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The Present State and Prospects of the Indian Economy and Economic Policies

Koji Kobayashi
Senior Economist Mizuho Research Institute Ltd. (Research Department-Asia)

Introduction

In India, where the term of office of legislators in the Lower House will expire in May 2019, the general election campaign that has already started is evolving around, among other issues, on the Modi administration's economic management. While China, which has driven the world economy, now suffers from a lowering growth rate, the Indian economy, which is the second largest after China among the emerging economies, is attracting overseas attention. This paper is intended to examine the Indian economy, focusing on the Modi administration's economic policies. Section 1 will summarize India's economic overview and review the economic history of India after Independence; Section 2 will analyze economic trends and policy trends under the Modi administration, and Section 3 will discuss the future prospects of the Indian economy and its economic policies.

1. India's economic overview and the Indian economic history after Independence

(1) India's economic overview

The population of India as of 2018 is 1,136.9 million (IMF estimate1). It is the second largest in the world after China's 1,390.1 million, and about ten times larger than that of Japan. According to a United Nations forecast2, the population of India will continue to increase, to exceed that of China in the first half of the 2020s, and will reach a peak of 1,680 million around 2060.

India's nominal GDP is 2.6 trillion dollars (IMF estimate) in 2017, sixth in rank in the world after the United States (19.4 trillion dollars), China (12.0 trillion dollars), Japan (4.8 trillion dollars), Germany (3.7 trillion dollars), and the United Kingdom (2.6 trillion dollars) --- following on the heels of that of the United Kingdom, India's former suzerain state. The IMF estimates that India will overtake the United Kingdom in 2019, in terms of nominal GDP.

India's nominal GDP per capita is 1,976 dollars in 2017 (IMF estimate), far behind Japan's 38,449 dollars and China's 8,643 dollars. Compared with major emerging countries in Asia, it is somewhat lower than Vietnam's 2,353 dollars. In the World Bank's World Development Indicators that classify countries based on nominal GNI per capita (GDP plus income from overseas)3, India ranks as a "lower middle income country" along with the Philippines, Indonesia, Vietnam, etc., while Japan ranks as a "high income country" and China as an "upper middle income country."

When it comes to India's industrial structure, the primary industries account for 17% of the 2017 nominal GDP, the secondary industries 29% (manufacturing industry: 17%, the rest: mining, construction, etc.), and the tertiary industries 54%.4 Compared with Asian countries of the same level of development, a feature of India's industrial structure is that the ratios of the primary and tertiary industries are high, while that of the secondary industries is low. India's tertiary industries, represented by IT-related high-tech services, include various businesses such as distribution, finance, and real estate, to name a few.

Looking at the composition of India's exports, the largest item is jewelry and precious metals. Businesses that import raw ores and re-export polished and processed products using inexpensive labor force are active.5 Next come exports of textiles and agricultural and marine products. Generally speaking, India is competitive in exports of labor intensive or low value added merchandize.

(2) The economic history of India in the post-Independence era6

Looking back at the years after Independence in 1947, the initial INC (Indian National Congress) administration adopted a socialist planned economic system. The industrial licensing system, one of its major policy measures, allowed government-licensed corporations alone to engage in business activities, in order to protect existing domestic industries. Due to the rigid economic system, the Indian economy stagnated and the yearly growth rate lingered at around + 3% --- this situation mocked as "Hindu growth rate" continued until the 1970s.

In the 1980s, partial economic liberalization began under the INC administration. The industrial licensing system was relaxed and foreign capital companies were allowed entry. For example, it was in 1982 that the Suzuki Motor Corporation of Japan entered the Indian market.

When the Gulf War broke out in 1990, homeward foreign currency remittance from Indian migrant workers in the Gulf area declined, and in the following 1991, an economic crisis took place, where India's foreign reserves dropped to a critical level of covering payment for just two weeks' imports.

The 1991 crisis marked a turning point for economic liberalization in India. As if pushed from behind by the crisis, the then INC administration led by Prime Minister Rao implemented a big bang type of economic reform. Finance Minister Singh took control of the reform, abolishing the industrial licensing system. Afterwards, Prime Minister Vajpayee from the Indian People's Party (BJP), who first assumed power in 1998, took various measures, including the promotion of IT industry.

Due to these efforts, India's economic growth rate rose, and it began to stay at around + 7% from the latter half of the 1990s. In 2003, the US investment bank Goldman Sachs coined the acronym "BRICs" made up of each initial letter of Brazil, Russia, India and China, and India was included as one of such remarkably developing emerging countries.

