INDIAN ECONOMY - All Izz Well

Comparison Between India and China Economies

If the start of the year 2009 was marked by extreme risk aversion amongst the investors and entrepreneurs, the start of the year 2010 is being celebrated by return of risk appetite and normalization of risk aversion. After witnessing a one of the worst financial and credit crisis on record in the year 2008, the year 2009 was the year of governments and central bankers coordinated efforts through fiscal spending and monetary policies to revive world economy. And it seems that they have succeeded so far in their efforts. However the new growth path of the world economy will be different. US consumer – a de facto driver of world economy in last decade is unlikely to stretch further under the compulsion of financial deleveraging. A lot depends on Asia’s consumption and investment. And when it comes to Asia, comparison of growth profile of India and China is inevitable.

China’s growth in last decade was magnificent at around 10% in real terms and it is on the verge of overtaking Japan as world’s second largest economy. It has successfully created world class infrastructure and has been able to create world class factories to feed world consumption in many areas. Compare to that India’s real growth around 7% in last decade seems rather slow and infrastructure development in India is indeed poor compare to China’s infrastructure development. However in last decade, India has successfully emerged as best outsourcing destination for IT and ITES. Though China’s growth seems much stronger compare to India on surface, study of growth profile of both the countries reveals that India’s growth is much more sustainable and real in “New Normal” world economy.

Some of the positive facts about Indian economy are:

• In many respects India’ economy seems to be the natural development of a market place under the burden of bureaucracy, and incremental but slow moving changes in policies & regulations; but boosted by pent up demand, demographic profile and entrepreneurial energy existing at grass root levels. Whereas, unlike India, China is a command economy working on top-down approach.
  
• China’s growth profile is more skewed towards growth in exports and growth in investment unlike India’s growth profile which is more balanced between domestic consumption, investment and exports. In China’s case, undervalued currency and global credit boom during 2002-2007 has pushed its current account surplus to record level of 10% of GDP in 2007 meaning China has to export 10% of its output to balance its domestic demand and supply. A downturn in growth of external demand has affected its economy heavily in 2008-09 with large amount of spare capacity across many industries. On other hand, India runs current account deficit meaning its growth is domestic demand driven. Though financing a large current account deficit (as in 2008 for India) can be a cause of concern, a moderate current account deficit can be easily financed through remittance from Indians working abroad and FDI.
  
• Gross Fixed Capital Formation (GFCF) is also a cause of concerned for China. Recently GFCF to GDP has reached 50% level unseen by any other developed economy in there respecting development stage. This is because of China’s response to recent economic crisis by effecting biggest lending surge in its history (whereas in India, banks have slowed down on loan growth to remain prudent on quality of loans). Year on year, marginal return on investment in China is falling and it shows speculative nature of China’s capital spending boom in manufacturing, infrastructure and real estate sectors. Though investment in infrastructure can be sustainable or even grow due to its massive population; for manufacturing and real estate sectors, investment boom seems unsustainable. In this scenario, China might enter a phase of permanently reduced overall capital spending activity whereby consumption growth will become an upper boundary of growth. Compare that to India where GFCF is around 35% of GDP and infrastructure spends to GDP is around 4-5% (compare to 16% in China). India’s underdeveloped infrastructure is indeed a big opportunity for virtuous cycle of capital spending/absorption and savings. India’s GFCF seems more sustainable due to its high domestic consumption at around 65% of its GDP compare to China where domestic consumption is only about 40% of its GDP. In India, it is consumer demand that is driving investments and product development to fulfill latent Indian market and these investments in turn drive economic growth, employment and incomes. It is a virtuous cycle.
• The sustainability or otherwise of economic growth rate depends on pool of real savings and price signals sent to agents who use the capital. In China, availability capital is de facto controlled by the government and capital being effectively free with real interest rate running negative for some time, there is an encouragement to invest well beyond common sense resulting in misallocation of capital and creation of excess capacities. In India, story is different. India scores well on capital pricing environment and role of private sector in investment is important in India. India’s high fiscal deficit means the cost of capital will stay high. It may be negative in some senses but then those entrepreneurs seeking capital undertake only high return quality investments. In nutshell, those who are looking for return on investment, the growth in India is more remunerative than that of China.
• India has underinvested in its infrastructure in last decade. However, with return of risk appetite elsewhere in the world bodes well for India’s infrastructure development in next decade as most of the infrastructure sectors are now to open to private sector participation and private entrepreneurs have embarked huge investment in infrastructure sector. These projects can be easily funded by foreign capital (in addition to domestic savings) in search of quality and remunerative returns.
• India’s response to economic crisis of 2008 was more skewed towards fiscal measures. It is fair to say that India’s fiscal stimulus has been somewhat more successful than in many other countries. A fiscal stimulus was already underway through revised pay of government employees and rural employment guarantee schemes even before crisis became full blown. Additional stimulus through tax cuts was also demand positive. During the process, India has successfully galvanized the demand potential of its rural area. Though current level of agro commodities inflation is alarming, a mild inflation of agro products coupled with increase in government’s support prices of some agro products has actually helped rural economy due to some wealth transfer from urban to rural economy.
• One of the most exhilarating prospects for the overseas investors is India’s demographic profile. Demographic dividend that India is set to reach in next decade or two – working age population to reach almost 70% of total population by 2040 – is mouth watering as long as its policies remain market friendly. No investor can ignore the prospects of returns from youthful India.

