India's blossoming economy

Dec 4th 2006From the Economist Intelligence Unit ViewsWire
But there are fears of tough times ahead

The acceleration of economic growth in India recently has generated upbeat assessments that Asia's other giant is finally becoming as dynamic as China, but also warnings that the economy is overheating. With GDP growth in the July-September quarter rising to 9.2% year on year, the headline news is encouraging. But there are crucial differences to the picture in China. Inflation has nearly doubled over the past 12 months. Equity and housing markets look overbought and the current account has moved sharply into deficit. Besides interest-rate hikes by the Reserve Bank of India (RBI, the central bank), little is being done by the government to orchestrate a soft landing.

GDP growth has been above 8% in six of the last seven quarters, and in the first half of the current fiscal year (April-March) it reached 9.1%, the fastest pace since economic liberalisation was begun in 1991. The second-quarter growth figure is better than the Economist Intelligence Unit had expected; consequently we are going to revise our full-year growth forecast (which currently stands at 8.4%) upwards.

That said, the economy is increasingly at risk to overheating, as a number of indicators suggest. The stockmarket has spiked, with the benchmark Bombay Sensex index rising more than 50% in the past year (and fourfold in the past three years). Property prices have soared in a number of cities. And—unlike in China, where inflation remains subdued—the cost of living has been rising at a worrying rate. The rate of headline inflation has nearly doubled in the past year as strong consumer demand, itself buoyed by wage inflation, is putting upward pressure on prices. The wholesale price index showed inflation running at 5.3% in early November, only just off the upper limit for the year specified by the RBI of 5.5%. We expect this limit to be broken, with inflation averaging 5.6% this year.

The RBI has acknowledged the risk of overheating and has been tightening monetary policy steadily, raising its benchmark repo rate (the rate at which the RBI adds funds to the banking system) 100 basis points in the past year, to 7.25%, and the reverse repo rate (the rate at which the RBI drains money from the banking system) 75 basis points to 6%. The RBI's next move will probably be a 25-basis-point increase in the reverse repo rate, to 6.25%, possibly before the central bank's next scheduled official policy announcement on January 30th 2007.

It is debateable whether this alone will be sufficient to ease inflationary pressures, however. The economy is running near or above capacity, and the RBI has noted that production must rise at a pace sufficient to match overall GDP growth if further inflationary pressures are to be avoided. Capacity is rising swiftly—we expect industrial production growth to exceed GDP growth this year and rise by 9.6%—but it is not certain that this can meet soaring domestic demand.

This highlights another difference from China, namely that in India domestic demand, not exports, is driving growth, fuelled by steady wage inflation. This (helped by a fair amount of trade liberalisation) has led to a surge in imports, turning a current-account surplus only three years ago into a substantial deficit in 2006, a swing equivalent to about 4% of GDP. In October the trade deficit hit a record US$6.2bn for the month, more than double the US$2.9bn seen in the same month in 2005. This has exacerbated imported inflation, as have high oil prices (although surging portfolio and direct investment, and high levels of remittances, have mitigated any downwards pressure on the rupee).

There is a case to be made that concerns about overheating are themselves overcooked. Much of the rise in inflation recently can be attributed to short-term supply constraints, such as a shortage of key foodstuffs thanks to an erratic summer monsoon. The government has said as much, claiming that future harvests will ease inflationary pressures (although a lack of investment in the agricultural sector is a long-term problem; in the second quarter agricultural output rose only by 1.7%, year on year, the slowest pace in one and a half years). The soundness of India's banking system means it does not share Chinese-style concerns about the future viability of loans being extended to finance soaring investment (and high credit growth has not had a direct impact on inflation).

However, lured by the prospect of finally catching up with China's growth performance, the government and the RBI are in danger of persisting with an accommodative, growth-oriented strategy that could be storing up problems for the future. Besides the RBI's rate hikes, little is being done to orchestrate a soft landing. The government has tried to ameliorate the rising cost of living by cutting domestic fuel prices (on November 29th), but this has more to do with the need to keep the electorate happy ahead of upcoming elections in four key states than with addressing the underlying causes of inflation.

Future policy is likely to stay accommodative, although a variety of measures—including steps to ease supply-side pressures, moral suasion, or prudential regulations to tame specific sectors—could be employed to lead the economy towards a soft landing. The danger is that if the RBI decides to act more aggressively in future it could trigger a sharp slowdown. Nonetheless, the government is unlikely to do much to jeopardise what Palaniappan Chidambaram, the finance minister, has called "a moment to savour" in India's modern economic history.

Kick-starting corporate bond markets

A modern economy cannot run on love and fresh air. It runs on modern practices,” said the finance minister, P Chidambaram, speaking in Hyderabad earlier this month.

He was bang on, except that in one major area — the corporate bond market — there’s little sign of modern practices being introduced. This, despite the fact that it’s close to a year since the Patil committee set out a detailed roadmap on what needs to be done to energise the market.

