The Indian economy is going through a mixed phase of both growth and consolidation on the one hand and uncertainty on the other. In his 2005-06 budget, Finance Minister P. Chidambaram warned that despite India's high growth rate, several disturbing trends have emerged over the last two years, including liquidity overhang, inflationary pressures and a decline in business confidence.
The Congress Party-led United Progressive Alliance (UPA) government has opened the economy to a certain extent continuing where the previous Bharatiya Janata Party-led National Democratic Alliance (NDA) government had left off. The federal government this week allowed 100 percent foreign direct investment (FDI) in five new areas such as power trading, processing and warehousing of coffee and rubber, construction of greenfield airports and petroleum infrastructure.
India is facing acute power shortages, which is partly the result of a mismatch between the demographics of power generation, which is concentrated in the northern and central regions of the country, and electricity consumption, which is concentrated in the southern and western regions.
The power sector could be attractive to foreign investors, but the government would have to amend the Electricity Act of 2003 to allow power trading, which would also reduce regional imbalances in power sources and therefore tariff levels.
The government is keen to reduce controls in several sectors of the economy; it would have to invest much more in infrastructure, such as transmission to attract the requisite FDI flows.
The economic reform task ahead is tough. The GDP growth rate in 2004-05 has been estimated at 6.9 percent with the manufacturing sector expected to grow at 8.9 percent. However, while industrial growth averaged at 8.8 percent for the period April-September 2005 compared with 8.3 percent for the corresponding period in 2003; the average growth of the infrastructure sector was down to 4.6 percent for the April-October 2005 period compared with 6.8 percent for the same period in the previous year.
This trend followed the growth in exports. Exports for the April-October 2005 period were up 22.1 percent compared to 27.9 percent for the same period in 2004. Imports, however, grew slower at 33.1 percent compared with 35.3 percent for the same period. The country's foreign exchange reserves, excluding gold and SDRs (special drawing rights of the International Monetary Fund) stood at $137.29 billion at the end of October 2005.
Inflation has been reined in during 2005 and this has boosted business confidence. But this has largely been due to market forces rather than the Reserve Bank of India's tight monetary policy. Higher production has helped to maintain demand and supply parity, which in turn has had a stabilizing effect on prices.
The manufacturing sector, for instance, recorded a nine percent rise in production between April and November 2005 over the corresponding period in 2004. At the same time the rate of growth in the monthly wholesale price index (WPI) declined sharply from 5.2 percent in April-November 2004 to 2.8 percent for the same period in 2005.
More worryingly, the prices of grains have increased sharply following a fall in production in 2004. The average monthly WPI of grains increased by 5.6 percent in 2005 compared to a rise of 1.6 percent in 2004.
The 2005-06 budget will continue to focus on initiatives to tackle rural poverty and unemployment. Last year Chidambaram highlighted the goals of the government under the Bharat Nirman Plan to be implemented over a period of four years for building infrastructure, especially in rural areas.
These include bringing an additional land under assured irrigation, connecting all villages that have a population of 1,000 (500 in hilly/tribal areas) with a road, constructing additional houses for the poor, providing drinking water to the remaining 74,000 habitations, and providing electricity and phone connectivity.
While the management of the economy has received some praise both locally and internationally, there is growing concern that the economy is heading for a boom-and-bust economic cycle. This is largely due to booming asset prices, especially real estate, and a benign interest rate environment, with interest rates averaging six percent in 2005. In such an environment, investment managers may be prone to taking far greater risks.
Raghuram Rajan, chief economic adviser to the IMF, for instance, in a recent speech in India, strongly urged "extra vigilance" by the monetary authorities against real estate price inflation, which he said was necessary to avert a boom-and-bust cycle.
In 2005, the RBI started imposing stricter regulations on banks to mitigate their exposure to the real estate and housing sector, and to deter investment managers from taking excessive risks in the financial markets. He suggested an incentive structure for investment managers such as a cut back on regulatory capital requirements.
(Mushtak Parker is a financial analyst based in London.)
