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Financial Planning > Tax Planning > Tax Reform

Is India Turning a Corner?

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Only three years ago, India was shaking off the effects of the global financial crisis better than most, with GDP growth exceeding 8% year-on-year in real terms. Today, the Indian economy is going through a surprise soft patch that cannot be blamed purely on externalities. GDP growth in the fourth quarter of 2012 fell to 4.5% and some investors started questioning its long-term growth potential.

It is clear that a degree of economic complacency, political mismanagement and corruption have played their role. Politicians have not done enough to end the bottlenecks that are holding back private investment: India currently ranks 132nd out of 185 countries in the World Bank’s Ease of Doing Business Index. Meanwhile, bloated government subsidies have exacerbated its fiscal and current account deficits.

It is not hard to see why some investors have become disheartened: The combination of stubbornly high inflation and the twin deficits (the current account deficit in Q4 2012 hit 6.7% of GDP, and the debt-to-GDP ratio stands close to 70%) has left policymakers with few cards to play.

Important Progress Is Being Made

However, India’s 12- to 18-month outlook appears to be turning a corner. After months of inaction, the administration under Prime Minister Manmohan Singh appeared to jolt into action last September, announcing a series of reforms. These included cutting the fuel subsidy, opening retail and aviation sectors to foreign investors, the sale of stakes in state companies, and a series of tax reforms. A new cabinet committee has been created to resolve disputes between ministries that have held up billions of dollars of investment projects, often for over 10 years.

These reforms will not be an overnight fix, nor will they be enough on their own, but they hint at bigger things to come. India’s stock market is up, and it has avoided, for now, a downgrade of its credit rating. The current account deficit rose to 3.6% in the first quarter of 2013, and first-quarter GDP rose 4.8% over the prior year.

More encouragingly, recent inflation data have shown a surprise decline: WPI inflation fell from 4.9% in April to 4.7% in May, and importantly, core inflation declined further to 2.4%. This gives the RBI much-needed room to maneuver and makes possible a 50bp cut in the repo rate.

Reform Momentum Will Be Key

The need to maintain the momentum is important, and this is the biggest short-term risk. India does not have a strong track record for keeping its budget in check, and periods of belt-tightening are often short-lived.

Furthermore, with an important election looming in May 2014, the risk is that reform will stall as we move through this year. The outcome of the election is not clear, but it will be important for the direction and pace of reform.

Demographics as Destiny?

If India can successfully navigate its way out of its current soft patch, it has all the ingredients to return to healthy growth. In particular, with the second largest population in the world and a growing working population, India has extremely favorable demographics. Unlike China whose demographic advantage is peaking, India still has a way to go. More than half of India’s population is under 25, and by 2020 its average age will be just 29 (compared to 37 in China and the United States and 45 in Western Europe). Approximately 1 million people are expected to enter the labor market every month, and the IMF -projects that India’s demographic dividend could produce an extra 2% per capita GDP growth each year for the next 20 years.

Favorable demographics do not automatically translate into economic success. India must therefore provide the conditions to harness economic success, including providing jobs for new entrants into the work force and education for its growing youth, as well as addressing high levels of poverty.

We do not expect India to return to 8% growth levels in the foreseeable future, but we expect an uptick by the end of this year. Its longer-term growth prospects remain among the best in the world with growth between 6% and 7%. It is by no means without big challenges, but with roughly 1.3 billion people and increasing integration into the global economy, investors would be mistaken not to capitalize on its vast opportunities.


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