It’s also close to 10 years since the East Asian crisis that saw Asian governments resolve to develop their corporate bond markets as a cushion to deal with volatile capital outflows. But with the exception of Japan, none of the others, including India, has made much progress.

Indeed India today ranks last among the BRIC economies, Brazil, Russia, India and China, with outstanding corporate debt of little over $2 billion compared to Brazil’s close to $4 billion, Russia’s $10 billion and China’s $12 billion, according to IMF estimates (2004).

This is surprising since both government as well as financial market players have often expressed their eagerness to see a well-functioning corporate debt market in place. So what gives? Why have we not been able to make any progress? More important, is there any way of putting the pieces in place?

The main problem, as a finance ministry official speaking at the just concluded World Economic Forum confessed, is that there are just too many obstacles — political, legal and policy-related — to the emergence of a vibrant corporate bond market.

To begin with, there are 78 laws, starting from the definition of a corporate bond, that need to be amended. Unfortunately, given the glacial pace at which legislative changes happen in our country, none of that is going to happen overnight.

Some changes can, of course, be incorporated in the new Companies Bill. But there are other changes that would not only need amendments to various Acts but would also require a supporting institutional machinery to be put in place.

For instance, holders of corporate bonds are not sure they will be able to enforce their rights in case of default by bond issuers. So unless there is a complete overhaul of the role and responsibility of debenture trustees and of bankruptcy law and procedures, it is unlikely they will be attracted to the market.

Yet given our huge infrastructure deficit — it is estimated India will need $320 billion for infrastructure projects over the Eleventh Plan period — we desperately need to bring our moribund bond market to life.

The reason is three-fold: the inability of government to invest on this scale; the demise of development financial institutions that provided long-term money in the past; and the inability of banks to extend term finance beyond a point, since the bulk of their funds is of much shorter duration. Consequently, the bulk of infrastructure financing will have to be through corporate bond issues.

The government, therefore, has two choices. Either it can wait till it gets all the necessary legislation in place before it does anything. Or, as with much else in the Indian context, it can plunge in.

Do whatever is possible immediately and then keep tweaking the system as the situation evolves. This is what it has done in a number of areas, notably value-added tax (VAT), where we pushed ahead with a far from perfect VAT and yet have not fared too poorly as a consequence.

The process is definitely messy and is fraught with frequent policy contradictions. But it is better than waiting endlessly for everything to become picture perfect before taking the first step. More so given the Indian predilection to debate issues endlessly.

So, what are the immediate changes that can give a boost to the market? As the first step, the government needs to encourage more players and simultaneously, take steps to improve liquidity and transparency so that secondary market transactions become easier.

In the equity market, automated nationwide real-time trading and settlement, depositories and an active regulator transformed the Indian equity markets. If the same can be replicated in the case of corporate bonds, there is no reason why the bond market cannot be transformed.

Fortunately, there some signs of movement on the ground. The finance ministry has got Cabinet approval to remove the legal ambiguities over asset-backed securitisation. This will enable special purpose vehicles to issue asset-backed securities for trading and will partially address the issue of poor volumes on the supply side, apart from improving the quality of paper.

The RBI could contribute by relaxing its existing guidelines on securitising debts. It could also incentivise corporates to issue bonds rather than resort to cash credit facilities by advising banks to offer a lower rate of interest on bonds.

On the demand side, pending pension and insurance sector reform that would bring in more players seeking long-term paper, investment guidelines for existing superannuation funds could be relaxed in line with those for employees PF. It could also raise the FII limit for investment in corporate bonds.

The issue of states levying varying stamp duties, making trading cumbersome, could be addressed by Sebi mandating that all bond issues as well as subsequent trading should be in demat form, as with equities. Section 8A of the Indian Stamp Act 1899 already has an enabling provision to this effect. TDS (tax deducted at source), another irritant, could be done away with as has been done for government securities.

Sebi can help with easier listing requirements, shelf prospectuses and less stringent disclosure requirements for already listed entities so that the edge that private placements have over public issues vanishes. It can ask exchanges to create a centralised database.

True, some niggling turf battles between Sebi and the RBI remain. But these are essentially over derivatives and can be addressed later. K Kamaraj, the Congress president through the ’60s and ’70s had a stock answer to sticky problems: parkalam (let’s see). It held him in good stead and might do likewise for compatriot, P Chidambaram. So let’s start with a cash market and see!

The Pension bonanza

We could soon see an explosion in domestic institutional investments with the finance ministry permitting investment of pension fund assets into equity markets. This will not only put the pension fund into balance but also help in the explosion of the already high equity markets in India. The rise of pension fund deficits and regulatory change has finally brought new thinking on investment strategy for the public pension schemes.

The centrally managed funds carry assets reaching nearly 4% of the GDP amounting $30bn. The diversification in the investment strategy into equities and corporate bonds will be a very important development and a move for the funds towards liability driven performance targeting.

More on this in the coming blogs