Risk drivers and outlook

Unlike other BRIC countries, India’s short-term economic outlook is upbeat under a favourable economic context (e.g. sharp fall in oil prices), improved investor confidence and a reformist federal government elected last year. It is reflected by a low political risk rating (2/7), supported by comfortable liquidity, and a classification at a moderate level (B) for commercial risk thanks to strong GDP growth forecasts – towards 7.5% – and favourable financial conditions.

Yet, the medium to long-term horizon looks more risky as India is faced with structural impediments to growth, poor public finances and risks of higher inflation when oil prices rebound. Another weakness lies in the vulnerability to capital flight in a context of US monetary tightening so that the rupee might experience renewed depreciation pressures and make repayments on rising – but still overall manageable – corporate external debt costlier. A successful reform agenda and infrastructure development are of crucial importance to ensure India’s macroeconomic stability and raise its long-term growth. Backed by a strong mandate, a strengthened balance of payments, decreased inflation from lower commodity prices that allows cuts in subsidies and monetary easing, PM Modi has room for manoeuvre to boost economic activity as highlighted by announced fiscal reforms and plans to increase public development spending. Moreover, much-needed investments should be supported by political stability and confidence. However, the task is complex given local resistance to change and delicate equilibrium within India’s heterogeneous society. That’s why the implementation of reforms will remain India’s biggest challenge. All this justifies that India be rated in a more moderate medium- to long-term political risk category (3/7).

Facts & figures

Pros

  • Huge growth potential (demographic dividend, high savings and investment rates)
  • Broad-based economy
  • Strong services industry
  • Sustainable external debt

Cons

  • Frequent communal and socioeconomic tensions
  • National policies hindered by the federal system
  • Difficult business environment (infrastructure bottlenecks, red tape…)
  • Poor public finances

Main export products

  • Software services (12.7% of current account receipts), private transfers (11.9%), petroleum products (11.5%), agricultural products (7.8%), chemicals (7.6%), gems & jewelry (7.5%), textile (5.8%)

Income group

  • Lower middle income

Per capita Income

  • USD 1,570

Population

  • 1,252 M

Head of State

  • Pranab Mukherjee

Prime Minister

  • Narendra Modi (BJP)

Description of electoral system

  • Presidential: 5-year term, next elections in 2017
  • Legislative: 5-year term, next elections in 2019

Country risk assessment

A new government, a wind of change

The tide has turned after three long years of political crisis. The future looks more promising again, especially since the clear outcome of the May 2014 parliamentary elections. The landslide victory of BJP (Bharatiya Janata Party), the opposition party (within the National Democratic Alliance), and of its candidate Narendra Modi has indeed delivered a strong Prime Minister mandate. The BJP’s majority in the lower house without coalition constraint grants more room to launch reforms and re-boost confidence in the world’s biggest democracy. Its main rival party, the Congress party, which was knocked out at a historic low last May, faces an existential crisis and might need a profound transformation, possibly challenging the Gandhi dynasty, if it wants to regain Indians’ confidence. As a result, Mr Modi’s rule is likely to be overall politically stable.

Still, the situation within the Indian federal system is not entirely satisfactory as the BJP is in a minority in the upper house which will certainly hinder the legislative process for some reforms (e.g. land acquisition) and make deals with regional parties necessary. BJP’s crushing defeat by AAP (the “common man’s party”) in Delhi’s February elections, the BJP’s first defeat since it came to power, could have an impact on the government’s reformist agenda. It could, among other things, force the BJP to soften a few reforms, thereby highlighting the potential for other parties to benefit from the vacuum left by a Congress in disarray and to win popularity. Now, BJP’s recent electoral victories in a few major states bode well for progressive enhancement of federal power after the state elections that are scheduled in the next two years.

While in power, Mr Modi will have to show management skills and leadership. His supporters hope he will be able to replicate his long and successful experience as Chief Minister of Gujarat State where growth was robust, infrastructure much developed and red tape cut. This is a huge challenge given India’s higher political and economical complexity and diversity as a nation. The “Modi-mania” that surrounded his election must allow the government to take bold measures and also highlights the size of the expectations, notably concerning economic activity and public governance. Prime Minister Modi is a controversial figure – autocratic, nationalist and worryingly promoting Hindu supremacy. His attitude risks exacerbating tensions with the large Muslim community sooner or later (not in the short term). This risk could be mitigated as he has no choice but to maintain domestic cohesion in order to achieve his economic programme. Beside ethnic tensions, the enduring conflict with Maoist rebel groups is likely to persist in north-east and east states as Mr Modi seems to have no intention to deal with them and rather favours a confrontational approach.

