Factors Shaping India’s Positive Economic Outlook

By Dezan Shira & Associates

Posted: 22nd April 2016 09:45

Amidst the declining optimism towards emerging economies, India’s economic outlook remains positive. This is due to the Bharatiya Janata Party (BJP) led government’s dual focus on economic reforms and maintaining fiscal discipline, and a strong monetary policy directed by the Reserve Bank of India (RBI). In the context of the global commodity slowdown, it helps that India is not an export-dependent nation. These factors underline the World Bank’s positive projection that India’s gross domestic product (GDP) will grow at 7.5 percent in 2016 and 7.7 percent in 2017.
 
Working Towards an Optimal Policy Mix
 
Attaining an optimal policy mix entails maintaining a balance between monetary and fiscal policies to ensure long-term sustainable growth.
 
Fiscal Policy: The Ministry of Finance is responsible for the government’s spending and taxation plan to steer aggregate demand in the desired direction. Outlined in the annual budget, it impacts income distribution, savings, and investments.
 
When government expenditure exceeds revenue, a ‘fiscal deficit’ arises. India aims for this to be 3.5 percent in its 2016-2017 budget. Deficit spending is currently accommodating the wage hike recommendations of the Seventh Pay Commission to stimulate consumption and business growth.
 
Monetary Policy: The RBI, the country’s central bank, conducts monetary policy. The RBI also influences specific inflation rates and interest rates by changing the money supply in the economy. A low interest rate encourages borrowing, thus spurring consumption. Yet, if the rates are depressed for too long, inflation arises due to excessive demand. Other strategies include buying or selling government securities from or to the public and banks, and altering the liquidity in markets by changing the types of assets/reserves held by the RBI and/or other banks.
 
The RBI Governor, Raghuram Rajan, has exerted caution over lending and banking rates, irrespective of the high growth forecasts. His aim is to achieve an inflation target of five percent by 2016-2017. Most of the RBI’s principal interest rates have been kept unchanged, including the base bank rate, the statutory liquidity ratio (SLR), the reverse repo rate, and the marginal standing facility rate. However, the repo rate (rate at which the RBI lends money to commercial banks) was cut by 25 basis points on April 5 from 6.75 percent to 6.5 percent. Rate cut benefits, if transferred to consumers, boosts borrowing. The RBI also increased the Credit Reserve Ratio (CRR) allowing banks to hold more money.
 
Targeting Non-Performing Assets and Changes in Capital Requirements
 
The RBI has created a central repository, allowing it to see the balance sheets of banks. Large corporate defaulters have currently pushed India’s public banks into a tight corner. Recently, the RBI became aware that stressed assets were not being labeled as Non-Performing-Assets (NPAs). This is because assets declared as NPAs need to be backed up by more capital (as collateral), pressurizing banks to lend less. In India, the bulk of stressed assets are due to government interference, loan waivers, and difficulties in recovering dues.
 
The RBI has responded to the crisis by boosting the ability of asset reconstruction companies (ARCs) to facilitate the cleanup of public sector debt. ARCs stimulate the economy by resolving bad loans. They buy distressed assets from banks, card companies, and other financial institutions, and re-package them to sell in the market. Banks can sell NPAs to ARCs at a discounted price to clean up their balance sheets. ARCs can also float bonds in order to directly recover dues from borrowers.
 
To induce an influx of capital, companies like J C Flowers & Co and Apollo Global Management are now allowed to set up ARCs in India without the previously required regulatory approval. Edelweiss ARC, the country’s biggest bad loan buyer, plans on buying US $2.4 billion (Rs 160 billion) worth of bad loans this fiscal year; it will need about US $300 million (Rs 20 billion) in new capital before reselling at a profit.
 
Capital Adequacy Ratio (CAR) is another tool that aids public debt consolidation. It is defined as the measure of a bank’s financial strength expressed by the ratio of its capital (net worth and subordinated debt) to its risk-weighted credit exposure (loans). Most banks in India have a capital adequacy of more than 12 percent. Banks with higher capital adequacies are safer because if their loans go bad, they can rely on their net worth. The increase of the CAR has allowed banks to recognize part of their real-estate assets, foreign currency assets, and deferred tax assets as capital, effectively moving them from their Tier 2 reserves to their more accessible Tier 1 reserves so as to combat capital-hungry NPAs.
 
