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India: slow reform progress prevents the economy from growing faster

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India’s economy is expected to grow strongly at roughly 7.5% in 2016 and 2017, although, among others, a slow reform progress will prevent the Indian economy from growing at a faster rate. India’s external position has strongly improved since 2013, but there are some reasons for caution.

Strengths (+) and weaknesses (-)

(+) Positive demographic characteristics

India will enjoy the benefits of a growing working age population. This should boost economic growth in the years ahead.

(+) Large and diversified economy

India has a large, diversified economy, which limits its vulnerability to external shocks. While the agricultural sector is the main employer, the services sector accounts for about two-thirds of GDP.

(-) Infrastructural bottlenecks and difficult business environment

Infrastructural bottlenecks are estimated to reduce GDP growth by one to two percentage points per year. Businesses also face hurdles in the form of red tape, corruption and state intervention.

(-) Political environment hampers reform process

The federal structure of India complicates decision making and policy implementation, while the political environment remains fragmented, even after the BJP securing a majority in the Lok Sabha.

Key developments

1. Loss in Bihar state elections implies reform pace will remain slow

The pace of reforms is expected to remain slow, as the party of Prime Minister Narendra Modi, the Bharatiya Janata Party (BJP), was defeated in the Bihar state elections in November, while in 2016 there will be state elections only in more minor states that are not traditionally won by the BJP. To speed up the overall reform pace, the BJP needs to win state elections, as this will increase its power in states. This is needed as many needed reforms fall under the responsibility of state level governments. Moreover, winning state elections will  secure more seats in the upper house of Parliament, where the BJP currently lacks a majority, which is needed for passing most national level reforms. The opposition, mainly the Congress party (part of the Grand Alliance) has blocked important reforms last summer and winter, such as the Goods and Services Tax (GST) and land acquisition bill in the upper house. Consensus is, however, that the GST bill (the introduction of one value added tax for all states, replacing a variety of state taxes and therefore creating a single internal market), which has been pending for over a decade, might finally pass in 2016. Furthermore, the government introduced a state level ease of doing business index in September 2015, which is validated by external experts at the World Bank. It ranks the India’s states on progress made in reforming business regulation in eight areas, including tax and employment, therefore aiming to raise competition between states. This is expected to nudge states to improve the business environment, which is critical given India’s poor overall ranking on the World Bank’s ease of doing business index (130nd out of 189 countries). 

2. Economic growth remains robust, but private infrastructure investments are lacking

India’s GDP growth is expected to grow at roughly 7.5% in 2016 and 2017, largely driven by domestic demand, which is supported by low oil prices. However, weak growth in the agricultural sector as a result of a bad monsoon, slow reform progress and external headwinds will probably prevent the Indian economy from growing at a faster rate. Furthermore, the balance sheets of Indian state-owned banks, which account for roughly 75% of the system’s total loans, remain stressed. According to the Reserve Bank of India (RBI, the central bank), the average ratio of gross non-performing assets (NPAs) increased to 6.4% in June 2015, up from 4.1% in June 2013. NPAs have increased mainly due to stress in infrastructure projects like highways, steel, power and state controlled electricity distribution companies (Discoms). This puts a drag on economic growth by discouraging investments in the power sector, infrastructure and manufacturing. As a poor infrastructure is one of India’s main problems, the government will likely implement a plan to increase infrastructure development by strengthening the framework for Public-Private Partnerships (PPP) in the coming months. However, infrastructure companies’ focus on deleveraging, state banks’ cautious approach to providing new loans to the infrastructure sector and bureaucratic hurdles will constrain private sector infrastructure investment in the short to medium term. As a result, public investment will remain  the main driver of infrastructure expansion. Although the government is likely to increase capital expenditure, nearly fully directed at infrastructure, by 8% in FY2016-17, India’s huge long-term infrastructure needs will not be met without significant private investments as well. This is because the relative high public debt level (51% of GDP in 2015) and the government’s commitment to reduce the budget deficit, will constrain public investment.