Despite many advantages, India’s economic structure has some its own Achilles’ heel. India’s fiscal position is one of them. Total government debt (central plus state) is widely quoted at over 80% of GDP. However, against this Indian Government owns many assets, from energy resources to telecommunications licenses to power generation, distribution and transmission and roads, ports and airports. A major disinvestment program can reduce government’s fiscal strain. Only relief in India’s fiscal deficit is that the most of the government debt is held domestically and can be financed through domestic savings. And when India’s economic growth in real term is in structural uptrend along with mild inflation over longer run, current fiscal position seems tolerable to investors provided governments is determined to control fiscal deficits.

Long term food and energy security is another area where India need long term solutions to satisfy demand from its growing population, rising income level, propensity to consume due to rising aspirations and low living standards compare to developed world. However, it is rightly said that a necessity is the mother of invention. New gas discoveries on India’s eastern coast side and many more such potential area still left unexplored can solve India’s energy need partially. India has potential to become a gas based economy over a long run. Nuclear energy is another area where a lot of progress is possible in India. As far as food security is concern, due to limited availability of arable land, productivity improvement is the only way India can achieve self sufficiency in food demand. Nevertheless, even if India (along with China) is not self sufficient in food requirement, once it becomes a “Developed Economy” (say after couple of decades), then developing economies like Africa, which has sufficient resources to feed world’s food demand, can be a outsourcing destination for our food demand making a win-win situation for both India (along with China) and Africa.

India’s strengths like domestic consumption driven economy, potential to grow domestic consumption multi fold in coming decades (on back of India’s demographic profile, rising income, rising aspirations against the backdrop of low living standards, and more inclusive growth with rural economy becoming a significant driving force), investment cycle supported by growing domestic consumption and huge infrastructure development potential, entrepreneurial energy of private sector, sophisticated financial system and above all a truly democratic society makes India’s case much stronger than China when it comes to long term investment. When it comes to India, put your hand on your heart and say “All izz well”.

by,

Manish Marwah

http://www.sapphireconsultinggroup.in/economy_countries_manish.html

Time to Revisit

The Indian economy is booming, stock markets are buoyant, homegrown entrepreneurs are spreading their wings, exports are growing, and consumerism isrising. In this scenario, it is definitely worth revisiting the issue of full Capital Account Convertibility (CAC). Most likely, CAC would improve the business environment, giving Indian industry access to lost-cost capital and the economy more options for asset allocation, bringing in higher inflows and improving the confidence level among foreign investors.

But is the time right?
But is the time right?When Global imbalances are worsening, commodities are in strong bull cycle, interest rates are rising all over the globe, inflation is looming and asset markets sky rocketing, will introduction of full CAC will bring desired results?

Answer lies in India’s approach…Though RBI is revisiting the issue of capital account convertibility again after 1997, it will still favor a phased roll out of full CAC in India - probably a time horizon of next 3-4 years- due to its concerns over inflation, quality of credit growth, rising interest rates and some asset markets. The finance minister too does not foresee a full convertibility of rupee before 2009 when India’s revenue deficit could have been be wiped out and fiscal deficit could have been brought down to 3%.


The things have changed.The fundamentals of Indian economies has changed significantly since RBI first appointed S S Tarapore Committee in 1997 to study Capital Account Convertibility (CAC) issue taking guidance from 1997 Union Budget Speech. At that time, the GDP was growing at lackluster pace of 5% against 8.1% projected for 2005-06. The center’s gross fiscal deficit was also hovering around 5% against 4.1% today. Compare to foreign exchange reserve of USD 26 billion (covering 7 month import) in 1997; India’s foreign exchange reserve currently stands at more than USD 150 billion. Non-performing assets of banks, then at double digits (~14% in 1997) too have come down to below 5% today and to allow greater flexibility to banks the Cash reserve ratio has been lowered from 9% in 1997 to 5% in 2005.


India’s manufacturing exports has also grown from USD 35 billion in 1997-98 to USD +100 billion in 2005-06 whereas its IT & related services exports has grown from less than USD 2 billion in 1997-98 to USD +23 billion in 2005-06. Not only that, India has emerged as one of the most significant global players in IT/ ITES related exports. India is also gaining momentum in manufacturing exports mainly in the areas of Textiles, Auto ancillaries, Engineering and Specialty chemicals. India’s +1 billion population, with young age bias, rising income & growing middle class have also fueled consumption led growth making Indian economy more resilient.