The recovery of NPAs by ARCs will prevent further stalling of large-scale projects, ease borrowers’ abilities to pay back debt, and relax the constriction of cash flows of private companies (currently corporate earnings lag behind despite the high GDP growth rate). Increased scrutiny over NPAs will also produce a more transparent, competitive business environment – one more devoid of corruption.
 
Proposed Legislative Reforms
 
The 2016-2017 Union Budget reiterated the government’s focus on addressing the structural deficit in India’s economic framework. Apart from the budget’s stimulus for infrastructure and agriculture spending, various critical bills are currently stuck in the upper house of parliament. If the bills get passed, they will boost real growth by combatting regulatory pressures and ease doing business in India.
 
Some of the important bills are:
 
Goods and Services Tax (GST) Bill: The proposed GST seeks to replace the current tax system where a specific good is taxed on production and then again on sale. Currently, State Value Added Tax (VAT), which varies from state to state (like other aspects of compliance) causes unnecessary complexity. The additional Central Service Tax or excise duty paid on inputs results in high costs for service providers and traders. Reduced costs and less inter-state trade time will result from the GST law. Also, businesses registered under the GST would be eligible to take tax credit on the GST paid on goods and services.
 
Insolvency and Bankruptcy Code Bill: According to the World Bank’s Ease of Doing Business report, it takes about 4.3 years to resolve insolvency in India. The bankruptcy bill aims to reduce the resolution time to less than a year. The bill proposes a time bound framework for the debt reorganization of corporate partnership firms and individuals. This prevents loss of asset value by easing the exit of failing entities from the business environment. If passed, it could benefit entrepreneurs as credit will become more freely available, and payment of government dues would be prioritized.
 
Land Acquisition Bill: This is another highly awaited law, which will boost transparency in land dealings, leading to savings in project costs. The land bill is concerned with the acquisition of rural private land by the Union or State for industrialization, development of infrastructural facilities, or urbanization. It provides for proper compensation (while taking into account price rise), rehabilitation, and resettlement of affected land owners.
 
India’s Reaction to External Headwinds
 
How India reacts to several current properties of the global economy will shape its progress towards a stronger manufacturing sector, increased entrepreneurship, and employment.
 
Weakening Commodity Prices: Being a net importer of crude oil, India benefits significantly from falling oil prices. To ensure gains in the trade deficit, the government has sought to dampen domestic demand for costly commodities like gold with a high import tax rate, a domestic excise duty, and new schemes like Sovereign Gold Bonds. Rising foreign direct investment (FDI) in response to the government’s ‘Make in India’ drive also helps to narrow the current account deficit.
 
India’s Currency Reaction: Despite suffering from relatively lower exports due to the global slowdown, the RBI is insistent on avoiding currency devaluation. Moving away from the equilibrium-determined currency could compromise the competitiveness of Indian exports. Devaluation makes imports more expensive and Indian producers could get complacent and less innovative, stifling long-term productivity.
 
Slowdown of China: India has been shielded from the Chinese slowdown, relative to other countries, mainly due to its weak export links with the northern neighbor. As a net importer of commodities like metals, India benefits from the Chinese slowdown in manufacturing. The situation can also allow India to become an alternate exporter in some categories, and lower labor costs aid India in this endeavor. However, the global commodity slowdown has negatively impacted India’s own domestic heavy manufacturing sectors, and is a long-term threat.
 
Observations
 
India is precariously positioned. While FDI inflows are crucial to its growth, structural changes are required to attract and retain them. The public perception of India is crucial to foreign investors. Towards this, the government and the RBI are aggressively targeting policy reforms to reduce inefficiencies, increase transparency and accountability, and ease doing business in the country. Responsible fiscal and monetary policies aid India’s plans to achieve its projected high growth rate, and are fundamental in combatting the current slowdown in the global economic recovery.
 
Since its establishment in 1992, Dezan Shira & Associates has been guiding foreign clients through Asia’s complex regulatory environment and assisting them with all aspects of legal, accounting, tax, internal control, HR, payroll and audit matters. As a full-service consultancy with operational offices across China, Hong Kong, India and emerging ASEAN, we are your reliable partner for business expansion in this region and beyond.
 
For inquiries, please email us at info@dezshira.com. Further information about our firm can be found at: www.dezshira.com

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