When the INC returned to power in 2004, Dr. Singh, who took control of the 1991 economic reform as finance minister, was sworn as prime minister. Expectations increased for continued reform. In his first term, the Indian economy registered a high growth of +8% to +10%; however, in his second term from 2009 the ruling coalition party failed to maintain its majority in the Lower House, weakening its power base. As a result, the government's economic policy lost momentum and the Indian economy deteriorated. The Indian economy suffered from a declining growth rate, an upswing in inflation, and twin deficits in the fiscal balance and the current account. In 2013, the economy was hit by a sharp depreciation of the rupee. It was this year that India, which had been praised as a major "BRICs" player, was designated as part of the "Fragile 5", along with Turkey, South Africa, Brazil and Indonesia, all of which faced a sharp currency depreciation around the same time.7

At the time of the General Elections for the Lower House in 2014, the deterioration of the economic situation prompted momentum toward a change of government. As chief minister of the Gujarat state, Narendra Modi had earned a reputation for his successful economic reforms. The BJP fought the General Elections to elect Modi as prime minister of the country, and won a historic victory by securing the majority in the Lower House by a single party for the first time in 30 years. Prime Minister Modi came up with a policy guideline nicknamed "Modinomics." The public had high expectations for Modi to implement such a big bang type reform as in 1991, utilizing his strong political power base.

2. The Indian economy and economic policies under the Modi administration8

This Section will analyze trends of main economic indicators under the Modi administration, based on economic indicators, and will discuss the administration's economic policy management related to the trends.

(1) Economic growth rate

India's economic growth rate per annum was +6.4% toward the end of the Singh administration (2012-14). It rose to +7.4% under the Modi administration (2014-present). If considering the long-term average growth rate to be the potential growth rate, it is assumed that India's potential growth rate has increased by 1% PT under the Modi administration compared with the last days of the Singh administration.

Looking at item-wise demand growth rates, growth in investment and consumption has been accelerating since the inauguration of the Modi administration. The growth rate rose thanks to increasing domestic demands. In contrast, growth in exports rather slowed down.

As background of investment growth under the Modi administration is the improvement of the investment environment in India. The Modi administration worked on the improvement of the investment environment, adopting the World Bank's Ease of Doing Business Index as a benchmark. This index evaluates scores of ten business regulations, such as the ease of starting up businesses and the ease of acquiring construction permits, for 190 countries. Although the index for India at the transition period from the Singh to the Modi administration ranked 130th to 140th in the world, it rapidly rose to the 100th place in 2016-2017. In the latest 2018 survey, India ranked 77th.9 For example, the Modi administration's efforts to utilize IT in business were highly evaluated --- electronic payment of employees' provident fund, online construction permits and online trade procedures.

The Modi administration's economic policies to ensure its certainty have encouraged corporations to implement their long-term investment plans. Toward the end of the Singh administration, the INC to which the prime minister belonged was unable to take leadership in the multi-party coalition government. The media criticized the administration for its "policy paralysis" fraught with frequent policy revisions. Meanwhile, the Modi administration worked on policy management under the personal leadership of the prime minister, taking advantage of the coalition structure where the BJP dominating the majority in the Lower House subjugates smaller parties. According to the economic policy uncertainty index developed by a US research institute "Economic Policy Uncertainty," the certainty of economic policies has improved under the Modi administration compared with the Singh administration.10

(2) Inflation rate

India's consumer price index (CPI) growth rate marked two-digit values on year-on-year basis toward the end of the Singh administration (2012-2013). Under the Modi administration, it turned stable in the inflation target range + 4% ± 2% of the Reserve Bank of India (India's central bank, hereinafter as RBI). As of January 2019, CPI growth rate was + 2.1%. The stabilization of the inflation rate contributed to the expansion of consumption as mentioned above.

Looking at the breakdown of CPI growth rate, each commodity item has slowed its price growth compared with the era of the Singh administration. Especially, food prices are notable in their stability. Price growth has slowed down across major foodstuffs such as grains, vegetables, meat, fish, and beans --- a staple food in India.

To bring about price stability, the Modi administration began with the reform of the agricultural distribution system. The Government of India has a program where the government buys agricultural products at a Minimum Support Price (MSP) for the purpose of distribution to the poor. Agricultural products purchased at MSP will be sold to the poor at a price lower than MSP; the loss margin accruing from such transaction will be compensated by the government finance. The Singh administration increased the MSP in a great measure to secure incomes for farmers and caused price hikes of agricultural products in the general secondary market. Meanwhile, the Modi administration checked the hike in the MSP to curb the fiscal deficit, and as a result prevented inflationary pressures on the secondary market.

