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Video: India's reform outlook and implications for growth

09 September 2014 Hanna Luchnikava

Newly elected PM Narendra Modi is poised to institute structural reforms to address India's economic challenges, which include low investment and inflation.

Hanna Luchnikava

Interview Transcript

What are the main economic challenges that India needs to resolve to accelerate growth?

The main economic challenges ahead of India is its very low levels of investment, its structurally high level of inflation, as well as its policy paralysis. I think there are two aspects to India's economic slowdown story. First of all, the slowdown has been cyclical. Years of monetary policy tightening, global recession, which led to a slowdown in demand for India's exports, as well as reduced capital inflows, as well as uncertainty related to India's general elections, clearly had its toll in India's economy. But, more importantly, the slowdown actually has been structural, which decelerated India's potential, or so called trend growth, from about eight percent to under six percent in the fiscal year 2013, which ended in March of 2014. So, in order to restart India's growth momentum you need to address all of these aspects.

In terms of the business cycle, we actually started seeing some of the recovery. Clearly, the election outcome has been overwhelmingly positive. We've saw that India's capital markets have started booming after the election. This has been the government, which is the strongest in around three decades in India. So, there is a lot of positive momentum in terms of the business sentiment.

We also started seeing, obviously, recovery in the global growth, which should help India's investment recovery. But, ultimately what India needs is supply side structural reforms, which will have to resolve its structural issues. And what I mean by it, is that it really has to implement reforms that need to address its investment problem, its structural inflation, where again the issue mostly lies on the supply side, as well as some of the policy bottlenecks particularly in the energy sector on the fiscal side, where India needs to reduce its subsidies, and so on.

So, as I said, the most important for India today is really structural reforms and the new government of the BJP under the leadership of Prime Minister Modi is well positioned to start the reforms.

What is the likely scope and speed of the new government's economic reforms?

I believe the government's approach to reform will be gradual and measured, rather than fast-paced and rapid. And a good indication of the policy intent is really the first budget of the BJP government, which has been widely seen as a key test of the government's policy reform agenda. And what the budget really shows, is that the government will first focus on addressing investment recovery, particularly in India's flagging manufacturing sector and its flat automotive industry, as well as infrastructure.

So, the government really will focus on addressing and de-clogging some of the stalled investment projects, and it will also provide some of the tax incentive, as already displayed in the budget, particularly for the manufacturing sector. It also will have to do more on the macroeconomic side, and this will be a second policy priority. Namely, the budget laid the fiscal deficient target at 4.1 percent of GDP, which is down from 4.5 percent last year. It also outlined a path to reduce the fiscal deficient to about three percent of GDP in three years. And the government did not necessarily specify, in my view, how exactly this will be addressed, because there was no mentioning of the reduction in subsidies, which are much needed.

At the same time, the budget did emphasize that the reduction in fiscal deficit will be mostly addressed through the revenue side. So, the government will try to raise revenue collections through increased taxes, which they have already mentioned that they will introduce the unified sales tax across India, entire India, rather than different states. And at the same time they will try to raise more money through the privatization. The budget itself sets the target of over ten billion U.S. dollars for this year, which is up from about four billion in the last year.

And finally, some of the structural reforms, which are more difficult to implement, which are more contentious - like labor reform, like subsidy reduction, like energy reform - will take more time to implement, and that's also something that budget doesn't necessarily address this time. So, really the key will be to watch what kind of policy measures the government will lay out in the coming years to see how these reforms will really play out.

What are the main risks to the implementation of reforms and the impact to growth?

There are near-term risks to India's growth particularly. And this is really the two…its tied monetary and fiscal policies, as well as the agricultural sector performance. Agriculture contributes about…or constitutes about 20 percent of India's GDP, and what we have seen this year, is that the dry monsoon season across entire region threatens to derail agricultural sector output, which will obviously project into weaker overall GDP growth.

It also will weaken the household incomes, particularly in India's rural economy. And what is probably even more important is that it will fuel food prices, which again, constitute a big part of India's inflation. And that is something that will keep monetary policy of the central bank very tight. There is really no room to ease interest rates, and if the risks to food prices materialize we will probably see even some tightening in the year ahead. Fiscal policy, as I already mention, those remains pretty tight as the government is committed to its consolidation. So, there will be no room to deploy any stimulus on the fiscal side either.

And finally, we see that the corporate sector is also undergoing some rounds of consolidation. The corporate sector in India has built significant leverage over the past few years and with the capital markets now booming, I think there is a big opportunity and chance for the corporate sector to deal leverage. But, clearly this will take time, which means that some deployment of fresh capital will also have a lack. But we might see an impact on growth, only from the fiscal year 2015. With that said, IHS projects India's economy to recover somewhere between 5.4/6 percent during the coming year, from 5 percent last year, so not a whole growth of a…not whole much of a growth rebound.

In terms of the medium term, I think the biggest risk still is the implementation of reform. The new government of Prime Minister Modi has an overwhelming majority in the lower house of Parliament, which will clearly help them to implement some of the difficult policies. But, at the same time, Modi still has some opposition in India's states, which do have quite significant weight in India's policy making, as well as the upper house of Parliament. Which means that pushing for some of the controversial reforms, like labor reform, like subsidy reform, will be quite difficult, and it will really depend on Modi's skills and ability to build a national consensus. He performed quite well as a chief minister of Godhra state, where he was able to implement most of his reform agenda, which clearly translated into quite impressive results for the state. But, again, the question is, whether he will be able to translate this same skillful policy management for the national level for India.

With that said, we currently expect India's growth to recover to about 7.5 percent over the medium term, but whether India will be able to achieve growth rates of above 8 percent, which it has seen in the past decade is still questionable because we did not see a clear path for the reform in the current budget.

Hanna Luchnikava Senior Economist, Asia Pacific, IHS Economics

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