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India: New Rulers, Fresh Doubts


Spencer White isn't convinced. Investor jitters over India have calmed considerably since the Indian National Congress party installed well-known reformers in top posts after its May 13 election victory over the right-wing Bharatiya Janata Party. But White, chief Asia equity strategist for Merrill Lynch & Co., has still cut the India exposure of his emerging-market funds from 6.5% to 4.5%. For the past year, "India has been the jewel in the crown," he says. "Its attraction was not only great companies but also a government that was creating more options for foreign investors and moving away from running state assets." Now, White fears, India will slow privatization and reform of stifling labor laws.

Such skepticism illustrates the paradox facing the new government. India is amid its greatest boom in decades, and two economists with impeccable reformist credentials lead the incoming team: Prime Minister Manmohan Singh and Finance Minister Palaniappan Chidambaram. Yet the markets are cutting Congress little slack. Despite a recent rally, stocks haven't recovered from a steep, post-election sell-off. A big reason is fleeing foreign investors, who have pumped a record $10 billion into Indian equities since last year.

UNTESTED COALITION

Investors have reason for caution. The Congress-led government is an untested coalition of 18 leftist and regional parties that swept into power promising greater resources for education, health care, irrigation, and other programs needed to lift the 650 million rural population out of poverty. Politicians in several financially strapped states have set off alarms by promising more subsidies -- moves that Singh has denounced.

So far, the government hasn't answered the biggest question: Where will the money come from? Federal and state governments are staggering under fiscal deficits equal to 9% of gross domestic product, one of the highest levels of government debt in the world. Yet Congress already has ruled out two obvious sources of new revenue: major sell-offs of state assets, which last year netted $3.5 billion, and tax increases. Protectionism is out, too. "In today's environment, one can't increase taxes or hike import tariffs or close the doors to foreign direct investment," says Jairam Ramesh, the party's economic adviser. What's more, with interest rates and oil prices rising and investor sentiment for emerging markets on the wane, the global climate isn't as friendly to India as it was in 2003.

This is why analysts anxiously await the budget that Chidambaram, who helped put India on firmer footing during a previous stint as Finance Minister in the mid-1990s, is to unveil in July. So far, Congress officials have released few details about how they will finance greater social spending. Observers aren't expecting miracles. India has lived with high budget deficits for 15 years, and neither the BJP nor Congress before it made much headway in reducing them. "The problem with the budget is hard to fix because it's structural and has a lot to do with the political dynamics of India," says Gregory Fager, Asia/Pacific director at Institute of International Finance Inc., a Washington think tank for the banking industry.

New Delhi can do many things to whittle that problem down, though, if Congress has the political will. For example, it could trim generous food and fertilizer subsidies, slash overstaffed bureaucracies, and use federal fund transfers to coax spendthrift states to do the same. The government also could find ways to get more companies to pay taxes without chilling investment. Despite a maximum 35% rate for corporations and 30% for personal income, India collects just 14% of GDP in taxes, a skimpy rate by world standards. That's because most farmers, small businesses, and rapidly growing service companies pay little or nothing, thanks to exemptions or evasion. As a result, the heaviest burden falls on salaried employees at big companies and on manufacturers. The government is starting to tax information technology companies on domestic earnings and will soon tax exports. But to get more companies on the rolls, it must overcome powerful lobbies and implement better systems to monitor small businesses.

New Delhi could make a bigger impact if it introduced a value-added tax, which imposes levies on the production and distribution of goods and services. In Europe the VAT raises more revenue than would sales taxes. A tax-reform commission headed by Finance Ministry official Vijay L. Kelkar in 2002 endorsed the VAT.

The northern state of Haryana already uses the VAT and has boosted tax revenues by 30%, Kelkar says, while states such as Kerala, Maharashtra, Karnataka, and Punjab plan to implement it this year. If used nationwide, the VAT could yield $20 billion annually in government revenue. Congress hasn't stated its position.

Business also hopes that Congress at least will continue to divest small stakes in state companies. After years of slow progress, the BJP in 2003 managed to spin off big stakes in oil, gas, and auto companies. Before the election, the government had slated 240 state-controlled companies for possible privatization. Investors are most interested in such outfits as telecom company MTNL, aluminum maker Nalco, and the Shipping Corp. of India.

But Singh says he will only sell money-losers. And many are in poor states such as Bihar and Bengal, where politicians use them to dole out patronage. Subir Gokarn, chief economist of rating agency Crisil Ltd., says such operations are only worth the land they stand on.

Deficit hawks are more worried about profligate state governments. A day after the election victory, Y.S. Rajasekhara Reddy, the new Congress chief minister for the southern state of Andhra Pradesh, promised free electricity to farmers. Economists estimate that would boost power subsidies by 20%, to $475 million. Politicians in neighboring Tamil Nadu then hiked power subsidies by one-third.

There are some bright spots. The Congress coalition inherited a strong economy with $114 billion in foreign reserves, up from $40 billion three years ago. India has a relatively high savings rate of 23%. And last year, low interest rates helped states retire $14.2 billion in loans owed the central government. This trimmed the deficit a bit. And although India's public debt load is high at 82% of GDP, it has been able to finance it through local institutions, rather than rely on foreign markets. "The banks are flush with liquidity," reasons Standard & Poor's sovereign ratings analyst Joydeep Mukherji. "So there's no risk of a crisis."

This fiscal fix won't be resolved overnight. The best the financial community can hope for is that the deficit keeps moving in the right direction rather than deteriorate under the new government. And investors? They'd better keep a close eye both on reformists in New Delhi and hungry politicians in the states.

By Manjeet Kripalani in Bombay, with Pete Engardio in New York


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