As another step to stabilize prices, the Modi administration reformed the management of monetary policies. The RBI practically introduced the inflation target just before the inauguration of the Modi administration. The new administration officially approved it. Furthermore, the Modi administration amended the Reserve Bank of India Act and transferred the authority to determine the policy rate from Governor to a six-member monetary policy committee (MPC) including the Governor. The formal adoption of an inflation target and MPC policy decision system intensified the independence of the RBI and the transparency of monetary policies, resulting in the suppression of inflation expectations.11

(3) Fiscal balance12

The budget deficit to nominal GDP ratio increased to 6% during fiscal 2008-2009 under the Singh administration, and lingered in the latter half of 4% range in 2012-2013 toward the end of the Singh administration. Under the Modi administration, the ratio in question began to fall and went down to a projected 3.4% in fiscal 2018. Nonetheless, India's financial restoration is considered to be still half-way, because the budget deficit to nominal GDP ratio has not yet reached a targeted goal of 3%, as stipulated by the Fiscal Responsibility and Budget Management Act.

India's fiscal deficit has been reduced, in accordance as the ratio of tax revenue to GDP has increased. Since the Modi administration has not implemented any particular tax increase, effective tax collection may be credited with the decrease of the fiscal deficit. For example, official tax collectors will be remunerated when they detect tax evasion cases. In July 2017, the government implemented a tax reform to introduce a unified Goods and Services Tax (GST), abolishing the indirect tax system across the country, which differed from state to state. The GST is intended to strengthen tax compliance rather than aiming at a tax increase. The new taxation system is designed to enlarge the taxation base by improving tax compliance.

On the expenditure side, interest payment that is the largest expenditure item accounting for one quarter of the total expenditure is fixed; on the other hand, subsidies next to interest payment in value have been reduced by the Modi administration. Subsidies for fuel purchase for the poor have been reduced. Since a financial burden associated with the agricultural distribution mentioned above was also budgeted as a subsidy, the MSP control has, therefore, led to the reduction of subsidy.

(4) Balance of payments13

The ratio of current account deficit (CAD) to nominal GDP registered 6.8% in October-December 2012 under the Singh administration --- the figure was more than double the rule-of-thumb threshold of 2.5% to 3.0%. Afterwards, the CAD began to decrease toward the end of the Singh administration, and the ratio to nominal GDP stayed in the 0% to 1% range after the inauguration of the Modi administration in 2014. However, the CAD began to increase again in and after 2017, and the ratio to nominal GDP climbed to 2.9% in July-September 2018. Looking at the breakdown of India's CAD, the petroleum-related trade deficit as well as other trade deficits (excluding petroleum) has increased since 2017. The value of oil imports increased due to crude oil price hikes, while the expansion of domestic demand caused increase in non-petroleum imports.

According to general definition of the so-called IS balance, the CAD is equal to the sum of (1) the fiscal balance of the government and (2) the difference between savings and investment in the private sector. Regarding (1), the fiscal deficit reduction by the Modi administration as described above contributed to the improvement of the current account balance. Regarding (2), however, the expansion of investment due to the Modi administration's efforts brought about a side effect of increasing the current account deficit through deterioration in the IS balance in the private sector.

As for the capital account balance, the excessive inflow of capital widened steadily under the Modi administration. Looking at its breakdown, direct investment, which represented the establishment of foreign corporations' subsidiaries in India, constituted a constant excessive inflow. The Modi administration has relaxed restrictions on foreign capitals and therefore has ensured a constant inflow of direct investment. Since the overall capital inflows including direct investment exceeded the amount required to finance the current account deficit, the accumulation of foreign exchange reserves advanced under the Modi administration.

However, in and after April-June 2018, the outflow of portfolio investments, representing short-term transactions of stocks and bonds, was observed on a large scale. As a result, despite a continued inflow of direct investment, the excessive inflow reduced in the entire capital account balance. In 2018, the United States continued to raise the interest rate; as a result, US investment returns relatively improved. Consequently, portfolio investments were withdrawn from the emerging financial markets including India's and were re-directed into the US market.

