It is good time, but not yet the best time!
India is in the last lap of 25 years into economic liberalisation, which began in 1991 with intent to counter emerging FX crisis. Since then, partial convertibility has been allowed both sides; opening up inbound investments to FPIs, FDIs and other approved investors & lenders, while allowing restricted outbound investments to resident individuals & companies. Now, the talk of full convertibility has again emerged as India prepares for second phase of 25 years of economic liberalisation. The discussion on this make-or-break decision has come out when India euphoria is high, since May 2014. It could get only better beyond 2015, when efforts of Modi Government will translate to on ground beneficial impact. The house is divided on the issue, some advocating Chinese model and many to go the way of other South Asian emerging markets. India requirements are somewhere between the two options, given the wide geography, huge population and complex political environment.
Macroeconomic fundamentals have turned good, but long way ahead to gain confidence
India is big in terms of geography and population, but the balance sheet size is not reflective of the potential. India GDP is not significant compared with many; but if sustainable 8-10% growth is maintained for the next 25 years, India would emerge as one of the major economic forces in the World. Scaling up of growth rate would mean comfortable fiscal position, and creation of public money for investments. The present position of "borrow-to-consume" mode gives no comfort. The way forward as first step is in meeting the cost from revenues, and borrow to invest in productive assets. As revenue generation picks up along with growth momentum, the system has to turn fiscal surplus to focus on social security spend. The significant improvement in inflation and Current Account Deficit is dream-come-true, not thought of during July 2013 - May 2014. The set targets on macroeconomic fundamentals for FY16-FY19 give great comfort for investors and consumers on the way forward to revive sentiments and build confidence. GDP growth target at 8-10%, fiscal deficit at 3.5-3.9%, CAD at 0-2% and CPI at 4-6% have sent positive vibes to external investors and global rating agencies. All taken, India is now seen as one of the attractive investment destinations, and gets the most attention in the elite BRICS group. Given this positive outlook, there will be off-shore long term inflows in plenty against minimal risk of reverse flow of existing foreign investments, while outflows from resident entities if any, may not be too big to cause concerns.
Political stability and good governance will enhance India balance sheet productivity and efficiency
It may not be incorrect to say that lack of political stability (and absence of political unanimity for common cause) and inefficient governance have been the problem since India Independence. The opportunities from expanded geography and consumption appetite of the huge population have not been explored. The mass affluent segment and the top-end super-rich size is small compared to the size of the lower end of the pyramid population. The system inefficiencies from below-the-line economic activities and resultant revenue leakages have kept the fiscal position poor. The Government is in "borrow to consume" mode resulting in build up of huge unproductive debt on the balance sheet and high interest cost keeping the P&L in red. While the tax revenue collection is sub-optimal, net contribution from Public Sector enterprises is negative or insignificant. Combination of leakages in revenue collections, insignificant contribution from the public sector and cost inefficiencies have contributed to poor financial reflection of India to the external world. In the absence of desired public sector investment, private investors had to take charge of building productivity in a limited scale, while foreign support is chicken-feed!
These hurdles are seen to be addressed for removal to ensure smooth ride ahead. Modi Government is on the move to plug revenue leakages through various measures - to unearth black money, monitor on disproportionate assets and control over foreign assets of resident entities. The agenda is also to expand the economic activity to where 70% of the Indian population reside to build inclusive prosperity. The financial inclusion agenda is built on economic inclusion, monetary inclusion and technology inclusion. The economic agenda on infrastructure, manufacturing and agriculture sectors will not only create consumption through capacity expansion, but will lead to creation of employment and wealth at the lower end of the pyramid. All these will need large scale investment. The combination of diverting domestic liquidity to desired sectors and opening up opportunities for external investors will do wonders in the long run. Modi themes around building skills and scale at good speed, and Make-in-India vision are steps in the right direction. It is essential to provide long term sustainable (and consistent) growth agenda to attract sustainable inbound flows to provide exchange rate stability. It is not difficult for RBI to manage excessive foreign currency inflows, while excessive outflows will leave behind growth destructive monetary impact through weak Rupee, high interest rates and liquidity squeeze.
India development agenda and larger space for foreign investors is good comfort
In the given global economic environment, India is bound to throw up huge opportunities for offshore investors. The flows into Capital Account (both debt and equity) will be lumpy through FDI flows. Although India will be less dependent on fair-weather and hot money FPI flows, the FPI flows will also increase chasing India valuation. The combination of FDI and FPI inflows will open the floodgates of inbound foreign currency flows. On the other hand, outflows from India is not expected to be significant. The net flows will be supply driven, thus diluting the risk and fear on the run on Rupee if resident Indian entities chose to invest and acquire assets abroad or from exit of existing foreign investors. For this scenario to stay sustainable, it is essential to provide long term political stability, consistent policies and maintaining high growth rate. India is in the last lap of completion of 25 years of economic liberalisation and Modi agenda to build inclusive economic prosperity through the next 25 years is great comfort to free up capital account flows. But, this is a major game-changing action which can't be taken in hurry. If strong base could be built in FY16 to step up FDI flows and get into double-digit growth mode by end of FY19, Modi 1st term report card will provide him the much needed absolute political majority to open up the Capital Account in 2019.
RBI preparedness and impact on the system
By FY19 (March 2019, ahead of next General election in May 2019), RBI foreign currency reserves will cross $500 bio on high probability of supply driven mode in the FX market from combination of low trade deficit, high net capital inflows and supply-driven forward market. The need is also to keep Rupee exchange rate competitive to FDI and exports through build up of high foreign currency reserves. The resultant supply of Rupees in the system is good to feed credit demand at affordable cost. The low cost of capital will drive money into investment for capacity-build and resultant wealth creation will spur consumption. A very high level of consumption along with supply of Rupee liquidity through absorption of external sector net foreign currency inflows is the story ahead. The cost of building reserves is high when the interest rate differential is elevated. But the beneficial economic impact on India balance sheet and social impact on the lower end of the pyramid population will be huge to the price for dollar sterilisation. It is also possible that by FY19, the interest differential will be squeezed as developed markets move the rates up while India gets into declining interest rate cycle. If Modi Government could execute their agenda well through FY16-FY19, downside risks on the system through free float of capital account will be minimal.
Let us hope for the best!
Moses Harding
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