Indias surprise recovery

IFR India Report 2009
10 min read
Emerging Markets

India’s economy is set to grow between 5%–6.5% in 2009, well above early expectations, thanks to an ambitious stimulus package and an improving global economy, which have bolstered domestic consumption and industrial output.

While this year’s growth will be lower than 2008’s 6.7% rise, it is expected to come in above earlier forecasts of as low as 4% as industrial output has increased significantly. “The impact of the recession has been far less severe than expected and the industrial and services sector are performing very well,” said Kevin Grice, an India economist at Capital Economics in London who forecast Asia’s third-largest economy would grow 6.5% this year and 7.5% in 2010.

Like other economists, Grice said robust industrial production would offset losses from this year’s monsoon drought, which is expected to curtail rainfall by 13% from June-September, according to the Indian Meteorological Department. So far, rainfall is down 26% from normal levels although it has improved in recent weeks.

In June, industrial production soared 7.8% – reversing a 16-month slump – showing that the economy was on a firm path to recovery. Economists expect production to remain robust in coming months, helping India’s US$1.2trn economy outperform all other Asian countries except China, which is forecast to grow 7%–8% in 2009.

Factories aside, Grice said Indian reforms to curb the country’s reliance on agriculture output would help cushion the drought’s impact. Agriculture now accounts for 18% of GDP, compared with 25% a decade ago, he said.

Falling rain

Grice said the poor rainfall will trigger a 2% decline in farming output this year and knock 0.5%­–1% off headline GDP. Still, this is significantly better than in 2002 when a 19% drop in rain depressed GDP to 3.8%, its lowest performance in 11 years.

Some economists were less optimistic, however. Deepak Lalwani, an investment director at Astaire Investments in London, said the drought could dent this year’s growth to 5%–5.5%. While he has a 6.1% GDP forecast, he said low rainfall could wipe as much as 4% off agricultural gains. Economists differ on the drought’s exact impact, but most agreed big gains in the industrial sector would offset agricultural losses.

The state is not taking any chances, however. At the time of writing, the Indian government was rushing to avoid a crisis and announcing plans to raise farming subsidies by US$59m to provide more seeds to expand crops and boost market prices. The aid package is expected to total US$12.3bn this year, up 15% from 2008.

Delhi will also maintain its rural aid initiative, through which it provides tax incentives, cash handouts, investment initiatives for key crops and rural employment programmes.

As the global economy strengthens, exports are forecast to swing into positive territory by the end of 2009, economists said. They fell 31% to US$35.4bn in the first three months of fiscal 2009, which began in April and ends next March. Plummeting exports in 2008 caused 500,000 job losses across 10 industries.

To boost exports, Delhi is rolling out aid programmes to help exporters find new markets as it strives to lower India’s dependence on trade with the US and Europe. Exports account for 25% of GDP, but this is expected to increase as India enters new markets and launches reforms to expand its low-cost manufacturing base (by introducing more flexible labour legislation) to take on China.

According to Grice, India’s move to diversify its exports has helped foreign trade recover more quickly than in the rest of the region. Still, the country was years away from recovering the 20%–25% pre-recession export growth, he said.

Economists have applauded Delhi’s stimulus package for working wonders on the economy, which expanded 6.7% in 2008 – an impressive feat even if it was the below the average 8.5% growth of the preceding five years.

Under the initiative, which was more ambitious than many expected, the country announced it would spend Rs3trn (US$62bn), of which Rs200bn rupees would be new spending. The government lowered taxes and introduced a stimulatory fiscal policy, while the central bank cut interest rates six times to record low levels.

The move has bolstered domestic demand, which accounts for 60% of GDP, revved up factory production and encouraged banks to unfreeze lending to businesses and consumers.

Risky road ahead

The overall outlook is positive but there are some short-term risks that could spoil the economic revival. India faces the spectre of high inflation stemming from its surprisingly quick turnaround.