(5) The rupee-dollar exchange rate14

The rupee-dollar exchange rate fell to 68 rupees against a US dollar in August 2013 under the Singh administration, registering the lowest value in those days. The prospect of the tightening of US monetary policy that spread in financial markets accounted for the selling of the currencies of emerging countries including India. At that time, India was collectively called "Fragile 5" together with other emerging countries whose currencies fell sharply in value (see Section 1 of this paper).

Although the rupee exchange rate recovered later, it slipped back once again in 2018 due to the above-mentioned withdrawal of portfolio investments from India. It dropped to 74 rupees per a US dollar in October 2018 and renewed the record low. After that, the rupee exchange rate market regained calm, and since early 2019, the rupee-dollar exchange rate has been staying in the range of 70 to 71 rupees vis-a-vis the US dollar.

Comparing the fundamentals of the Indian economy at the times of the depreciation of the rupee in 2013 and 2018, the current account deficit was smaller in 2018 and the ratio of foreign exchange reserves to short-term external debt was larger in 2018. Indeed, the rupee depreciated more in 2018 than in 2013, but since foreign exchange reserves have increased --- enough to deal with the current account deficit or for payment of external debts ---, India will be unlikely to face the risk of falling into such an economic crisis as in 1991.

(6) Employment

India is slow in developing reliable employment statistics. According to estimates by international organizations and private research institutions, the employment situation in India seems to have failed to improve under the Modi administration. The interview surveys the present author conducted with local economic scholars and economists in India in January 2018 revealed the problem of underemployment --- small-sized or self-employed business and contract employment constituted the major source of job creation, while the creation of regular employment by large corporations was insufficient.

In general, multiple factors are intertwined with job creation. According to the argument of former RBI Governor Subbarao,15 they are not only (1) the creation of employment demand (ex. acceleration of economic growth), but also (2) the flexibility of labor markets (ex. reform of rigid labor law), and (3) the expansion of labor force supply (ex. human resources development). As for (1), the Modi administration succeeded in accelerating the growth rate. Concerning (2), however, the flexibility of labor markets was promoted in several states alone through the relaxation of dismissal regulations.16 The Modi's union government took a forward-looking posture on this issue but did not submit any relevant bill. In general, the relaxation of dismissal regulations means that corporations could easily dismiss employees in times of recession and could employ workers with ease at ordinary times. It is a policy unacceptable to workers. Even the Modi administration, which built a solid foundation in the Lower House, seems to have hesitated to implement this policy that is unpopular to workers who make up the majority of voters. As for (3), there is no noticeable change in the long-standing situation where Indian workers are not equipped with necessary skills.

(7) Manufacturing industry promotion

The Modi administration proposed the Make in India Initiative to address the underdevelopment of the manufacturing industry mentioned in Section 1 of this paper, and to promote it. The administration set numerical targets to raise the ratio of manufacturing industry to GDP from a stagnant 17% to 25%. However, this ratio has remained flat around 17% under the Modi administration and no particular change has appeared so far.

According to a questionnaire survey conducted by the Japan Bank for International Cooperation with Japanese manufacturers, many respondents pointed out that India's insufficient infrastructures, remarkable compared with other emerging Asian countries,17 constitute an obstacle to the development of manufacturing businesses in India. When it comes to infrastructure development, since India's fiscal restoration is underway as mentioned above, budgets for this purpose are substantially restrained. There are other restrictions peculiar to India. It is difficult in the country to acquire land necessary for infrastructure development. In order to speed up the acquisition of land for infrastructure development the Modi administration attempted to amend the Land Acquisition Law, thereby exempting developers from acquiring consent from landowners, and from conducting a social impact survey, as far as infrastructure development in five areas is concerned, including the construction of industrial corridors. However, due to a "twisted parliament" --- the ruling BJP holds the majority in the Lower House but not in the Upper House ---, the amendment bill submitted by the BJP was shelved without support from legislators in the Upper House.18

(8) An overall evaluation of India's economic performances and economic policy under the Modi administration

To summarize the above, India's macroeconomic performances have improved in terms of the economic growth rate and the inflation rate under the Modi administration, compared with the preceding administration. Certain improvements, insufficient as they are, are observed in the fiscal balance and the current account balance. However, little progress has been made about employment creation and manufacturing industry promotion.

Looking at related economic policies, progress has been made in macroeconomic policies targeting economic growth promotion, inflation control, fiscal restoration, and current account balance improvement. Meanwhile, concerning employment creation and manufacturing industry promotion, the labor law revision did not progress and the infrastructure construction encountered budgetary restraints.

