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India: Make or break
The cyclical recovery will be short-lived without structural reforms.
• India’s economic fundamentals have weakened over the last four years, leaving the country with slowing growth, sticky inflation and large fiscal and current account deficits. The “2Gs” – government and governance deficits – are the root cause, in our view, while rising oil prices and weak global growth have not helped.
• India's economy is not short of potential, but its potential growth rate could fall further if the government fails to reduce the fiscal deficit and fails to pursue structural reforms to open crippling supply-side bottlenecks.
• Monetary policy easing on its own is not the solution, as lower interest rates would fuel consumption demand, worsening the demand-supply imbalance, thereby exacerbating inflation and the current account deficit.
• Against a backdrop of global deleveraging, high commodity prices, a structurally large fiscal deficit and high inflation, we believe GDP growth will average 7.0-7.5% pa in the next few years, compared with 8.5-9.0% before 2008.
• It is now make or break time for the government. Since 2008, real investment growth has averaged a lacklustre 6% pa. If maintained, we estimate that potential growth could slip below 7%.
We have a positive short-run cyclical view on India‟s economy: growth has bottomed, there are nascent signs of recovery and core inflation pressures should remain contained. However, policymakers flip-flopping on reforms and a widening consumption-investment gap have weakened the economy‟s fundamentals over the last four years.
Rising oil prices and weak global growth are partly responsible. However, we believe much of the blame lies with 1) the government‟s gaping structural fiscal deficit which is the result of a rising subsidy bill; and 2) a governance deficit, evidenced by slow decision making due to scandals and back-tracking on reforms from the increased bargaining power of regional political parties.
We believe that the 2Gs – government and governance deficits – are the root cause of many of India‟s economic problems, fuelling inflation, lowering the savings rate, crowding out private investment and widening the current account deficit by fuelling consumption – all of which are having the effect of retarding India‟s growth potential.
We estimate that India‟s potential GDP growth has fallen from close to 9% pre-2008 to around 7.5%. Our analysis shows that the fall in potential growth is the result of lower capital accumulation and declining total factor productivity – a measure of technological dynamism. Our model suggests that 45% of the decline in potential growth is attributable to weaker investment, 40% to weaker total factor productivity and 15% to weaker employment growth.
Can this be reversed? India has huge potential. Consumption demand remains very strong due to rising per capita incomes in both rural and urban areas, while its investment deficit is sizeable. Whether this potential is realized depends on jump-starting investment, the keys to which are in the hands of the government.
Piecemeal reforms may be implemented, but with general elections due in May 2014, it seems fast-tracking economic reforms or any serious effort to tackle the structural fiscal deficit is unlikely.
Against a backdrop of global deleveraging, high global commodity prices, a weak domestic political climate, a structurally large fiscal deficit and high inflation, we believe that India‟s average growth will be 7.0-7.5% per annum over the next few years, compared to 8.5-9.0% during 2003-07. In the last four years, average real investment growth has been a lackluster 6% pa. If this rate of investment continues, then India‟s potential growth could slip below 7%.
It is not that the economy cannot grow faster; rather it is becoming increasingly difficult to sustain stronger demand without running into supply-side bottlenecks. Without lowering the fiscal deficit, a high current account deficit and high inflation will force the Reserve Bank of India (RBI) to keep interest rates high. Without adequate investment to address the bottlenecks, any reduction in interest rates will only fuel consumption demand. As such, growth spurts will be inflationary and require tighter monetary policy.
Today, India is at a crossroads. The worsening of fundamentals suggests that the economy is moving in the wrong direction. India‟s relative growth still continues to be one of the highest in Asia, but a number of other EM countries are catching up quickly and could further gain to India‟s detriment. Whether the economy grows at 6.5%, 7.5% or 8.5% over the coming years depends crucially on whether the government makes the right decisions – those that can kick-start investment. Only then will the RBI have the space to cut policy rates more aggressively, and only then will a positive investment climate rekindle animal spirits. We identify 10 major structural reforms that we believe are needed to unlock India‟s growth potential.
