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October 2012

The Leader: India: – The “Hindu Rate” or a Pause Before the Next Lap?

Following nearly double-digit economic growth for the latter part of the last decade, India’s economy has slowed sharply, with the IMF recently lowering its growth forecasts for 2012 to slightly below 5%. This slowdown has raised the question whether the “India Story” is effectively over. A closer look at the underlying reasons for the slowdown reveals that India has hit a macroscopic crisis at the intersection of economics and politics which is increasingly laying bare the country’s underlying structural challenges. India clearly needs to take several immediate fiscal and monetary steps in order to step back from the brink, and recent announcements from the government provide encouraging signs of its commitment to do so. However, while failure carries the risk of India suffering a “lost decade” of sorts, the successful implementation of emergency measures alone will not suffice to bring India back on track to meet its long term development challenges.

After averaging 8.5% over the previous five fiscal years (FY07-FY11), India’s economic growth has slowed sharply to 5.3% and 5.5% in the first and second quarters of 2012, respectively, and to 6.5% for the fiscal year ended Mar-2012 1. Despite expectations of a moderate growth turnaround in the next 12-18 months, commentators in India and globally have been speculating whether the country, despite the quality of its entrepreneurs and potential, mired in structural problems, is heading back towards what was derisively called the “Hindu Rate” of growth (of 3-4%) the country achieved for decades before economic reforms in the 1990s. However, looking at the drivers of the slowdown and their origin in India’s structural challenges tells a more nuanced story about India’s growth prospects.

historical-real-gdf-growth-by-sector

Source: Reserve Bank of India (RBI)

historical-and-projected-gdp-growth

Source: International Monetary Fund (IMF)

First, let us take a brief look at some of the key issues. India’s economic fundamentals have clearly deteriorated and the proximate causes of the slowdown can be attributed to the following:

business-confidence-index

Source: Dun & Bradstreet, GS Research

exchange-rate

Source: Bloomberg

headline-vs-core

Source: CEIC Database, GS Global Economic Research

central-goverment-budget

Source: Reserve Bank of India

The Need for Structural Reform

Following the initial stages of the slowdown earlier in 2012, where India’s government sought to defend the country’s slump by pointing to the weak global macro environment, it has become increasingly clear that India faces significant underlying structural issues responsible for its sharp decline. As the Sign has argued in February (see our “India Wide Open” paper), there are areas where the cracks in the system are beginning to show. Our top three are:

central-goverment-budget

Back to the Past?

India’s ruling Congress Party is clearly alive to the stark reality facing the country and has appointed new leadership in the Finance Ministry that at recognises the immediate task at hand. The ministry has recently taken several common sense steps to (a) revive investor sentiment and ease bottlenecks for both foreign and domestic investment in the country, (b) reduce diesel subsidies, an unpopular and politically challenged reform, in order to demonstrate its commitment to reducing the fiscal deficit, and (c) radically clarify or remove changes to the tax code that recently unsettled foreign investors.

Our analysis suggests that India’s growth rate is highly sensitive to policy unblocking entrepreneurial action. The effect of simple actions makes a significant impact and more concerted effort revives the country back to its previous trajectory. The key findings are:

index-of-economic

Clearly, the fourth scenario is the critical one for Indian policy makers if India is to avoid the downside risk that India’s good housekeeping and policy throughput are thrown off course by exogenous factors outside of their influence. Regarding the third scenario, it remains clear that the political leadership to implement this has not yet fully galvanised. The recent loosening of FDI norms in the retail, aviation, insurance, and pension industries triggered coalition allies to desert the Prime Minister, and the Opposition (which in the past has supported some of the same reforms) to call for a general strike. This uncertainty about the country’s leadership and the will in India to accept reforms has cast doubt on its ability to deal with its deeper structural issues at a critical stage in the country’s development.

Conclusion. The cumulative impact of a successful India Wide Open strategy would have a significant effect on India’s growth, with annualised GDP growth rates of up to 11.2%, through 2025, reducing to 8.6% from 2025 to 2040, on par with China during the period of its fastest expansion. A Wide Open India in 2040 would look very different from India today. GDP/capita would be at US$17,700 or larger than Brazil or Russia’s today. India’s workforce would have expanded from 480 million today to over 950 million, with significantly increased female participation in the workforce. Literacy rates would increase from 75% currently to 85% or above. India’s economy and capital markets would be fundamentally transformed with manufacturing output rising over twenty-fold from US$200 billion to US$4.5 trillion and the total market capitalisation of the equity market would increase 16-fold (assuming current market capitalisation to GDP ratios).

Signs of Hope

Under the surface though, there are signs of potentially significant positive change underway in India. Some notable examples include:

real-gdp-growth

Conclusions and Implications for Investors

It is difficult to ignore a country of 1.2 billion people growing to 1.6 billion soon, with GDP growth rates of over 5%, a democracy too, in a Greater Pacific region with China as a growing power across one border and Pakistan teetering on the brink of chaos on another. The world’s major political and economic forces are necessarily drawn to the country despite its failings. From the perspective of international investors, whether India grows at 6% or 10%, it will continue to expand at three to five times the pace of most of the best case scenarios for the US and Europe in the near term. However, given the structural challenges that the country faces and the high growth variance between the highest and lowest regions and industries, investors will require a highly selective investment strategy. In India’s uncertain macro environment, successful investing requires focusing on the micro. In identifying opportunities investors need to carefully select the risks they are willing to take on. The reward for that risk can be considerably superior to most in the world based on our analysis and experience. The dimensions of that opportunity are:

Despite its current troubles, India will continue to grow at a reasonably rapid rate. The weakening of the global macroeconomic environment coupled with a series of exposes at home, has exposed the complexity of India and demonstrated that the India story has likely gone as far as it can go based on the current policies. India still offers the potential to be one of the most attractive economies in the world, but this requires a revolution, demonstrating visionary leadership, building a broad national consensus and passing a series of ambitious reforms. Is all this possible? Man’s first reaction is often to write-off the very difficult as the impossible. Fortunately for India, the seeds of its revolution are already in place if it looks in the right places and to the right examples. It now needs to grow these seeds and plant them all over the country.


1 : India’s national accounts use a financial year ending March 31 – all GDP growth numbers refer to year-on-year change in real GDP at factor cost (unless otherwise noted)2 :Source: Department of Commerce, Government of India3 : Aggregate for companies on the BSE-500 index which represents c. 95% of the market capitalization of the Bombay Stock Exchange (source: CapitalIQ)4 : Source: Reserve Bank of India Bulletin (as of August 2012)5 : The current draft of the XIIth Plan which runs from 2012-2017 envisions an average investment rate of 38.7% for a 9.0% growth scenario, and 41.4% for a 9.5% growth scenario; Source: Planning Commission of the Government of India, Faster, Sustainable, and More Inclusive Growth: An Approach to the Twelfth Five Year Plan6 : Source: Bibek Debroy and Laveesh Bhandari7 : Or latest available (FY12 state GDP growth figures for Maharashtra and Gujarat are not publicly available)8 : Source: New York Times, India Undertakes Ambitious ID Card Plan, by Vikas Bajaj, Jun-20099 : Source: Economic Times10 : Source: Hindu Business Line (http://www.thehindubusinessline.com/industry-and-economy/economy/article2161917.ece)

11 : Source: Frost & Sullivan

12 : Does not include Bihar, Chattisgarh, and Delhi which are also growing at 10+%

 

©2012 Greater Pacific Capital