Indian economy: a problem most would like to have

IFR Asia, September 2010

India is one of those rare world economies with a problem most others would like to have. Growth is good, but is it too good? The biggest challenge facing Indian policymakers today is not spurring the economy but stopping it from driving inflation out of control.

In July the International Monetary Fund (IMF) raised its 2010 growth forecast to 9.4% from 8.8%. “We are fairly bullish on the short term prospects for India, and mainly that comes from two things,” says Kalpana Kochhar at the IMF in Washington DC. “One, there is very strong domestic demand, consumption and investment, driven by a big push in the infrastructure field. And two, India’s exports have been much more resilient to the global crisis than one would have imagined. Between those two things we don’t see, as we do for a lot of other countries, major headwinds.”

India today looks as if the financial crisis never happened – and on the ground, one can argue it didn’t. “In the past six to 12 months it has become very clear to us that the growth dynamics in India didn’t slow down a lot,” says Rahul Bajoria, an economist covering India for Barclays Capital. He is expecting at least 8% growth this year. “I think most drivers like domestic demand and private consumption are likely to remain on a pretty strong footing.”

The problem is that domestic demand is so strong, and so much more boisterous than the supply side, that inflation has become a pressing issue. India’s wholesale price index rose 10% year on year in July, for example, and the consumer price index has flirted with double digit growth through the year. “Generally we are very optimistic about the outlook for India, but the prime challenge we see is inflation,” says Frederic Neumann at HSBC. “The risk is that if the RBI [Reserve Bank of India] doesn’t manage to stabilise inflation in the near term that could do more lasting damage.”

Neumann says it’s “not time to sound the alarm bell yet,” but there was a time when the RBI was widely considered to be too reticent. Many felt it should have raised rates in the first quarter, although it has made up for it with sharp rises since, most recently with a 25 and 50bp hike in the repo and reverse repo rates in July. “There was an impression in the first half of this year that the central bank was a little bit behind the curve,” he says. “But they have had unscheduled rate rises and more hawkish rhetoric saying inflation is a bigger concern than growth, so the central bank appears to be catching up.”

Managing these issues is enormously challenging. “It’s a tightrope walk,” says Neumann. “You have to raise interest rates to temper inflationary pressures, but the dilemma policy-makers face is that one reason inflation is rising in India is because the industrial sector cannot keep up with soaring demand. You need to raise investment to keep up with that demand growth, but if you raise interest rates too rapidly you risk stifling that investment.” Managing this requires close cooperation between fiscal and monetary policy, Neumann says, noting that historically they are “not necessarily pulling on the same string.” He would like to see a more dramatic cut back in fiscal expenditure, which would temporarily curtail demand without having to raise rates so aggressively, which in turn would keep the atmosphere conducive to investment.

Getting it right also has important social implications. “When you have rapid growth you take a lot of people with you but you leave some behind,” says Kochhar. “And if that grows rapidly in India, with so many poor people, there’s always the potential for a problem.” Bajoria adds: “A large portion of the population is on subsistence income, which makes it particularly important to control inflation.”

Another challenge is that the issues creating inflation in India are quite unique to that country. It’s chiefly about food inflation, with the added problem that it spills over into non-food sectors, but the behaviour of food and agriculture in India has unique characteristics apart from the historically low agricultural productivity. One is the government policy for inclusive growth, including its national rural employment guarantee scheme, enacted in 2005 and now in widespread operation. Under this scheme, any rural household is entitled to have 100 days of employment, on demand, at the wage of 100 rupees per day. “This has boosted rural demand,” says Kochhar. “Given that supply even beforehand was not able to keep pace, it is being strained even more, and this is pushing up food prices.”

