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Why India's Not Quite the Shining Star Many Hoped

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Despite the earnest desires of the world and India's citizens, India seems destined to never fulfill its economic potential.

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At the time of its independence, India was a stable and relatively open economy with high rates of economic growth and significant international trade and investment. By the 1980s, however the picture had changed. Three decades of poor economic management meant India had low growth rates, was closed to trade and investment, and prone to instability.

Despite the earnest desires of the world and India's citizens, India seems destined to never fulfill its economic potential.

India's poor economic performance was tied to the policies of its leaders. India's first Prime Minister Jawaharlal Nehru admired the Soviet Union, becoming one of the few followers of its (ultimately unsuccessful) economic policies.

The economy was administered by a central Planning Commission, through a series of five-year plans, modelled on a similar process used in the Soviet system. Major businesses were state owned and operated. Private firms required official licenses, since their operations were strictly controlled by the regulatory regime, rather than free-market demand.

The Indian economy was closed to the world. The principal policies were import substitution and relying on internal markets for development. India's currency, the rupee, was inconvertible. A system of high tariffs and import licensing restricted foreign imports.

This was the era of the "License Raj," a reference to the elaborate licenses, regulations, and stultifying red tape required to operate businesses in India. Up to 80 government agencies had to consent before a private company could produce goods or services. Under the terms of a license, the government regulated all aspects of operations, including production levels, prices, investment policy, and financing. The government restricted businesses from laying off workers or closing factories.

By the early 1990's, after tepid efforts at reform, the country was in dire straits. A combination of international factors (epecially high oil prices) and domestic failures (public finance problems and political turmoil) left the nation effectively bankrupt. Remaining foreign exchange reserves were only sufficient to cover payments for less than two weeks.

In one humiliating episode, the Reserve Bank of India ("RBI"), the country's central bank, was forced to airlift 47 tonnes of gold to the Bank of England as collateral for a loan, while it waited for assistance from the International Monetary Fund.

On July 24, 1991, Manmohan Singh, the current Prime Minister and then Minister of Finance, told the Indian parliament that "the room for manoeuvre, to live on borrowed money or time, does not exist any more." Mr. Singh succeeded in passing a reformist budget, devaluing the rupee, and opening the door to foreign investment in certain industries. He also reduced the tariffs and eased the system of licenses.

Mr. Singh ended his speech to parliament quoting French author Victor Hugo: "No power on Earth can stop an idea whose time has come." Within the next decade, the idea of India as a "major economic power in the world" seemed within reach.

India Shining

India's GDP rose by 43% between 2007 and 2011, slightly less than China, which increased by 56% but much faster than developed economies, which grew only 2%. It seemed to prove out the marketing slogan "India Shining" which was first popularized by the then-ruling Bharatiya Janata Party ("BJP") for the 2004 Indian general elections.

While India's economic progress was evident, the benefits were narrowly based. A large portion of the population continued to struggle with low living standards and poverty, lacking access to basic amenities such as sufficient nutrition, clean water, and sanitation, as well as basic education and health services.

After years without a good news story, the Indian media focused on the nation's "greatnesses," relying on extraneous facts. The fact that the market capitalization of State Bank of India surpassed that of Citigroup was cheered. The press celebrated the first Indian edition of Harper's Bazaar, which featured a crystal-studded cover; the introduction by Rolls-Royce of its new Phantom Coupe in India; and the opening of a new BMW showroom in Delhi.

In late 2011, the Indian government's twelfth five-year plan forecast growth of 9% between 2012 and 2017. By early 2012, India's growth had slowed to around 6%, high by the standards of developed countries but well below the levels required to maintain economic momentum and improve the living standards of its citizens.

On one hand, elements of the India Shining story remain intact : the demographics of a youthful population, the large domestic demand base, and the high savings rate. On the other hand, however, India's problems -- poor public finances, weak international position, structurally flawed businesses, poor infrastructure, corruption, and political atrophy -- threaten to overwhelm its potential.