The Modinomics, which was expected to advance in a big bang style against the backdrop of the BJP's overwhelming power base in the Lower House, seems to have made only partial progress, hindered by the intractable oppositions in the Upper House (Fig. 1).

3. The future prospects of the Indian economy and economic policies

Economic development models may vary in accordance with the stages of economic development. For example, at the stage of "lower middle income country" to which India belongs, ordinarily labor-intensive industries occupy the center of economic activity with labor input as growth driver. It will be a challenge for India as a "lower middle-income country" to promote capital-intensive industries with capital input (investment) as growth driver, thereby becoming a grade higher "upper middle-income country." (Fig. 2.)

In a mid- to long-term outlook of the Indian economy where almost all factors are uncertain, demographic dynamics is noted as a relatively reliable factor. In particular, the ratio of the production-age population of 15-64 years old to the total population is important. During the period when the ratio continues rising, or a "population bonus" period, labor input is apt to increase, as the population of working generation increases; and furthermore, in accordance as the ratio of the population of working generation rises, the savings rate (savings / income) is also likely to increase across the country. Thus, savings are expected to be invested in capital investment. The United Nations forecasts that a "population bonus" in India will continue until around 2040. Therefore, expectations are high not only for labor input essential to immediate economic growth, but also for the expansion of capital input for a mid- to long-term development.

Nonetheless, the effect of a population bonus may not be unconditional, but conditional on the improvement of environment for effective use of labor and capital. The improvement of environment will include, among others, human resources development, labor market reform, and financial system improvement to utilize collected savings into investment.

Our analysis employs the Global Competitiveness Index of the World Economic Forum as a proxy variable indicating comprehensive aspects of the improvement of environment that contributes to economic growth. This index evaluates into score factors of each of 140 economies --- factors which affect a long-term economic growth of each economy, based on about 100 economic indicators. An international comparison is conducted by use of the 2017 index levels and index variations in the past five years as momentum.

According to this analysis, India has a high level of competitiveness among "lower middle income countries," and in recent years, its improvement momentum has been strong (Fig. 3). Indeed, India still faces many challenges as discussed in Section 2. However, compared with countries at the same development stage, It is situated in a better environment to utilize a population bonus. Consequently, there is a high possibility that the country will develop in the mid- and long-term future.

However, it should be noted that the improvement of the economic environment that promotes economic growth is now becoming opaque. This is because the support rate of the Modi administration is declining toward the General Elections in May 2019. According to polls conducted regularly by a leading weekly magazine "India Today" and a forecast based on the poll of the General Elections for the Lower House, the ruling BJP coalition may fail to secure the majority. It is the latest January 2019 survey result and indicates the ruling coalition's set back from the majority for the first time after the inauguration of the Modi administration. According to this forecast, although the BJP coalition is expected to lose the majority, the BJP will keep the position of the largest party. So, it is still possible for the BJP to maintain the administration by incorporating part of the oppositions, but the presence of the BJP will diminish in a wider coalition. In case of such a wider coalition government, it is uncertain whether the ongoing reforms, partial as they are, driven by the Modinomics can keep the momentum. The potential growth rate of the Indian economy seems to have risen from the mid + 6% range at the end of the Singh administration to the mid + 7% range under the Modi administration, thanks to the reforms (See Section 2 (1) of this paper). Whether, however, or not the accelerating increase of the potential growth rate will continue is also uncertain.

A possible risk scenario is that if the INC-led opposition coalition succeeds in taking over the BJP's Modi administration, they may resort to a "money-scattering" policy although the details of the "minimum income guarantee scheme" pledged by the INC are not apparent at this moment.

While the direction of reforms and economic growth is becoming unclear at the national level, reforms and economic growth are expected to progress at the state level. In India, a federal state, state governments are endowed with a certain degree of authority and are in a position to carry out their independent reforms. The Modi administration has advocated "competitive federalism" where each state should compete for reform progress, and there is actually created a climate for each state to competitively improve the investment environment to invite corporations.

As a tool to encourage the "competitive federalism," the Modi administration has developed a Business Reform Index to evaluate each state's reform efforts. The new index is modeled on the World Bank's Ease of Doing Business Index. Although the states are not uniform in their commitment to business reforms, they are reportedly working on economic policies, with intention to improve their ranking in the index.

Since India is a huge country with diversity in terms of ethnicity, religion, language, etc., it is significant to view its economy and policy trends not only of a single country, but also state by state.

Bibliography

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