Meanwhile, in foreign affairs, it came with no surprise that, after a few years of détente, peace talks with neighbour Pakistan were rapidly suspended. This evolution was expected, considering India’s nationalist Hindu PM and the Pakistani military strengthening its position over a weakened civilian government. Violent attacks have increased in Kashmir and presage a more strained bilateral relation in the coming years. Relations with superpower rival China are cordial and constructive, and serve as a political and economic counterweight to the western world, but they remain delicate as well due to regional competition – fostering India’s strengthened geopolitical strategy in the Indian ocean sphere – and conflicts around some Himalayan borders, thereby favouring closer ties with the US.

A pro-growth and reformist agenda in an improved environment

Mr Modi’s liberalism and campaign based on pro-growth and reformist pledges have had a positive impact on the business climate. Economic momentum has improved markedly since general elections and should continue to do so to allow India to overtake a slowing China as the world’s fastest-growing large economy by the end of this year. After having bottomed out in 2012 at 4.5%, the economy has grown at an estimated 7.2% in 2014-15 and is forecast to reach 7.5% in the coming fiscal year1.

Graph1_India2015

1These figures take into account India’s Central Statistical Office’s recent methodological changes which have led to revised data. Still, given the gap with previous official data, this update is taken cautiously, namely more like a statistical event rather than a mirror of a recent and significant improvement of India’s real economy.

The Indian economy benefits from a more favourable (external and domestic) economic environment. With a large fuel bill (35% of import of goods), India is among the world’s most important beneficiaries from the collapse of oil prices, while also benefiting from a recovering US and EU demand. Mr Modi was lucky with this perfect timing right after his election as this collapse supports growth and facilitates unpopular measures such as the cut in fuel subsidies (cf. infra). Combined with decreased gold imports – which resulted from restrictions that have been lifted at the end of last year – while the export sector was growing modestly, the current account deficit has shrunk considerably from 4.7% of GDP in 2012-13 to less than 2%. The deficit is expected to remain in those areas in future and to be easily financed by FDI, which are projected to rise substantially under Modi’s rule and expected relaxed caps on foreign investment  in several sectors. One of the positive consequences is that the downward trend in foreign exchange reserves has reversed and should keep the import cover above a comfortable 6 months in the future.

Graph2_India2015

Inflation and depreciation pressures could loom again

Despite a strengthened balance of payments, India is not immune to global capital fluctuations, particularly with the upcoming US monetary tightening. As a matter of fact, the Fed tapering announcement in spring 2013 led to large capital outflows and a related sharp decline of the rupee (-23% from May to August) to a record-low against the USD. However, that happened in a context of continued political paralysis. Since then, the domestic context has completely changed: PM Modi has a strong mandate, confidence has returned, economic forecasts have improved and as a result, the rupee has recovered somewhat (+6%) despite a strengthening USD. Therefore, although renewed bouts of volatility are likely, depreciation pressures should be of lower magnitude.

As a result of lower commodity prices, inflation has quickly decreased to an eight-year low of 5%. To strengthen price stability and maintain consumer prices at lower levels, the government has legally awarded the Reserve Bank of India (RBI) to inflation targeting (set at 4% in the medium term, with a fluctuation band of 2%). Now, the RBI is easing its monetary policy by cutting interest rates – lastly to 7.5% – to support consumption and investments which are constrained by penalising high interest rates. A rebound in oil prices in the medium term and higher food prices in case of a bad monsoon are two main downside risks to the inflation outlook. Therefore, New Delhi has to tackle structurally high inflation partly caused by ineffective storage and distribution of food (i.e. the dominant component in the price index).

“Make in India” and improving the business environment amid higher financial fragility

During his rule, Mr Modi pledges to promote the “Make in India” policy. Beside a strong domestic demand, which largely drives economic growth through a big internal market and rising middle class, India’s manufacturing industry has long paled in comparison with China. The goal is thus for India to become a manufacturing hub (e.g. defence, automotive, telecom) and boost job creation – less than 10% of the total workforce is employed in manufacturing – in a country where services (e.g. IT and call centres) remain the strongest performers. A lower rupee is positive for exports and can make the sector more attractive to investors, but labour costs are relatively higher than in several other Asian competitors. All in all, the government will have to give a high priority to making the business environmentally friendlier, a top condition for long-term projects, as business is hindered by heavy bureaucracy, frequent power shortages, infrastructure bottlenecks and rigid labour regulations.