The central bank last month raised its 2009 inflation forecast to 5%, from 4% a month earlier, citing high commodity and food prices. Inflation pressures were further stoked after Finance Minister Pranab Mukherjeee unveiled plans to spend US$93bn improving the country’s infrastructure in July. The move will increase the budget deficit to a 16-year-high of 6.8% of GDP, from an earlier forecast of 6%.

The action unnerved some economists who said the deficit could trigger a downgrade in India’s credit rating. They urged the government to change its “accommodative” fiscal policy and raise interest rates soon to fight the risk of runaway inflation. One economist said Delhi’s 5% inflation forecast was conservative and was likely to be exceeded due to higher oil, food and other commodity prices. Already, consumer price inflation is running at between 7%–10%, driven soaring high food prices.

But Grice was not alarmed and said he did not expect inflation to rise to unmanageable levels. He said the recently re-elected government was capable of handling the inflationary pressures, adding that it would probably not hike rates until October as doing so earlier could reverse the economic recovery.

Jyoti Narasimhan, director of India research at Global Insight, agreed. “The direction of economic demand and its effect on exports is still a big question mark,” she said. “Tightening too soon will choke up growth at a time when there are uncertainties in the global system.”

While the central bank could lift rates in October, she did not expect this to happen until January when the global economic outlook became clearer. Narashiman said India’s ballooning budget deficit was a manageable short to mid-term risk but urged the government to implement reforms to tackle it as soon as possible. It should look for ways to increase revenues and taxes, while reducing large state and government expenses, including high civil servant pay, she said. Still, she did not envisage the current deficit triggering a rating cut on Indian credit as the economy was improving and “they’ve never had problems financing their debt”.

Infrastructure spend crucial

Economists expect India’s GDP to grow 7%–7.5% in 2010 as the economic recovery solidifies and private and public spending increases.

Still, many do not expect Delhi to reach its desired 9% annual GDP growth target unless it improves infrastructure and creates a better investment climate. That possibility brightened after the May 16 re-election of Prime Minister Manmohan Singh in a landmark victory which gave his party more power against Communist opponents blocking his capitalist reforms package.

Singh has been a pivotal figure in India’s recent economic boom. As finance minister in 1991, he introduced a plethora of free-market policy reforms that marked a departure from India’s long-running central planning, helping the economy quadruple in size.

With Singh reinstated, many expect these reforms to continue, notably major asset sales of state corporations as well as other initiatives to lift curbs on foreign investment. Mukherjee’s spending programmes are part of that plan. Financed though future asset sales and a tax overhaul, it is directed at improving jammed ports, stressed power grids, rickety roads and other poor infrastructure that shaves about two percentage points off the country’s growth rate.

Grice said the government had done a good job at increasing spending with the investment-to-GDP ratio leaping to 35% from 20% a decade ago. However, he said Mukherjee needed to do more develop infrastructure and improve the business environment to foster private and foreign investment.

“They need to create an environment where the private sector can take a higher percentage of future investment and this won’t happen unless they do a massive infrastructure investment,” he said.

Easing the burden

According to another economist, India is one of the worst emerging markets in which to do business, which is something else that needs to be addressed.

“More than in China, it’s difficult to do business in India,” he said. “Setting up a business is complicated, while inflexible labour markets make hiring and firing workers difficult. The legal system is also very problematic, full of red tape and unreliable.”

He added that “there is lots of money to be put to work in India but this won’t happen unless there is a new round of reforms to mobilise funds from foreign and local investors.”

Perhaps then will India achieve its long-term ambition of becoming a major world power. Some economists said India could overtake Britain to become the world’s fifth-largest economy within a decade if it can repeat the huge growth rates of past years. The country could also eclipse the US by 2050, becoming the world’s second- biggest economy after China.

But given that India’s power cuts continue to rise, while many of its roads are pot-holed and crumbling, those dreams may take longer to be realised.

Ivan Castano