Very Public Troubles

In recent years, India has consistently run a public sector deficit of 9-10% of GDP (if state debt and off-balance-sheet items are included). The problem of large budget deficits is compounded by poorly targeted subsidies for fertilizer, food, and petroleum, which amount to as much as 9% of GDP. Currently the official deficit is just over 3% of GDP, but trending higher and the highest in the G-20.

In March 2012, India brought out a budget forecasting an official fiscal deficit of 5.9%, well above its previous fiscal deficit target of 4.6%. India's strong rate of recent growth (an average rate of 14% between 2004-2005 and 2009-2010) made large deficits, in the order of 10% of GDP, relatively sustainable. Slowing growth will increasingly constrain India's ability to manage large deficits.

As its debt is denominated in rupees and sold domestically, India faces no immediate financing difficulty. Instead, the government's heavy borrowing requirements crowds out private business.

However, exports are slowing as a result of weakness in India's trading partners. Higher imports, mainly non-discretionary purchases of commodities and oil, have increased. India imports around 75% of its crude oil from overseas.

India's weak external position has manifested itself in the volatility of the rupee, which was one of the worst performers among Asian currencies in 2011. Indian businesses, which have unhedged foreign currency borrowings, have incurred significant losses as the value of their debt rises as the rupee falls. Many Indian companies face large debt maturities in the coming year.

India has around US$250-300 billion in currency reserves. Foreign debts that must be repaid in the current year represent about 40-45% of this amount which highlights the increasing weakness in India's external position.

Further, India is plagued by inadequate infrastructure especially in critical sectors like power, transport, and utilities. While its workforce is young and growing, there is a shortage of skills which has led to large increases in salaries for skilled workers.

Corruption and Political Atrophy

Another major problem is large-scale, deep-seated and endemic corruption, highlighted by scandals surrounding the issue of telecommunication licenses and the sale of coal assets.

Used to accessing power and influencing politicians, businesses have advanced their interest in securing rich natural resources, especially land and minerals, and ensured a favorable regulatory framework restricting competition, especially from foreign companies.

India's economic challenges are compounded by internal and external security concerns. For 2012, Indian defense spending is forecast to be $41 billion, around 1.9% of GDP or the ninth highest in the world. Financing this spending diverts resources away from other parts of the economy.

Political paralysis is another impediment to economic development. Successive governments have failed to undertake meaningful reforms. Complex coalition governments are a barrier to decisive action. The current government failed to implement its own plans to allow limited entry of foreign retailers. The government also failed to get a key anti-corruption bill through parliament.

Changes in land and property laws have not been made. Problems in acquiring land, for instance, are a factor in 70% of delayed infrastructure projects. The land acquisition process falls under a 19th century law and amendments proposed three years ago remain unlegislated.

Tax law reforms, including introduction of a direct sales tax correcting cumbersome differences in individual states, have not been completed. Changes to mining and mineral development regulations to allow proper, environmentally controlled exploitation of India's mineral wealth have not been made.

Other crucial areas that remain unaddressed include rationalizing unwieldy and economically distorted subsidies; implementing economic pricing of utilities; promoting foreign investment in key sectors; reforming agriculture, especially the wasteful and inefficient logistics system for transporting produce to market. Reform of labor markets and privatization of key sectors has not progressed.

Not World Beaters After All

India's disappointing response to the challenges is to disavow the problem or to look for short cuts. The overall tendency is for "spin," ignoring the fundamental failures. The country seems unable to face the truth and undertake fundamental long term changes.

In the 1980s, Indian sociologist Ashis Nandy observed, "[I]n India, the choice could never be between chaos and stability, but between manageable and unmanageable chaos." The observation is relevant today as India deteriorates.

Without urgent changes, India may never be able to live up to its promise.
No positions in stocks mentioned.

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