Infrastructure development will be a crucial method of improving supply and thus balancing out inflation. The government has made it a mainstay of its policy to boost infrastructure spending and development. Nobody would argue with that. But numerous successive administrations have seen the same requirement and sought to address it, rarely with great success. There are landmarks to point to in airports, highways and ports – New Delhi’s new airport terminal was entirely financed by the private sector – but in the vital area of electricity generation, for example, there are familiar problems with land acquisition and tension between state and federal government bodies in this most vibrant of democracies. “Unless there is some clear measure to incentivise the private sector and at the same time hold it accountable, progress on infrastructure improvement is going to be painstakingly slow,” says Venkatraman Anantha-Nageswaran at Julius Baer. “There’s the legal challenges, the financing, the rules of the game changing in midstream, and the corruption. It all adds to the cost of executing infrastructure projects for the private sector.” Neumann echoes these sentiments and argues availability of capital is not the real problem. “It is often said that the availability of finance is the main problem curtailing infrastructure, but I think that’s only partially true,” he says. “A bigger hindrance is the somewhat arcane legal and regulatory environment in India, which makes it exceedingly difficult to build highways, ports and airports where they are needed. It’s a by-product of the very commendable democracy in India, but it’s also something that needs to be addressed.”

Kochhar acknowledges that “they have been talking about it for several years and consistently under achieving by large margins”, but she is more optimistic for two reasons in particular. One is greater movement on a corporate bond market, discussed in detail below; the other is that there has been no sign of a clampdown on foreign financing following the financial crisis – instead a gradual tilt towards modest liberalization. For a next step, “We have been advising India to have a one-stop shop, a person or committee who is in charge of implementation,” she says. “If I was a private investor I could go to this one place and have confidence all my problems could be handled.”

Infrastructure development affects two other crucial areas of Indian finance: the banking sector, and the development of a bond market. Banks generally are doing well in India. “The banking sector is on strong ground in India,” says Bajoria, citing prudent policies at the RBI, generally high credit quality, greater integration among ordinary people with the financial markets, and low NPLs. Neumann adds: “The banking sector on the whole is very geared towards investment in government bonds and lending to government-type entities, so from that angle bank balance sheets look reasonably sound.”

But will they stay sound with major lending to infrastructure projects? “One concern is the big push on infrastructure, given the way the Indian financial system is still very bank-centric,” says Kochhar. She explains: “One thing we have been warning about for three years is that financing long-gestation infrastructure projects through a banking system that has, on average, short liabilities is not a good idea.” Doing so clearly introduces asset-liability mismatches, which is a particularly unpleasant prospect when there is still a danger of non-performing loans increasing in the wash of the financial crisis.

This is one reason the IMF and others want to see further development of a corporate bond market. “That’s much better equipped to deal with the provisions of long-term financing and insulating the banking system from anything that goes wrong with the projects,” says Kochhar. “When you are making a big push [as on infrastructure] you are bound to make some mistakes, but the trouble is if the banking sector is involved and the big mistake becomes propagated through the whole economy.” (Not everyone agrees with the impact of a buoyant bond market on infrastructure; Anantha-Nageswaran feels “It will make a difference at the margin. But there are countries that have grown without a bond market.”)

India actually already has a vigorous capital market, but it lacks two things: an entrenched establishment of institutional investors such as pension funds with long-term liabilities that would match long-term bonds; and foreign participation. “The big reform India might contemplate is to broaden access of foreign investors into the fixed income markets,” says Neumann. “It would help to bypass some of the big financing bottlenecks for infrastructure. We believe foreign investors would be very happy to finance public infrastructure development in India, or purchase government bonds,” which would indirectly have the same effect. Nobody is expecting or calling for instant deregulation, even the IMF: “The IMF has never recommended for a country like India to have unfettered capital inflows and outflows,” says Kochhar. “We’ve been quite happy with the pace of liberalization.”

Which is just as well, as India has never moved at anything other than its own rate. “I think as with everything in India it’s moving in the right direction, but at a glacial pace,” says Neumann of capital markets development. “We just have to wait and see if that pace is sufficiently fast.”