Experts question speed of India’s economic reform

India said last week that it would hold its general election over April and May, in a poll set to encompass more than 700m voters. The country’s slowing economy is expected to be a key battleground in a closely-fought campaign.

GDP growth in the world’s biggest democracy slowed to an annual pace of 5.3% in the fourth quarter of 2008, below many forecasts and sharply lower than the rates of expansion above 9% recorded annually from 2005 to 2007.

The credit crunch and slowing global growth squeezed the Indian economy, leading to a contraction
in agricultural and manufacturing output in the fourth quarter. The International Monetary Fund has pre­dicted that India will expand 5.1% this year, but a growing body of experts worry that the country will undershoot that figure.

“India’s economy performed far worse than expected in the fourth quarter of 2008, with industry barely growing at all, relative to the same period a year earlier,” says Mark Williams, an international economist at Capital Economics, an independent research consultancy.

Williams says he expects worse is yet to come for India, and forecasts the country’s economy will expand no more than 4% in 2009, with “risks firmly on the downside”.

Such concerns have been uppermost in the minds of foreign investors, who have fled India’s capital markets. They pulled out more than $10 billion (£7.1 billion) net in 2008. The country’s stockmarket fell some 72% between its peak at the end of December, 2007 to early March this year, based on the MSCI India index.

Indeed, the huge fall in the Indian stockmarket has largely unwound the giant boom it experienced from 2003 onwards, whose scale dwarfed the performance of arch rival China and Asia Pacific as a whole (see graph).

The outflow of foreign money has contributed to a slide in the Indian rupee to record lows against the dollar. The central bank has said that India’s foreign exchange reserves are down about a fifth from their record high of more than $315 billion in mid-2008, as it moves to defend the national currency.

Aside from these worries, election uncertainty is growing and raising questions about whether the pace of economic reform will slow under the next administration. The Satyam scandal and fears of protectionism in the West have also dented investor confidence.

Satyam, an Indian software prov­ider, could become India’s most significant case of corporate fraud. Its founder said in January that he had inflated cash balances and the firm’s other assets to the tune of $1 billion. The case shook trust in India’s key outsourcing industry, which is said to account for 7% of its GDP.

Meanwhile, American plans for a curb on tax breaks for firms that outsource jobs to destinations such as India, have cast another shadow over the outsourcing sector. It remains to be seen exactly what steps America takes, but the Indian government has already warned against such measures.

“Developed countries should not resort to protectionism to resolve the crisis,” Pranab Mukherjee, the Indian finance minister, reportedly said in early March, according to wire services. “This is the time that developed countries should ensure there is no hindrance to the flow of funds from developed to developing countries.”

However, despite these problems, it is notable that even the most pess­i­mistic forecasts suggest that India’s economy will continue to expand this year and next, albeit at sharply lower rates than previously. This is a major contrast to the recessions elsewhere in the world, such as in rich countries.

Meanwhile, some pundits have begun to wonder if Indian stocks offer good value following the precipitous crash in the Mumbai bourse since the end of 2007, particularly if Asia is the first region to recover from the global economic slump.

Much depends on the mood of inter­national investors, who are key to the fortunes of the Indian market. For now, they remain risk averse amid the ongoing global financial crisis. The steps taken over recent months to shore up the Indian economy have apparently failed to convince them to keep faith with Indian stocks.

These measures included the Reserve Bank of India’s decision to slash interest rates, and the government’s move to craft fiscal stimulus packages. The latter includes extra spending of $4 billion, but that figure is small compared with the huge sums being spent in China and the developed world. More Indian rate cuts are expected, since the scope for stimulus spending is restricted by high fiscal deficits.

On the whole, many investors and commentators still remain convinced of India’s long-term economic potential. It has vast numbers of young, underemployed and able-bodied workers, whose productive capacities are being realised, but slowly.

Reforms and liberalisation have boosted economic potential over the past few years. Maya Bhandari, a senior economist at Lombard Street Research, says that “considerable structural improvements, including strong savings and investment rates, have lifted India’s potential growth rate by a hefty two percentage points since 2000”.

However, some experts worry that the impact of the credit crunch and the retrenchment in the global economy will, in the worst case scenario, significantly delay the fruition of India’s long-term potential. At the very least, India’s current problems, framed against the worst global financial crisis since the Great Depression, have certainly stoked caution.

“Our long-term view on Indian economic growth remains positive, driven by structural factors such as the extensive infrastructure investment programme, strong consumption growth and favourable demographics,” says Shelley Kuhn, manager of the Neptune India fund.

But Kuhn adds that in the short term “cyclical and sentiment risks are a major concern”, and her portfolio was positioned defensively at the start of 2009.

MSCI India performance since 1992