Though in 1997 Tarapore Committee came out with a report laying pre-conditions for CAC by year 1999-2000, the issue of CAC was put on the back burner due to precipitation of financial crisis in South East Asia soon after (blamed to CAC of those countries). Recently RBI has again appointed a committee to set out the framework for fuller CAC, in response to the government’s declaration of revisit the CAC issue. Due to significant improvement of India’s macro fundamentals, most of the pre-conditions laid by 1997 Tarapore committee has already been achieved. (See “Road Map to CAC”)

Progress so far

Though East Asian Crisis put the government’s plan to adopt full CAC on hold, India has achieved a significant progress towards partly CAC since 1997.some of the measures recommended by Tarapore Committee in 1997.For, example, Tarapore Committee recommended that Indian Corporates should be allowed to invest up to USD 50 million in direct investment abroad, where as per present guideline, Indian Corporates can make overseas investments up to 200% their net worth under automatic route. And see the way this facility is used by Indian corporates today: Just in one quarter (first quarter of 2006), Indian companies have acquired more than USD 3 billion worth foreign entities. The overseas borrowings / fund raising by Indian corporates have also been liberalized up to certain extent but with few restrictions like overall cap, company level cap, minimum maturity, and end use. The FDI route is also now open for most of the sectors (retail trading, atomic energy, lottery business, gambling, agriculture and plantations being exceptions) with sectoral cap on few sectors.

However, capital account is still restricted for banks and individual to a large extent. For individuals, there are caps on spending limits for various purposed like foreign travel, foreign education, overseas medical treatment, etc. Individuals too have limited options to invest in overseas assets as the annual limit is US$ 25,000 per individual for overseas investment. Banks are also not allowed to raise fund through ECBs and only allowed to borrow upto 25% of tier I capital that again with certain restrictions. Along with restrictions on borrowings, there are restrictions on assets side too with banks’s money market investment restricted to USD 10 million and debt market investment restricted to USD 25 million.


Why fiscal discipline is important Success of CAC depends on balanced flow of forex, and for developing countries like India, it means attaining the right balance between exports and consumption led growth, and ensuring adequate investment in infrastructure and new capacities. (See “How India’s forex requirement is balanced”)

It has also become an imperative for India to invest continuously in infrastructure and capacities to attain the higher economic growth. India is relying on three main sources for its investment needs namely foreign investment, domestic savings, and government. Though foreign portfolio investment strong so far in India, foreign direct investment has not picked up compared to other Asian countries. Domestic savings were at 29.1% GDP in 2004-05 but due to strong consumption led credit off take, significant portion of domestic savings are diverted away from investment In this scenario, government’s role to fund India’s investment requirement, particularly in infrastructure sector, is very important. And that is where importance of fiscal discipline comes in to play. The large revenue deficit means increasingly borrowing to finance current expenditure of government rather than investing in growth. It holds the economy back by crowding out private investment, imposing heavy burden on the budget and using the resources that can be directed towards development needs. (See “How India’s Public debt/GDP compares with others”). That is why though our deficit has come down, our finance minister is also not foreseeing a full convertibility of rupee before 2009 when India’s revenue deficit could have been be wiped out and fiscal deficit could have been brought down to 3%(See “Central Government’s fiscal and revenue deficits”).


Benefits
Experience of few emerging markets suggests that a move towards full CAC could result into large capital inflows and can trigger appreciation of the exchange rate. Strong inflows can definitely have positive effects on economic growth but it also requires a very healthy financial system. Two obvious benefits of a CAC will be reduction in cost of capital and access to larger capital for India corporate At a time when India requires an imnvestment of US$ 1.5 trillion over the next five years to accelerate its growth to +10% from the current 8%, higher capital flows are definitely welcome.


Full CAC will also allow Indian corporates having operations in multiple countries to effectively hedge their risks. Full CAC will also open overseas asset markets for Indian investors/companies thus can provide them with more options and better portfolio diversification. In fact with cross border integration of global markets, capital controls over longer periods are infact costly, ineffective and distortive. A gradual appreciation of Rupee coupled with removal of infrastructure bottlenecks and productivity increase will sustain India’s competitiveness in exports markets coupled with reduction in import bill thus having positive effect on the trade deficit. A gradual appreciation of Rupee will also have a positive effect on inflation and government’s oil subsidies as oil accounts for 30% India’s import. However there are certain external risks which India faces and can result into strong capital out flow (See “Factors that can spoil party”).

Conclusion
A full capital account convertibility will definitely be a welcome move that expected to result into larger inflows of foreign savings and investments at a time when India is needing it the most. But fiscal discipline and safeguards are needed to be in place before that happens.

Article Author: Manish Marwah