Concluding thoughts
Breaking the fall: Latent demand in India is large; per capita consumption is low; rural demand is just picking up; half the land mass is arable; infrastructure investment needs a big push and the working age population is very young and set to expand. It is not that the economy cannot grow faster; rather it is becoming increasingly difficult to sustain any increase in the pace of demand-side growth because of supply-side bottlenecks. Without lowering the fiscal deficit and reforms to improve the investment climate, the current account deficit will remain large and inflation high, leaving the RBI little leeway to lower interest rates. For in the absence of an investment revival to expand the economy‟s productive capacity, any reduction in interest rates will only fuel consumption demand. Hence, monetary policy easing without structural reforms and fiscal consolidation is likely to lead to only a short-lived growth spurt, because of rising inflation and a widening current account deficit.
Signposts to look for: The circuit-breaker to this deadlock is fiscal consolidation and structural reforms, but with general elections due in May 2014, it seems as though fast-tracking economic reforms or any serious effort to tackle the structural fiscal deficit is unlikely. We identify five signposts that we believe are realistically achievable over the next two years to avoid a short-lived cyclical upswing (see Box 1 for details):
Fuel and fertilizer prices need to be hiked to prune the subsidy bill, reduce the fiscal deficit and create more space for capital expenditure.
The cost of doing business can be reduced by fast-tracking land and environmental clearances and passing the mining bill. This could jump-start a large number of investment projects that are currently stalled.
Increasing the limit on foreign direct investment in civil aviation and, perhaps, in multi-brand retail.
A second Green Revolution is the need of the hour. Creation and management of cold chain infrastructure for agriculture is an important step in this direction.
Anti-graft reforms to tackle corruption and increase transparency in public procurement.
The cost of inaction: GDP growth is the main casualty as the cost of capital would remain high. Volatility would also remain elevated since, with a large current account deficit and a fragile global economy, India would have less cushion to cope with a sudden stop in net capital inflows. India‟s relative growth should continue to be one of the highest in Asia, but a number of other EM countries are hot on its heels and could make further gains to India‟s detriment. The high cost of doing business and continued domestic policy uncertainty could push companies to relocate operations overseas, and India‟s young, skilled labour could follow. The keys to avoiding this potentially negative spiral are in the hands of government.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
India: Make or break
The cyclical recovery will be short-lived without structural reforms.
• India’s economic fundamentals have weakened over the last four years, leaving the country with slowing growth, sticky inflation and large fiscal and current account deficits. The “2Gs” – government and governance deficits – are the root cause, in our view, while rising oil prices and weak global growth have not helped.
• India's economy is not short of potential, but its potential growth rate could fall further if the government fails to reduce the fiscal deficit and fails to pursue structural reforms to open crippling supply-side bottlenecks.
• Monetary policy easing on its own is not the solution, as lower interest rates would fuel consumption demand, worsening the demand-supply imbalance, thereby exacerbating inflation and the current account deficit.
• Against a backdrop of global deleveraging, high commodity prices, a structurally large fiscal deficit and high inflation, we believe GDP growth will average 7.0-7.5% pa in the next few years, compared with 8.5-9.0% before 2008.
• It is now make or break time for the government. Since 2008, real investment growth has averaged a lacklustre 6% pa. If maintained, we estimate that potential growth could slip below 7%.
We have a positive short-run cyclical view on India‟s economy: growth has bottomed, there are nascent signs of recovery and core inflation pressures should remain contained. However, policymakers flip-flopping on reforms and a widening consumption-investment gap have weakened the economy‟s fundamentals over the last four years.
Rising oil prices and weak global growth are partly responsible. However, we believe much of the blame lies with 1) the government‟s gaping structural fiscal deficit which is the result of a rising subsidy bill; and 2) a governance deficit, evidenced by slow decision making due to scandals and back-tracking on reforms from the increased bargaining power of regional political parties.
We believe that the 2Gs – government and governance deficits – are the root cause of many of India‟s economic problems, fuelling inflation, lowering the savings rate, crowding out private investment and widening the current account deficit by fuelling consumption – all of which are having the effect of retarding India‟s growth potential.
We estimate that India‟s potential GDP growth has fallen from close to 9% pre-2008 to around 7.5%. Our analysis shows that the fall in potential growth is the result of lower capital accumulation and declining total factor productivity – a measure of technological dynamism. Our model suggests that 45% of the decline in potential growth is attributable to weaker investment, 40% to weaker total factor productivity and 15% to weaker employment growth.
