India

GOVERNMENT FINANCE

Red tape bureaucracy abound

India’s fiscal position remains unbalanced; after the global financial crisis of 2007-2008, a 200 billion rupee (US$4.0 billion) stimulus package has acted to inflate India’s general government budget deficit. The country’s government has remained embattled with corruption, which is endemic to the regional and central political process. The government’s bureaucratic processes, vested interests, out-dated political structures and an increasingly distrustful public are preventing any potential reform to the government budget. One key example is India’s fuel subsidies; attempts to reform the subsidy have failed even though the subsidy is causing a significant drag on the government budget.

The country has attempted to rein in spending since the stimulus, however, below trend growth in 2011 and a lack of reform has caused the budget deficit to widen as the country’s tax revenues decline. In 2011 government spending represented 26.0% of the country’s total GDP. However revenue has not kept up with spending growth, resulting in a general government budget deficit equivalent to 8.3% of GDP in 2011. Without major reform the budget deficit path is likely to be unsustainable.

Public debt as a percentage of GDP has however been reduced since 2006, largely through one off revenue windfalls from privatisation projects. In 2011 public debt stood at 65.1% of GDP, or Rs58 trillion (US$1.2 trillion).

Taxation in India is the major source of government revenue which stands as a percentage of GDP at just 17.7%, the lowest in any of the other BRIC economies. In 2012 the structure of India’s tax system remains complex, with a mix of consumption tax, a relatively high effective corporate tax rate of 32.4% for the 2011-2012 fiscal year and a three-tiered income tax structure. Given the size of India’s informal sector tax evasion is a pervasive issue for the country. According to India’s finance industry the shadow economy’s output is estimated to be around US$500 billion annually, none of which is taxed by the government.

According to Moody’s, a credit rating agency, as of July 2012 the government’s rating outlook is stable, though ranking government bonds at Baa3 shows major risks are present in the economy, similarly Standard & Poor have rated the country BBB-. Lower growth is a short term issue due in part to the business cycle and external factors. However lower term growth prospects provide risks to India’s public debt position. Although debt remains relatively low a lack of reform by government will create significant downside risk to government solvency.

FINANCIAL STABILITY

The inexorable rise in prices

India’s financial environment is one of two deviating trends. First of all, thanks to the country’s relatively small external sector and unsophisticated financial sector, the impacts of major external shocks are not immediately felt. For example the 2007-2008 global financial crisis dragged Europe and North America into long, protracted depressions while India, at the bottom of its slowdown in 2009, grew by 5.7% in real terms. On the other hand India’s domestic economic position is more unstable. Inflation has been a consistent problem in India which averaged 8.8% a year between 2006 and 2011. Bottlenecks in production are producing build-ups of demand, leading to inflationary pressures in the country. Similarly underlying food inflation remains an issue in the country as trade cartels, weak distribution networks and volatile global prices are affecting food prices for consumers. Increasing debate over reducing the fuel subsidies pose more risks to the country’s inflationary environment. In 2011 inflation was 8.9%, a reduction from the inflation rate of 12.1% seen in 2010 as consumer and business demand in the economy declined.

The Reserve Bank of India (RBI) has an effective dual mandate, to maintain the currency and credit system of the country to its advantage and secure monetary stability in India. As such the bank does not purely target inflation in policy decisions. According to RBI the perceived comfort zone for inflation is around 5%, however much of the inflationary pressure is due to supply chain bottlenecks, something the central bank has no control over. Between 2010 and 2011 the money supply has decreased by 2.0% in real terms, a marked slowdown on previous years. This has been part of the RBI’s attempts to tighten monetary expansion to slow inflation. The long term interest rate has declined in the first 8 months of 2012, to a rate of 8.2% in August, meaning the cost of government to borrow is cheaper than the beginning of the year.

India’s nonperforming loans as a percentage of total gross loans declined between 2010 and 2011, though have historically remained relatively steady. In 2011 2.3% of loans were classed as nonperforming in India; the US economy for comparison had a nonperforming loan rate of 4.7% in 2011. The relatively tight monetary position by banks has kept lending relatively low, reducing investment spending. As the economy continues to hit the roof of capacity, growing calls for increased spending on investment are being heard.

REAL ESTATE

Property prices bubbling up

The real estate market boomed in India in 2011. According to the Global Property Guide house prices rose in almost every major city in India between Q1 and Q2 2011. India ranks as having the second fastest annual growth in residential property prices out of 50 world economies. Migration of India’s population to the country’s super cities carried on in 2011 resulting in growing demand for housing and the continued growth of sprawling informal settlements. Between 2010 and 2011 there has been a pronounced increase in the house price index, which rose by 30.8% on a y-o-y basis. The increase in prices is supported by relatively out-dated planning laws and poor infrastructure in the country’s major cities, resulting in a lack of housing supply. Construction of new housing has not kept up with this increasing demand. In 2010 3.7 million new houses were completed; in 2011 housing completions were the same.

The lack of supply of accommodation in India’s major cities is threatening the affordability of housing, as incomes have not been able to keep up. On a per capita basis, annual gross incomes increased by 4.4% in real terms between 2010 and 2011, a much lower rate than 30.8% growth in house prices. According to the Global Property Guide India’s housing price to income ratio is 740%. The house price-income ratio is the ratio of the cost of a typical upscale housing unit of 100 square metres compared to the country’s GDP per capita and is related to the affordability of houses. This rate is 5.5 times higher than China’s ratio and one of the highest ratios in the world, the average Indian has to work for 740 years to afford an upscale house in the country. Therefore risks of a sharp correction to house prices in India’s major cities are rising.

