This time around India's government looks to be serious about its plans to lift the country out of its economic misery and keep its investment-grade rating.
After enduring months of embarrassing speculation over whether it will be the first Bric nation to be downgraded to junk, India snuffed out the imminent danger of such a credit move by announcing a number of reforms to help plug the widening deficit and inject foreign cash into the capital-starved economy.
In a commendable move on September 14, the government said it will hike diesel subsidies by INR5 per litre (US$0.10) and raise foreign investment caps on sectors such as aviation and cable networks to 49% and multi-brand retail to 51%.
The announcements came at a political cost, with the ruling Congress party losing the support of the Trinamool Congress, a major political party ally, and with it its majority in parliament.
The willingness of prime minister Manmohan Singh's government to pursue them nonetheless deserves recognition. The premier, who built his reputation when reforming India's stumbling economy in the early nineties, conducted a rare, televised speech from his office on September 21 to defend the necessity of the reforms. His willingness to publicly back them in such a manner has helped cement confidence that he and his party will do “everything necessary” to make sure these reforms are implemented, although he also reminded the public that it will require difficult decisions.
But the fact Singh felt the need to emphasise that these reforms will be followed through also reflects the concern that the measures will face formidable challenges and delays. This is why it is too early for India to think that they have moved far away from the threat of a credit downgrade.
Fitch said in a statement on September 17 that the reforms look credit positive at first glance, but that considerable execution risks remain. Moody’s, which rates India ‘Baa3,’ said the risk of these reforms from rolling back outweigh any positive benefits.
That’s because India has a poor track record of following through on reforms and policy changes. Such was the case in November when parliamentary interference caused delays on foreign direct investment (FDI) announcements on multi-brand retail reforms. Standard & Poor’s, which rates India ‘BBB-,’ said in June that inefficient policy implementation could result in a junk rating. HSBC cited the Reserve Bank of India as saying that policy uncertainty cost the country one percentage point of GDP in 2011.
Execution risk certainly lurks in the details of these newly announced reforms. Take a look at the multi-brand retail sector, for example. Individual states can choose to accept whether they want to implement such measures, and only nine of 28 states, including Delhi and Andra Pradesh, have said they will allow it. Other major cities such as Bangalore, Chennai and Kolkata have yet to accept these reforms.
This is a problem. To begin with it reduces the potential revenue flows to international retail investors. Additionally, to establish local retail outlets foreign retailers have to spend a lot of money on backing infrastructure such as transport and processing facilities, some of which may need to be established in states that have not approved these reforms. This may trigger unnecessary tension between a state and a foreign retailer, or may force the retailer to invest more in infrastructure than previously planned.
To ensure successful implementation, the government need to clarify investment guidelines on infrastructure that will have to be built in states that have not adapted these multi-retail reforms. New Delhi should also specify whether the minimal investment requirements will change if the foreign retailer invests in infrastructure that is scattered in states that have not accepted these reforms. If so, the foreign retailer should be given certain exemptions.
The government should also try to educate its populace in general on the many benefits of allowing in foreign retailers into India. More efficient infrastructure networks means more timely deliveries, which in turn helps to lower the cost of goods and means families have more money to spend on other products. That may force farmers, street vendors and mom-and-pop stores to change, but it doesn't necessarily mean that they have to lose out. The government should advise them on how best to adapt too.
Additionally New Delhi should send advisers to each state to teach them about how best to negotiate prices with large-scale counterparts and how to promote jobs at foreign retailers. This would help expedite the process of getting all the states to accept the reforms, increase the economic impact and ensure successful implementation in order to keep its investment-grade rating.
It would also help if India could make its investment process less bureaucratic. The country is notorious for the amount of approvals and regulations demanded of investors, which frustrates their interest and raises the possibilities of public sector graft.
Additionally, the Reserve Bank of India and Ministry of Finance should develop its financial system further so that domestic banks will be able to largely service the cash management and remittance needs of these foreign investors, as well as work to make the rupee convertible.
Narrowing the deficit
The good news is that despite the challenges ahead, the new reforms have somewhat boosted sentiment in the economy. The rupee is now trading near a four-month high of INR53.10 against the US dollar. The government’s subsidy cuts on diesel and LPG (liquefied petroleum gas) cylinders will also increase confidence among foreign investors that India is able to push through crucial structural changes to narrow the current-account deficit.
But New Delhi will need to keep cutting its subsidies if it is to balance its budget. HSBC estimates that the latest cuts will cause the government deficit to drop to 5.8% of GDP this financial year, still well over its initial target of 5.1%. It is important that the government successfully implements these reforms in the initial stages to sustain an improvement in FDI and foreign inflows. That way the next time New Delhi announces more subsidy cuts the economy will be in better shape to accept rising costs.
Above all India has to show foreign investors and ratings agencies alike that it has the intention and the ability to keep cutting subsidies and opening its economy. Fail to follow through on these reforms and both groups may decide that there is little hope for the country's economic development.
After months of inertia India's government should be credited for championing these reforms, but an absence of implementation will only expedite a downgrade to junk.