreign buyers and sellers has made foreign investors nervous. Foreign investors have also been taken aback by policy reversals, such as the government’s move in November 2011 to permit foreign direct investment in multibrand retail, only to backtrack a few weeks later. These missteps have increased the policy risk that foreign investors associate with India.
Backtracking on the move to open up multibrand retail to multinational players was a particularly egregious move. Increasing productivity in agriculture has made India one of the world’s biggest grain producers. Because of an extremely weak supply chain infrastructure, however, an estimated 40 percent of India’s grain production rots before it reaches the consumer. An open door policy for foreign direct investment in retail would have helped eliminate much of the problem, with several far-reaching consequences—higher compensation to farmers, lower prices for consumers, and an even more robust export performance. Lower food price inflation would also have eased pressure on the central bank to keep interest rates high.
Prime Minister Manmohan Singh is an extremely capable economist with an unblemished record of personal integrity. In the early 1990s, he led the team that designed the policies to liberalize India’s economy and get it moving at China-like speed. The problem is that he is not a politician and appears clueless about how to keep his ministerial colleagues (many of them known to be highly corrupt) in line or to get support for urgently needed policy moves from a disparate set of coalition allies. At the same time, social activists, an independent auditor-general, and a vibrant media have finally begun to expose widespread corruption by key ministers in the
government. The net result has been policy paralysis combined with spectacular flip-flops.
For all of the government’s weakness, though, India would be surprisingly insulated from any implosion of the euro zone. India’s exports to the Continent account for only 3 percent of the country’s GDP. Thus even a significant reduction (such as 20 percent) in exports to Europe would have a limited negative impact on India’s economic growth. Moreover, a euro zone implosion would lead to a significant moderation in oil prices. As a major oil importer, India would benefit immensely from a moderation in oil prices. Even a 10 percent drop in oil prices would reduce the import bill by an amount large enough to compensate for the likely reduction in direct or indirect exports to Europe.
Notwithstanding these arguments, India will not remain unharmed by a euro zone implosion. Such a crisis will negatively affect India’s other trading partners. Thus there will be spillover effects on India. Does that mean the “India story” is over? Was the talk of India as a rising superpower premature?
We believe not. Every major economy—Europe, the U.S., China, Russia, Brazil—is slowing down. Even at its current pace, India remains one of the two fastest-growing large economies in the world. More importantly,
India’s fundamentals remain strong. Despite recent hiccups, India’s rate of savings and investment (as a proportion of GDP) remains one of the highest in the world. With a median age nine years lower than China’s, India has a young population. This implies not just a growing labor force but also lower wage inflation. Adult literacy has risen sharply during 2000-10. With a growing per capita income and the spread of 3G connectivity, inexpensive tablet computers, and free learning apps created by India’s master teachers, improvements in basic literacy and other skills should be greater during the current decade than in the last one.
Further, India’s private sector remains one of the strongest among the major economies of the world. Indian companies are not only innovative but also very capable in leadership and organization. Witness the large number of billion-dollar or bigger acquisitions made by Indian companies in Western Europe and the U.S.
As the past 30 years illustrate, India’s governments have a history of responding with bold reforms only when the country’s back is to the wall. Given the sharp slowdown in growth due largely to self-inflicted wounds, a worsening external environment, and the high likelihood of a possible downgrade in the country’s long-term sovereign credit rating to below investment grade, this may well be the scenario under which India’s political leaders are able to muster the courage to undertake reforms that should have been launched more than two years ago.
It is possible that the government may remain mired in paralysis until the next elections in 2014. It would be a shame, however, to lose the two precious years between. Multinational corporations and financial investors are sitting on large pools of liquid money. Before investors send the money flowing to India, however, they do need policy predictability and a steady march toward further liberalization of the economy.
Three moves, in particular, deserve greater urgency, and all three are on the government’s table. First, the government should start opening more industries to foreign direct investment. The need to do so in multibrand retail and aviation is particularly urgent. Second, the government should pass and start implementing a national Goods and Services Tax (GST) that would replace a host of state-level taxes. A GST would lead to a significant reduction of friction in interstate commerce and accelerate the emergence of a unified national market. Third, the government should eliminate as urgently as possible the uncertainty caused by its proposal to levy a retroactive capital gains tax on transactions in Indian assets by foreign buyers and sellers. The latest ideas under consideration—for instance, the retroactive tax should be levied only in those cases where India-based assets account for more than 50 percent of the deal—hold considerable merit.
The world is rooting for India to get its act together. Given its strong fundamentals, a slowdown in China, and economic turmoil in Europe and the U.S., this could be a golden period for the country. Do India’s own political leaders realize that?