Last updated: 11:16 / Tuesday, 19 May 2015
Analysis by Investec

India: Balancing Fiscal Discipline and Growth

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India: Balancing Fiscal Discipline and Growth

It is nearly a year since Narendra Modi and his Bharatiya Janata Party’s landslide election victory in India. At the time Investec wrote about its cautious optimism that the new prime minister and his team could implement much needed reforms to unlock the country’s economic potential. A year later, the Modi administration has broadly met expectations with a number of pro-market reforms and most recently a pragmatic budget, balancing the needs for fiscal consolidation with that of spurring growth.

On the fiscal consolidation front the biggest step so far has been the cut in fuel subsidies. Mr Modi was dealt a fortuitous hand after oil prices collapsed in the latter half of 2014. The Indian government was the first of many to see the opportunity to cut inefficient oil subsidies – and the 2015-16 budget estimates a 50% cut from 2014-15 fuel subsidies. However, point out Investec´s experts, rather than take a dogmatic approach to fiscal consolidation, the government have taken a more balanced view and modestly relaxed the pace of the adjustment (the 2015-16 target fiscal deficit has been revised up to 3.9% from 3.6%). Hence it has used some of the savings from subsidy cuts to commit to a 25% year-on-year rise in capital spending, with a large chunk due to be spent on the country’s dilapidated road and rail networks. A number of steps have also been made to reform the tax code. Corporate taxation is set to be brought down, over a staggered period, to 25%. Meanwhile, the first steps to introducing a goods and services tax (GST) were introduced with a rise in services tax and a commitment to implement the GST next year. This is a long overdue move: tax rates will go down, while tax revenue should increase due to higher tax buoyancy.

Other important pieces of legislation were approved by parliament in March. Firstly, the insurance bill (delayed over a number of years) was finally passed which will allow increased involvement by foreign firms in developing the country’s underdeveloped insurance market. Secondly, two pieces of legislation designed to liberalise the coal mining industry also passed through congress. The pending land reform bill, which would make it easier to acquire land for industrial development (and deemed to be the most contentious), will be a big test of the government’s ability to pass legislation through the parliament. That said, overall Modi’s reform agenda since taking office has been impressive and deft political manoeuvrings in the upper house should be enough to secure the passage of key bills without support from the opposition.

These much-needed fiscal and structural reforms have been supported by a government commitment to officially adopt inflation targeting as the new monetary policy framework. This will help to secure the credibility of monetary policy that has been won in the two years since Raghuram Rajan was appointed as central bank governor in 2013. He ensured India was among the first emerging market economies to hike interest rates in the wake of the ‘taper tantrum’, helping to ease the current account deficit and building up the monetary authority’s credibility. The move to formalise the inflation targeting regime is particularly welcome as it should help to underpin transparency and consistency in monetary policy, as well as hopefully ensure that excessive inflation – long a problem in India – becomes a thing of the past. The central bank’s foreign exchange reserves have also shot up to an all-time high of US$340 billion. So overall, we have seen a pertinent shift in both fiscal and monetary credibility. This has underpinned investor sentiment and the once imperilled investment grade credit rating is now no longer at risk; indeed Moody’s have recently upgraded India’s outlook to positive.

There is of course still much progress to be made. Not least, India’s underdeveloped manufacturing sector is not going to mushroom overnight. Yes, government policies such as ramping up capital expenditure on infrastructure will help, but much more will be required in the coming months and years to improve transport links, energy infrastructure and perhaps most importantly, cutting through the country’s infamous swathes of red tape to make it easier for businesses to invest. We feel that the significant progress Mr Modi has already made indicates that India has never had a better chance of attaining the strong growth rates the country needs to catch up with its peers.

"We remain overweight in the rupee and have recently added more exposure. The current account deficit has narrowed sharply since 2013. It now stands at 1.6% of GDP and should continue to improve this year assuming oil prices remain contained around these levels. Meanwhile, foreign inflows have picked up, with around US$13 billion inflows since the start of the year. With a much improved FX reserve position, the central bank has both the willingness and capability to underpin the rupee through FX intervention. As such it should remain relatively stable, making it an attractive currency while headwinds to emerging market currencies remain prevalent while the implied yields on the rupee are a very alluring 6-7%. We expect India to continue to outperform its peers over the medium term as investors become more discerning as we approach the start of Fed rate hikes; India with its credible fiscal and monetary policy is well placed to negotiate the headwinds", conclude Investec.

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