India’s Economy – At A Critical Crossroad?

As we write this article, the month-long Indian election is nearing its end. The political machinations for building a coalition to form the next Indian Government have already begun in earnest. As soon as it gets sworn in, the new Indian Government will have to take strong steps to revive the Indian economy.

So we thought this week would be an appropriate time to discuss the challenges that face the Indian economy.

During the bubble years, the American Financial Media, loved to use “Chindia” as a catch-all phrase. Why are food prices so high? Why are oil prices so high? Why is global growth so strong? Why will the global economy avoid a recession? Why has the US turned from being a price-maker to a price-taker? The answer to all such questions, according to the Financial Media, was “Chindia”.

Yet, the economies of China and India are radically different and so are the problems facing both economies. China received unprecedented amounts of foreign capital during the bubble years. This flow of money was not short term portfolio money but long term foreign direct investment (“FDI”). This is led to an infrastructure boom in China of  historic proportions. The natural result was creation of overcapacity in major sectors of the economy. The traditional aftermath  of such a capacity boom is an eventual bust and a bout of deflation. (See our November 15 2008 article
Chinese Slowdown – Revenge of the Austrians?).

The amount of capital inflows into India were a pittance compared to what China received. Besides, the bulk of the inflows were portfolio monies, or monies for investment in stock and bond markets. Unlike FDI monies, these are short term monies that can (& did) exit the country as quickly as they came in.

The Indian economy has historically been starved of capital necessary for growth. Compared to the Chinese or the South East Asians, Indians tend to spend more and save less. The majority of the savings are kept in India’s nationalized banks and by some reports, the Indian Government tends to capture about 75% of the country’s savings for its fiscal spending, thus crowding out the private sector.

So, the capital inflows of the 2003-2008 period were a boon to Indian corporations and financed India’s biggest ever credit and spending cycle. The cumulative inflows of $224 billion into India led to a 350% increase in outstanding credit in India. As a result, the growth accelerated and averaged nearly 9% during this period.

The 2008 bust in global markets and heightened risk aversion of global investors resulted in flight of capital from India. As a result, the Indian economy now faces a sudden shortage of investment capital.
Rather than dwell on this topic ourselves, we refer readers to an excellent article by Vikas Bajaj of the New York Times titled
  India, Suddenly Starved for Investment“. Below are a few excerpts from this article:

  • At its peak, more than a third of investment came from abroad, according to Credit Suisse. But in the last three months of last year, foreign loans and direct investment fell by nearly a third, to their lowest level in more than two years.
  • A few short years ago, construction sites here buzzed 24 hours a day, crews working through the night, cramming down food from onsite trucks during breaks in the twilight. Now real estate sites lie fallow. The once-booming art market has slowed to a crawl. And charmed professionals with coveted degrees, like Sumit Sapra, are unemployed or taking pay cuts to hold on to their jobs.
  • In a recent report, the International Monetary Fund said Indian companies were among the world’s most vulnerable, after American firms, because they borrowed aggressively during the boom. Using data from Moody’s, the credit rating firm, the I.M.F. estimated in a recent report that defaults among nonfinancial South Asian firms could climb to 20 percent in the coming year, up from an expectation of 4.2 percent a year earlier. (American firms are expected to default on loans at a rate of 23 percent.)
  • The decline in foreign investment has taken a big toll on sectors like real estate, manufacturing, infrastructure and even art, which was bolstered by demand from globalization’s nouveau riche here and abroad. In the last quarter of 2008, the economy’s growth rate plummeted to about 5.3 percent, the lowest in five years.

This dependency on foreign capital makes the Indian stock market extraordinarily sensitive to increase in the global appetite for risk. Since the global rally began on March 5, India’s Sensex rose by 39% in 34 days. In April 2009, the Sensex rose by 17.5%, its best monthly performance since May 1999.

(Construction materials await the return of financing and workers to continue development of this mall site in Gurgaon – NYT)

During our stay in Mumbai in November-December 2008, we were told by virtually every one we met that India was protected from the global meltdown because India did not open up its economy to the world or embrace capitalism.

We see this attitude as a great obstacle to India’s economic growth. In our opinion, the global economic crisis is a golden opportunity for India to open its economy and welcome global capital while the developed countries are getting more restrictive. This is the perfect time for India to accelerate its economic reforms.

Unlike most economies in the world, India does NOT face deflation. Unlike developed countries, India does NOT suffer from lack of demand. So India can use external capital to increase domestic production to meet the latent consumer demand and grow its economy. Such growth would be a magnet for higher capital inflows leading to further growth and a virtuous circle.

Will the new Government concur? We are not sanguine. In our opinion, the entire political community in India has been shell-shocked by the economic crisis in America and their gut reaction is to get back into their comfortable semi-socialist cocoon.

Vikas Bajaj of the New York Times discusses this attitude in his article “
India’s Path to Economic Reform Reaches a Fork“.  Below are a few excerpts from this article:

  • Policies that seemed increasingly outdated during the fast growth of the past 15 years are getting a fresh hearing, partly because they are seen as insulating much of India from the global slump.
  • Since the subprime mortgage crisis in the United States set off a global downturn, however, the antipathy toward capitalist excess has only grown. Now, smaller parties that respond more readily to populist demands seem poised to stall liberalization and perhaps even roll back measures, like more openness to foreign investors, if they gain seats in Parliament.
  • Many in the political class are skeptical that India, after nearly a decade of high growth and rising prosperity, needs more openness to investment, fewer state-owned companies, or greater deregulation of the private sector.
  • Economists and political analysts who favor deeper reforms in India say they are worried by the tone of vindication among those who opposed the country’s fitful embrace of foreign trade and competition in recent years.

The silver lining in this article is that India’s Business leaders do not seem unduly worried.
The article quotes Chandrajit Banerjee, the executive director of the Confederation of Indian Industry, as saying that the populist talk would dissipate once a new government confronted economic realities of slowing growth and falling foreign investment.

We hope Mr. Banerjee proves correct. But we are not sanguine. We recall that last year, America’s corporate leaders were not unduly worried by the anti-business tone of Candidate Obama’s election rhetoric. Today they are far more worried because President Obama is acting even more interventionist and more anti-Business than his campaign rhetoric suggested.

Will the new Indian Government follow the Obama approach? We will all know soon.

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