Mortgage lending increased by 2.2% in real terms between 2010 and 2011 to reach Rs3.7 trillion (US$77.9 billion) in 2011. Mortgage lending has not kept up with growing house prices, meaning there is a potential short fall between the growing cost of housing and the access to credit for purchase. There have been few significant attempts by India’s government to stimulate further construction in the country in 2011; apart from minor subsidies, little support has been forthcoming. Without reform of legislation and support for increased investment in affordable housing, house prices will continue to rise.

A slowdown in overall economic growth has however led to a slowdown in the growth of gross value added from construction between 2010 and 2011, increasing at a real rate of 6.9%, compared to 8.3% growth in real terms between 2009 and 2010. The weak global environment is having knock-on effects on India’s investment as potential investors become more risk averse. As a percentage of total GDP construction was therefore relatively steady at 8.0% in 2011.

Chart 8 Real Growth in GVA from Construction and Real GDP Growth in India 2006-2011

annual change (%) 

Source: Euromonitor International from International Monetary Fund (IMF), International Financial Statistics and World Economic Outlook/UN/national statisticsNote: Growth in the construction sector is quantified in terms of Gross Value Added, a measure of the contribution to Gross Domestic Product (GDP) made by an individual producer, industry or sector. Gross Value Added (GVA) is the value of output less the value of intermediate consumption. It is calculated without making deductions for depreciation of fabricated assets or for depletion and degradation of natural resources.

ENERGY & ENVIRONMENT

Energy security a distant hope

India’s energy imports provide a key risk to the country’s economy. In 2011 the country’s meagre production of oil represented just 24.9% of India’s consumption of the energy. Imports of petroleum cost India US$128 billion in 2011, making up 28.6% of the total imports. As a result crude oil, a notoriously volatile commodity, is having a significant impact on India’s economy. Crude oil prices (Europe Brent spot price) registered a 31.1% y-o-y increase between Q4 2010 and Q4 2011, resulting in an increased petroleum energy bill for India of 30.8% in US$ terms between 2010 and 2011. The government is the most susceptible to changes in prices, rather than the public. Oil and petrol subsidies are a major contributor to the government’s expenditure as it tries to remove some of the volatility for the consumer. Periods of high oil prices such as 2011 are proving a significant burden to the government’s already shaky public finances.

Coal remains India’s main energy source thanks to large deposits in the East of India in Orissa, Jharkhand and Chhattisgarh. One of the largest producers of coal in the world, India is able to produce the majority of its coal demand, though production growth has not been able to keep up with consumption growth. This is resulting in major CO2 emissions; in 2011 India was the third largest emitter of CO2 from the consumption and flaring of fossil fuels in the world, behind just the USA and China. Though the pollution levels have risen significantly, at an average annual rate of 7.4% a year between 2006 and 2011, in 2011 India’s emissions amounted to just 20.0% of China’s and on a per capita basis, the country’s emissions are low.

Energy shortages at the local level are pervasive. Poor infrastructure, especially in the most rural areas of India, means many villages remain without electricity. According to the International Energy Agency 404 million Indians had no access to electricity in 2010. According to the Asian Development Bank India’s current spending on infrastructure amounted to 8.0% of GDP in 2011, lower than China’s 9.0%, however high levels of corruption at the regional and local level reduce efficiency in spending.

Infrastructure development has not kept up with the growing energy requirements of India’s major cities. This is resulting in large and damaging black outs. In July 2012 for example more than 700 million people were left without power over the course of the 30th and 31st of July 2012, one of the largest blackouts in history. A lack of infrastructure investment has meant numerous regions run energy deficits. These power outages and lack of capacity have the potential to cause considerable damage to the country’s potential output growth.

Renewable energy in India remains underfunded, while the lack of energy infrastructure means opportunities for renewable energy are relatively limited. In 2011 the combination of combustible renewables and waste generation, solar power, wind power and hydroelectric equalled 12.7% of the total electricity produced in the country. The geographical position of India means solar power would be very effective, however the lack of extensive infrastructure has stymied efforts so far; as a result solar power only contributes marginally to electricity production, at 0.003% of production in 2011.

India currently has few nuclear power plants in operation. According to the Nuclear Power Corporation Limited, India’s nuclear power public sector enterprise, the government is planning to significantly expand the number of nuclear power plants in operation by 2032. With numerous new sites identified, construction of plants is currently underway.

India’s vast geographical area means the country has various environmental and climate challenges. Droughts are a real danger to rural economies, where a lack of a safety net makes adverse weather conditions potentially fatal. Flooding, especially in the mountainous north of the country is another issue for India’s population. According to the Centre of Research on the Epidemiology of Disasters between 1993 and 2010 the total economic cost of major disasters in India totalled US$29.6 billion; however the toll on displaced and affected people was higher.

Climate change poses risk to India’s development path. The country depends on a reliable monsoon season for crops, while droughts and floods are risks for large swathes of the country. As a result the country has significant incentives to address climate change. Policy in India however has a co-focus; promoting and addressing climate change issues while not restricting the country’s development. As a result policy is not aimed solely at reducing or mitigating greenhouse gasses. The National Action Plan on Climate Change was introduced in 2008, boosting renewable energy usage as well as promoting energy efficiency in industry are among its top priorities.