In the meantime, financial fragility is deepening. The banking sector, though considered solid, keeps slowly deteriorating with a continued rise of the bad loan ratio (from 2.4% in 2010-11 to 4% last year) especially among dominating public banks (owning ¾ of bank assets), and of corporate debt (estimated around 45-55% of GDP). The latter upward trend is particularly significant among the larger number of financially weak companies.

Graph3_India2015

Moreover, like emerging market peers, Indian companies have been borrowing more and more externally at lower interest rates on the international capital market, which increases their vulnerability to a strong USD, an upcoming increase in US interest rates and unfinished rupee depreciation in future. That being said, India’s total private external debt and debt service ratios remain low in absolute terms and compared to peers in other emerging markets. Besides, weakened public banks and rising (domestic and external) corporate debt, which is much exposed to the infrastructure sector, negatively hit the domestic loan demand by keeping bank credit growth at a low 10% and thus could hamper future private investments and economic growth.

A fiscal policy balanced between consolidation and economic support

The recently presented 2015 budget, the new government’s first full budget, goes in the right direction as it aims to boost growth while keeping fiscal consolidation on track, albeit at a reduced pace. The government plans to increase public expenditures in infrastructure, particularly transports and power generation, two chronic hindrances to economic activity. The fiscal reform programme provides for a major rationalisation of subsidies (already started at the end of former PM Singh’s mandate) and for the fiscal system with several taxes to be scrapped and replaced by a single national goods and services tax. Last October, eased by a strong decline in oil prices, the government decided to abandon diesel subsidies and make domestic prices market-based. Fuel, food and fertiliser subsidies accounted for about 2.2% of GDP last fiscal year but are to be brought down to 1.6% by the fiscal year 2016-17, and partly replaced by direct cash transfers to poor people. Besides, a gradual decrease of the corporate tax from 30% to 25% has been announced.

Graph4_India2015

Those measures will help to drive economic growth but will slow down the budget adjustment. Hence, the general government budget deficit and the public debt ratio will remain on a progressive but slow downward trend from an expected 6.8% and 62.6% of GDP, respectively, in 2015-16. Successive governments have committed to curtailing public debt, which was above 85% of GDP ten years ago, but interest charges still represent 25% of budget revenues. Further and continued effort is thus needed in the medium term to create fiscal space and make more room for economic stimulus together with the monetary policy. Meanwhile, debt sustainability risks are mitigated by the fact that public debt is primarily domestic and the total external debt ratio (including private debt) is expected to stay under 25% of GDP thanks to strong economic performances.

Local resistance is a major obstacle to Modi’s reformist agenda and investments

Although investor sentiment is bullish since the victory of reform-minded Modi, concrete achievements have been limited so far. PM Modi has seemingly chosen a gradual over a fast-track strategy given the extent of challenges and political obstacles to implementing long-awaited reforms. The land acquisition bill is one of the touchiest laws that the government wants to revise and is symbolic of the challenges India faces to accelerate development and to support the “Make in India” policy. Reaching the latter goal will require simplifying the law that remains restrictive and makes land access difficult for economic purposes. The issue is controversial in a country where the majority of the people are very poor, live in rural areas and fear for their economic subsistence. Given farmers’ protests and the opposition’s majority at the upper house, the BJP might have to wait until 2016 upper house elections to see it passed. In fact, to the exception of the recently and eventually approved amended insurance bill that raises the foreign investment ceiling from 26% to 49% in Indian companies, Mr Modi’s other reform plans (e.g. labour, fiscal…) also face strong opposition which could decide him to bypass the normal parliamentary process by calling joint sessions until 2016. BJP’s heavy defeat in Delhi elections could indeed favour a more cautious attitude. Meanwhile, failing to pass new laws would send a bad signal to investors of the risk of persisting political hindrance and structural hurdle to business and infrastructure development. In the coming years, better fulfilling India’s economic potential could partly depend on Mr Modi’s determined reform stance which is currently seen as a mitigating factor of the country’s downside risks.

Analyst: Raphaël Cecchi, r.cecchi@credendogroup.com