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Why India Is Forced to Reform Its Economy

By A. Gary Shilling
December 19, 2012 6:30 PM EST
Illustration by Stephen Cheetham
Illustration by Stephen Cheetham

Economic conditions in India became so dire last summer that the government was forced to implement reforms.

The crisis was precipitated by weakness in the global economy and the effects of recent policy errors. Other contributors were the strategies left over from the pre-1991 Soviet-style planning era and the Congress Party’s socialist background and bent toward income redistribution in favor of rural areas instead of economic growth. Furthermore, the elections scheduled for 2014 added further urgency to take action because the next budget, in the spring of 2013, will probably have a populist tinge.

India suffered from the global recession, though -- unlike China -- its economy is mostly domestically focused. This bias and India’s traditional zeal to protect local businesses, especially small shopkeepers, has prevented Wal-Mart Stores Inc., Carrefour SA and other large retailers from entering the market in a major way. Single-brand retailers such as Ikea of Sweden AB and Nike Inc. had been allowed to own 51 percent of their Indian operations.

That threshold has been raised to 100 percent as of November 2011, though the retailers must source products worth at least 30 percent of their sales from small- and medium-sized Indian companies. Also in November 2011, the government proposed allowing foreign big-box retailers such as Wal-Mart to enter India, though it backtracked on the plan after opponents said it would put small shopkeepers out of business.

Foreign Retailers

In July, however, the plan to let foreign multi-brand retailers own as much as 51 percent of local ventures was revived to attract foreign direct investment, improve supply-chain infrastructure, raise incomes for farmers by cutting out marketing middlemen, and reduce costs for consumers.

Nevertheless, individual Indian states have to approve the proposal, and only nine out of 28 have done so promptly. The central government also is allowing single-brand foreign retailers to source from bigger Indian companies.

With poor infrastructure, including inadequate warehouses and cold-storage facilities, and difficulties in buying land, Wal-Mart says it will take a year to 18 months to open its first Indian store, and profits may be much further off. A maze of sales taxes, local road taxes and other levies add to costs. Furthermore, foreign retailers are only allowed in cities of more than 1 million people as a way to protect small-town retailers.

Facing similar startup problems in China, it took a decade for Wal-Mart to make money there. It may take even longer in India. In early November, the Reserve Bank of India asked the enforcement wing of the Finance Ministry to investigate Wal-Mart for illegally investing in a local supermarket chain before the recent policy liberalization. Furthermore, Wal-Mart is examining whether some of its employees violated the U.S. Foreign Corrupt Practices Act by paying bribes in India.

Among other recent policy changes geared to help the economy, foreign carriers will be allowed to own as much as 49 percent of Indian airlines. This is seen as a way to help prop up this troubled sector: Only one of India’s six commercial airlines makes a profit because of high fuel costs and the expense of jet leases.

In addition, the cap for foreign investment in cable- and satellite-television operations will rise to 74 percent from 49 percent. The government also plans to sell $5.56 billion of equity in several state-controlled companies in the current fiscal year and open the pension sector to foreign investors. To ease borrowing by local companies and spur capital inflows and infrastructure investment, the government raised by 50 percent the limit on rupee loans that infrastructure and manufacturing companies can finance overseas.

Diesel Fuel

Furthermore, the government increased the price of diesel fuel by 14 percent. Still, diesel fuel, along with kerosene, fertilizer and food, continues to be heavily subsidized. The International Monetary Fund estimates that freeing diesel prices and reforming other subsidies would eliminate about two-thirds of the baseline fiscal deficit. Also, the gap between the price of gasoline, which was deregulated in mid-2010, and still-subsidized diesel fuel has created severe problems for Indian auto producers. Gasoline prices are almost 45 percent higher than those of diesel, and sales of gasoline-fueled vehicles have declined. The 12 percent interest rate on car loans has also depressed sales.

Low diesel prices have forced the government to subsidize the losses of state-owned oil companies. Labor disputes have disrupted the Indian automotive industry, among others. In July, nine policemen and 100 managers were injured at a diesel-vehicle-producing factory belonging to Maruti Suzuki India Ltd., when workers rioted over the suspension of a worker who beat up a supervisor.

The government also hopes to cut subsidy costs by switching to direct cash transfers to individuals. The finance minister has said that giving recipients cash to buy food and cooking gas, and to cover rural job guarantees, will be more efficient than price discounts and will reduce fraud. He also said the switch will result in huge savings, though it’s not clear how.

The government’s five-year plan targets a deficit of 5.3 percent of gross domestic product for the fiscal year ending March 31, with the shortfall shrinking to 3 percent by 2017. The IMF, however, says the budget deficit may widen to 9 percent of GDP this fiscal year from 5.8 percent in the previous 12 months.

The recent batch of reforms was clearly forced on the government, and it remains to be seen if they will be pursued vigorously and effectively. In any case, the coalition government apparently hasn’t convinced the Reserve Bank of India that the weak economy and new reforms warrant a further cut in interest rates, even though the central bank set deficit reduction and encouragement of foreign direct investment as prerequisites for monetary easing.

GDP Forecasts

In July, the Reserve Bank of India also lowered its real-GDP-growth forecasts for the current fiscal year to 6.5 percent from 7.3 percent. Many forecasters expect growth to be as low as 5 percent. In the third quarter, real GDP fell 0.4 percent at annual rates from the second quarter.

The central bank continues to be concerned about inflation, which accelerated to 9.6 percent in October compared with a year earlier. Artificial demand created by food and fuel subsidies, and inefficient supply, give inflation an upward bias and insulates it from monetary- and fiscal-policy control.

In any event, in justifying its decision in September to leave interest rates unchanged, the central bank stated, “In the current situation, persistent inflationary pressures alongside risks emerging from twin deficits -- current account deficit and fiscal deficit -- constrains a strong response of monetary policy to growth risks.” The Reserve Bank of India hasn’t moved since it cut its policy rate by 0.5 percentage point in April, though in September it did reduce bank reserve requirements by 0.25 percentage point to 4.5 percent of deposits.

Unlike the U.S., India doesn’t enjoy the luxury of being able to run twin deficits. Foreigners so value the dollar and U.S. Treasuries that they freely recycle the dollars they receive from the U.S. current-account deficit. Those recycled greenbacks help finance the budget shortfall.

(A. Gary Shilling is president of A. Gary Shilling & Co. and author of “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation.” The opinions expressed are his own. This is the fourth in a five-part series. Read Part 1, Part 2 and Part 3.)

To contact the writer of this article: A. Gary Shilling at insight@agaryshilling.com

To contact the editor responsible for this article: Max Berley at mberley@bloomberg.net

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