Its the politics stupid
On the political front, 2008 is unlikely to be a quiet year. Elections in the critical state of Gujarat will kick off what could be a volatile year with mid-2008 elections a strong possibility. The Congress-led ruling United Progressive Alliance (UPA) may seek to buck the anti-incumbency trend and the seeming disarray in the opposition camps to seek an early vote. Expect market volatility to increase if elections seem nigh and markets to react to important bits of political news.
Meanwhile, rising inequality, demands for reservations and protests against land acquisition threaten to mar the local investment climate and once again lower reform and growth aspirations of the political class. Even though the economy has become increasingly divorced from the politics, crucial reforms such as opening the financial sector and retail, enabling Special Economic Zones (SEZs), resuscitating a moribund agricultural sector, reducing the fiscal deficit, and improving health and education require determined political action. Therefore, continued reform inertness constitutes a significant long-term threat to the India growth story.
A dangerous neighbourhood
With political instability in Pakistan, Sri Lanka, and Nepal, and army rule in Bangladesh, the South Asia region is not exactly an oasis of tranquillity. Risks of a large negative shock in one of the neighbours leading to some spill-overs onto India have increased. However, Indias limited economic ties with the rest of South Asia suggest that the fall-out on the domestic economy may be limited.
Of greater consequence is the general slowdown in activity in the rest of the worldand the impact on the economy. We estimate that a 1% slowdown in the US, impacts India by about a quarter of a percentage point. However, the impacts are non-linear with a US recession having a much larger impact. Indias reliance on domestic demand and lower external linkages implies it is relatively more shielded from a US downturn than other emerging markets.
Upside risk to aggregate demand stems from any fiscal loosening. With general elections on the horizon, fiscal profligacy may be expected through an increase in subsidies and other government programs such as the National Rural Employment Guarantee Act. In addition, there are two other significant fiscal pressures. The government has chosen not to increase domestic oil prices even as international prices have risen, but to provide off-balance sheet subsidies to the oil companies, thereby significantly increasing the quasi-fiscal deficit. Second, the Sixth Pay Commission submits its report on public sector wages in April 2008. By precedent, pay commissions normally result in a sizable upward revision of pay scales which increase demand.
We think that even though revenue buoyancy (tax revenues have been increasing by over 25% for the last three years) will help, the government will find it difficult to reduce the fiscal deficit as mandated under the Fiscal Responsibility Act, and thus may add to demand.
The risks to our growth projections are roughly balanced, with larger-than-expected inflows or impact of monetary and fiscal policy easing compensating for a worsening of the political and external climate.
We think concerns of a much larger slowdown la 1997-2001, when economic growth slowed to less than 5.5% after three years of nearly 8% growth, on the back of significant monetary tightening are overdone. The economy is structurally very different from 1997. Continued opening up to trade, rapid growth in the financial sector, and the IT and communications revolution are all recent developments which have unleashed productivity benefits and have considerable distance left to run. In addition, nearly every macro-indicator is more favourable from higher savings and investment rates, lower fiscal deficit, strength in the financial and external sectors, lower interest rates, higher reserves, and lower external debt. In early 2007, we had estimated that Indias potential growth had ratcheted up from about 6% in the 1990s to about 8% currently due to structural factors.
None of the structural factors have changed, although their strength will be put to the test in 2008 as the economy faces cyclical resistance from high interest rates, currency appreciation, high oil prices, and a worsening global economy. Be that as it may, we believe opportunities to invest in one of the more dynamic emerging economies will remain plentiful.
Excerpted from Asia Economics Flash economic research from the GS Institutional Portal The Goldman Sachs Group