3. Attempts to improve ties with Pakistan and Bangladesh

In 2015, India has made attempts to improve ties with two of its neighbours. First, India and Pakistan announced that they will resume bilateral talks, which stopped after the 2008 terrorist attacks in Mumbai. The countries will probably improve cooperation to support stability in Afghanistan and contain terrorist activity in the region. However it is unlikely that long-standing territorial disputes will be resolved and nuclear rapprochement is probably also out of reach. The high level of mistrust on both sides, criticism of domestic nationalists in both countries and hardliners within both governments will limit the cooperation in these areas. The fragility of the relationship is underlined by an attack on an Indian military base and Indian consulate in Afghanistan in January 2016, both linked to Pakistan-based militants. Second, India and Bangladesh signed an agreement to adjust their border, which has led to the exchange of 162 enclaves (citizens of one country but located in the other) in June 2015. Also, both countries signed agreements to improve bilateral trade, India’s access to its northeast region, and direct movements of goods to and from India from Bangladeshi ports and the establishment of Indian companies in Bangladesh. These agreements will probably improve the trade and investment flows between both countries in the long-term.

4. Improved external position, but reasons for caution

India’s external position has improved since 2013 and also considering India’s relatively high level of FX reserves (USD 332bn and 8 months import cover in 2015), it is better prepared to deal with possible capital outflows. That being said, there are reasons for caution. First, the steady increase in FX reserves since end-2013 came to a halt and there was even a small drop in FX reserves (USD 0.9bn) in the third quarter of 2015. The RBI has been using reserves to counter the rupee depreciation, although the rupee performed relatively well in 2015 compared to other emerging markets, depreciating by 4.5% against the USD. Second, despite low oil prices, the trade deficit is expected to widen marginally in 2016. Third, various measures of the RBI will open up India’s relatively closed domestic capital market. The government debt limit that foreign investors can hold will be raised, foreign investors will be allowed to buy state government debt and Indian companies will be allowed to issue debt in rupees, which will probably primarily be bought by foreign investors. These developments might increase India’s vulnerability to global financial markets turmoil. On the bright side, investor confidence is supported by an import cover of 8 months and by the fact that consumer price inflation is staying on track to meet the RBI’s 5% target (due to low oil prices), which boosts the RBI’s rupee management abilities.

Factsheet of India
Factsheet of IndiaSource: EIU, CIA World Factbook, UN, World Economic Forum, Transparency International, Reporters Without Borders, World Bank.

Background information

India is a large and extremely diverse country with huge regional differences, a huge gap between rich and poor, and very diverse economic sectors. Per capita income was about USD 1,600 in 2015 (roughly USD 6,100 in PPP terms). India’s Planning Commission reported that in 2011-2012, 30.9% of the rural population and 26.4% of the urban population lived below the national poverty lines (which are lower than the World Bank’s standard). Although India is still home to more undernourished and poor people than all of sub–Saharan Africa, progress on poverty reduction has been impressive when India’s rapid population growth is taken into account. India will benefit from a growing working-age population in the coming decades. This could be a catalyst for growth but also a source of social unrest. The agricultural sector is very important to the rural community. Although it only produces 16% of GDP, about two-thirds of the population depends on this sector for its livelihood. At the other end of the spectrum there is the world-class IT sector that is a major driver of the services sector. India has a federal structure and many subjects have been delegated to state governments. At the central level, the Bharatiya Janata Party (BJP) secured a majority in the lower house of parliament in the 2014 election. It was the first time in three decades that one party managed to do this. However, the pace of reforms is expected to remain slow as the BJP lacks a majority in the upper house of parliament which is needed for passing most national level reforms. To speed up the overall reform pace, the BJP needs to win state elections, as winning state elections will secure more seats in the upper house and many areas that need to be reformed fall under the jurisdiction of state governments. There is frequent social unrest and occasional communal violence in some parts of India, often in areas that have a strong tribal presence or experience religious and ethnic tensions.

Economic indicators of India
Economic indicators of IndiaSource: EIU


Carlijn Prins
RaboResearch Netherlands, Economics and Sustainability Rabobank KEO
+31 6 1929 6455

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