What is stopping India from shining again?

 

Since the turn of the 21st century, "India Shining" has been the slogan for the country.  After growing at more than 8% in the decade ending before 2008, India has been fighting several challenges to revive growth following the financial crisis. After struggling both on the external and domestic front with high fiscal and current account deficits the country now seems to have overcome the worst.

The expectation of a stable government at the centre post the elections has driven the economy in recent times. There has been an upsurge in the flow of foreign funds into the domestic economy, pulling the rupee up against the dollar. With restriction on gold imports and a marginal rise in competitiveness the current account deficit has come down.

However the picture is not as rosy as it seems, the economy is weighed down by factors such as high inflation, low capital expansion and heavy reliance on imports of oil and gold. In the short term the strengthening rupee backed by inflow of foreign funds might be enough to lead the economy towards the growth trajectory but in the long run growth will come from reduction in oil and gas subsidies, regulatory reforms, improvement in the business environment and an increase in productivity in the economy(through increased private investment and capital expansion).

Several factors prevent India from reaching its potential levels. Some of them have been highlighted below.

Application of the Expectations hypothesis- Much needed reforms. 

The expectations hypothesis states that investors take decisions based on their expectation of future outcome. Market prices don't move by the release of information that is well anticipated.

Given the current scenario, the foreign institutional investors in India have already factored in a Narendra Modi-led government at the centre this term and have pumped in money into the Indian markets in expectation of regulatory reforms and increased foreign direct investment limits. The net investment by FIIs in India has crossed over Rs 30,000 crores in the equity markets and about Rs 29,000 crores in the debt markets from the beginning of 2014. This inflow has driven the equity markets in the last couple of months. The FIIs, however, are merely betting on a stable and pro-business government at the centre and the inflow of funds is not backed by the increase in productivity in the economy.

 

One person alone cannot turn the economy around. Even if BJP succeeds in forming the government this year, any further increase in inflows from FIIs will only be possible if the government enacts reforms in the regulatory sector, improves the business environment and reduces the cap on Foreign Direct Investment (FDI).

 

And if this expectation does not materialise the stock market will experience a free-fall with the FIIs pulling out of the market leaving the rupee struggling at a life-time low. This would be accompanied by a fall in the investment grading of the country, as threatened by the rating agency Moody's. All this would be catastrophic for a country like India that is heavily dependent on foreign capital to support its economy and provide liquidity in the markets.

Unsustainable fall in the Current Account Deficit

The current account deficit(CAD) is defined as the difference between total investment in the economy and total domestic savings. A large deficit in the current account can be devastating, as it leads to an increased dependence on foreign savings for financing domestic investment, making the economy vulnerable to external contingencies, depleting the value of the currency.

After struggling with 4.9% CAD in the first quarter of 2013-14 India’s current account deficit has recently come down to a figure of 1.9% of GDP.  Though it seems to be a relief for the economy, we need to go beyond just the numbers to evaluate the situation. The fall in the current account deficit has been led by the fall in imports and by the marginal rise in exports given the depreciation in the rupee. There has been a 75% fall in the gold imports in the last six months raising fears of an increase in gold smuggling following the imposition of restrictions. Another major factor responsible for the fall in the current account deficit is the fall in capital imports, which reflects the falling investor sentiments and business confidence.  The fall in private investment by over 8% of the GDP in the last five years is also an indication of the weak business confidence among investors in India.

 

All the above facts point to one conclusion - the low current account deficit cannot be sustained over the long run if the export sector is not made more competitive and public savings don't pick up.  The decrease should come from increased savings and not decreased investment. In order to achieve higher growth the country needs to focus on improving the investment climate and keep the rupee from appreciating further(if the results of the election lead to a high inflow of foreign funds).

Re-accelerating Inflation and the fear of El-Nino

India since long has been fighting high inflation rates given the supply-demand gap in food grains and the heavy reliance on imports for oil supply.  Recently the inflation rate showed a downward trend when the WPI fell to a nine month low in February 2014. However this fall was short-lived and March again saw an increase in inflation to a three month high of 5.7% from 4.7% in February while the CPI rose to 8.31% from 8% in month before. This has been attributed to the rise in prices of fruits and vegetables.

There is one major concern for India from BJP, which is expected to form the next government and focus on reviving growth and shoring up investment. The traditional growth versus inflation trade-off remains. In order to support investment the interest rates would have to be pushed down which would add to the already high inflation in the economy.

(picture source: barangayrp.wordpress.com)

Another factor that might affect inflation rates is the 60% probability of an El Nino which would lead to a below normal monsoon. Though past data reveals that the impact of low rains on the stock market may be insignificant, it is bound to impact retail inflation and the agricultural GDP. This may even result in a fall in the rural demand hurting the consumer goods industry.

 

Falling Industrial Output  

Investor's concerns over India's economic growth were amplified after the Index of Industrial Production (IIP) contracted 1.9 per cent in February. This is the worst fall seen in the last nine-months and contrasts the estimates by economists who expected a modest growth in the industrial output.

 

While the mining and electricity sectors performed well, it was the low investment and consumer demand that slowed the production in the manufacturing sector and is appearing to put off the recovery in the economy. The slowdown was led by the sharp contraction in capital goods by 17.4 percent and consumer durables by 9.3 percent.

The temporarily increased demand for exports which had led to the recovery of the industrial sector also seems to have subsided as indicated by the fall in the India’s merchandise export earnings. (as reported by DGCI&S).

The fall in industrial production will increase the supply-demand gap in the economy adding to inflationary pressures to the economy and dampen the chances of meeting its growth estimates.

In order to surpass the 5% growth rate India has to create a healthy investing environment through adequate regulatory and policy reforms in order to absorb the new entrants to the labor force. The export sector needs to pick up and the rupee needs to remain stable at its current level to further support the competitiveness of the sector. There is also a need to enhance public savings to meet the investment needs and reduce the dependence on foreign capital. 

- Jasmine Makkar.

 

Jasmine Makkar is a first year PGDM- Finance Student at SPJIMR. She has completed her graduation in Economics(H) from Lady Shri Ram College, DU. She enjoys writing, dancing and is a theatre enthusiast.

Follow Jasmine at jasminemakkar.insideiim.com