Can this be reversed? India has huge potential. Consumption demand remains very strong due to rising per capita incomes in both rural and urban areas, while its investment deficit is sizeable. Whether this potential is realized depends on jump-starting investment, the keys to which are in the hands of the government.
Piecemeal reforms may be implemented, but with general elections due in May 2014, it seems fast-tracking economic reforms or any serious effort to tackle the structural fiscal deficit is unlikely.
Against a backdrop of global deleveraging, high global commodity prices, a weak domestic political climate, a structurally large fiscal deficit and high inflation, we believe that India‟s average growth will be 7.0-7.5% per annum over the next few years, compared to 8.5-9.0% during 2003-07. In the last four years, average real investment growth has been a lackluster 6% pa. If this rate of investment continues, then India‟s potential growth could slip below 7%.
It is not that the economy cannot grow faster; rather it is becoming increasingly difficult to sustain stronger demand without running into supply-side bottlenecks. Without lowering the fiscal deficit, a high current account deficit and high inflation will force the Reserve Bank of India (RBI) to keep interest rates high. Without adequate investment to address the bottlenecks, any reduction in interest rates will only fuel consumption demand. As such, growth spurts will be inflationary and require tighter monetary policy.
Today, India is at a crossroads. The worsening of fundamentals suggests that the economy is moving in the wrong direction. India‟s relative growth still continues to be one of the highest in Asia, but a number of other EM countries are catching up quickly and could further gain to India‟s detriment. Whether the economy grows at 6.5%, 7.5% or 8.5% over the coming years depends crucially on whether the government makes the right decisions – those that can kick-start investment. Only then will the RBI have the space to cut policy rates more aggressively, and only then will a positive investment climate rekindle animal spirits. We identify 10 major structural reforms that we believe are needed to unlock India‟s growth potential.
Concluding thoughts
Breaking the fall: Latent demand in India is large; per capita consumption is low; rural demand is just picking up; half the land mass is arable; infrastructure investment needs a big push and the working age population is very young and set to expand. It is not that the economy cannot grow faster; rather it is becoming increasingly difficult to sustain any increase in the pace of demand-side growth because of supply-side bottlenecks. Without lowering the fiscal deficit and reforms to improve the investment climate, the current account deficit will remain large and inflation high, leaving the RBI little leeway to lower interest rates. For in the absence of an investment revival to expand the economy‟s productive capacity, any reduction in interest rates will only fuel consumption demand. Hence, monetary policy easing without structural reforms and fiscal consolidation is likely to lead to only a short-lived growth spurt, because of rising inflation and a widening current account deficit.
Signposts to look for: The circuit-breaker to this deadlock is fiscal consolidation and structural reforms, but with general elections due in May 2014, it seems as though fast-tracking economic reforms or any serious effort to tackle the structural fiscal deficit is unlikely. We identify five signposts that we believe are realistically achievable over the next two years to avoid a short-lived cyclical upswing (see Box 1 for details):
Fuel and fertilizer prices need to be hiked to prune the subsidy bill, reduce the fiscal deficit and create more space for capital expenditure.
The cost of doing business can be reduced by fast-tracking land and environmental clearances and passing the mining bill. This could jump-start a large number of investment projects that are currently stalled.
Increasing the limit on foreign direct investment in civil aviation and, perhaps, in multi-brand retail.
A second Green Revolution is the need of the hour. Creation and management of cold chain infrastructure for agriculture is an important step in this direction.
Anti-graft reforms to tackle corruption and increase transparency in public procurement.
The cost of inaction: GDP growth is the main casualty as the cost of capital would remain high. Volatility would also remain elevated since, with a large current account deficit and a fragile global economy, India would have less cushion to cope with a sudden stop in net capital inflows. India‟s relative growth should continue to be one of the highest in Asia, but a number of other EM countries are hot on its heels and could make further gains to India‟s detriment. The high cost of doing business and continued domestic policy uncertainty could push companies to relocate operations overseas, and India‟s young, skilled labour could follow. The keys to avoiding this potentially negative spiral are in the hands of government.
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