Research Paper: Achieving India’s Growth Potential

Just as the Indian economy reels from its double-digit inflation to the tune of approximately 11%, Goldman Sachs, the leading investment bank, has issued its latest research paper titled Ten Things for India to Achieve its 2050 Potential. This is part of a series of papers published over the last few years by Goldman Sachs covering the BRIC economies of Brazil, Russia, India and China.

The paper builds on Goldman Sachs’ Growth Environment Scores (GES), in which India scores below the other three nations. Further, it ranks 110 out of 181 countries, and for 7 of the 13 components India scores below the developing country average. The current report contains some prescriptions for India to achieve its potential by 2050, noting that “[h]aving the potential and actually achieving it are two different things”. This effectively boils down the lack of proper implementation of reforms that slow down economic progress.

The following are the key recommendations extracted from the paper:

“We highlight ten key areas where reform is needed. In all likelihood, they are
not the only ten, but we consider them to be the most crucial:

1. Improve governance. Without better governance, delivery systems and effective implementation, India will find it difficult to educate its citizens, build its infrastructure, increase agricultural productivity and ensure that the fruits of economic growth are well established.

2. Raise educational achievement. Among more micro factors, raising India’s educational achievement is a major requirement to help achieve the nation’s potential. According to our basic indicators, a vast number of India’s young people receive no (or only the most basic) education. A major effort to boost basic education is needed. A number of initiatives, such as a continued expansion of Pratham and the introduction of Teach First, for example, should be pursued.

3. Increase quality and quantity of universities. At the other end of the spectrum, India should also have a more defined plan to raise the number and the quality of top universities.

4. Control inflation. Although India has not suffered particularly from dramatic inflation, it is currently experiencing a rise in inflation similar to that seen in a number of emerging economies. We think a formal adoption of Inflation Targeting would be a very sensible move to help India persuade its huge population of the (permanent) benefits of price stability.

5. Introduce a credible fiscal policy. We also believe that India should introduce a more credible medium-term plan for fiscal policy. Targeting low and stable inflation is not easy if fiscal policy is poorly maintained. We think it would be helpful to develop some ‘rules’ for spending over cycles.

6. Liberalise financial markets. To improve further the macro variables within the GES framework, we believe further liberalisation of Indian financial markets is necessary.

7. Increase trade with neighbours. In terms of international trade, India continues to be much less ‘open’ than many of its other large emerging nation colleagues, especially China. Given the significant number of nations with large populations on its borders, we would recommend that India target a major increase in trade with China, Pakistan and Bangladesh.

8. Increase agricultural productivity. Agriculture, especially in these times of rising prices, should be a great opportunity for India. Better specific and defined plans for increasing productivity in agriculture are essential, and could allow India to benefit from the BRIC-related global thirst for better quality food.

9. Improve infrastructure. Focus on infrastructure in India is legendary, and tales of woe abound. Improvements are taking place, as any foreign business visitor will be aware, but the need for more is paramount. Without such improvement, development will be limited.

10. Improve Environmental Quality. The final area where greater reforms are needed is the environment. Achieving greater energy efficiencies and boosting the cleanliness of energy and water usage would increase the likelihood of a sustainable stronger growth path for India.

Perhaps not all these ‘action areas’ can be addressed at the same time, but we believe that, in coming years, progress will have to be made in all of them if India is to achieve its very exciting growth potential."

While the research paper does well to identify key concerns relating to growth and the areas to be addressed, it does pose some fundamental issues at a macro level. One of the criticisms that may be levelled against the paper is that it does not present any new findings or prescriptions, and all of those contained in the report are well-known and debated (with perhaps little concrete action being taken). But, this critique is more to do with the form and less with the substance of the matters covered.

More fundamental is the approach towards some of the solutions to the problems. Here, one finds that most prescriptions turn towards market-based models of economic policy and liberalisation—for instance the recommendations for removal of capital controls, for liberalisation of the financial markets and so on. It is important to note, however, that all of those solutions may not directly apply in the Indian scenario. There is a need to contextualise the prescriptions for reforms so that they appropriately fit into the Indian macroeconomic framework as well as with its past experience. Some of the ideas (and materials) that support this thinking are as follows:

(a) Commentators have argued that some level of restrictions and governmental regulation on economic and financial activity may be necessary in the context of developing economies. Joseph Stiglitz is a leading proponent of this view, as he strenuously makes his arguments in his book “Globalization and Its Discontents”.

(b) Similarly, as far as India is concerned, arguments have been made that it is India’s partially restrictive policies that have helped weather the recent global credit crisis or even the Asian financial crisis that swept the region over a decade ago (see an earlier post on this blog).

(c) It is also useful in this context to review Dr. Shankar Acharya’s critique of the Draft Report of the High Level Committee on Financial Sector Reforms headed by Dr. Raghuram Rajan, where the point has been made about the need for taking into accounting the realities in India while examining the nature of reforms.

Role of Law and Politics in India’s Economic Growth

There is a recent paper titled “Law, Finance, and Politics: The Case of India” by John Armour and Priya Lele that has been posted on SSRN. The authors join the debate as to whether a country’s legal origins (e.g. common law or civil law) necessarily have an impact on the extent of its financial development, and in doing so, they examine India as a case study. The authors find that in India’s case, political explanations have a greater bearing in explaining India’s growth, and that its legal heritage as a common law country has not played a significant role towards that end.

Here is the abstract:

“The process of liberalization of India's economy since 1991 has brought with it considerable development both of its financial markets and the legal institutions which support these. An influential body of recent economic work asserts that a country's 'legal origin' - as a civilian or common law jurisdiction - plays an important part in determining the development of its investor protection regulations, and consequently its financial development. An alternative theory claims that the determinants of investor protection are political, rather than legal. We use the case of India to test these theories. We find little support for the idea that India's legal heritage as a common law country has been influential in speeding the path of regulatory reforms and financial development. There is a complementarity between (i) India's relative success in services and software, (ii) the relative strength of its financial markets for outside equity, as opposed to outside debt, and (iii) the relative success of stock market regulation, as opposed to reforms of creditor rights. We conclude that political explanations have more traction in explaining the case of India than do theories based on 'legal origins'.”

The paper also contains a useful background discussion about the development of various institutions in India’s business and financial sectors. These include the evolution and the roles of bodies like the Securities and Exchange Board of India (SEBI) and the Reserve Bank of India (BSE) as well as other self-regulatory bodies like the stock exchanges. The paper also offers some reasons why the capital markets in India have been growing at a fast pace and acquiring greater depth, while the debt markets (including for bank lending) have not been keeping the same pace.

Impact of Global Crisis on the Indian Economy

It could have been worse. That is the message emanating from leading commentators on the Indian economy. This is attributable to the Reserve Bank of India’s conservative policies that have largely staved off a deeper crisis within the country.

Today’s Business Standard carries a column by its editor T.N. Ninan, where he argues:

“For years, the wunderkinds of the financial world have railed at the Reserve Bank’s dullness and stupidity, its unwillingness to allow innovations, and its excessive caution. But the RBI seems about to have the last laugh. Those super-bright financial brains who created those wondrous hedging options, innovated away with structured products till no one knew or understood what was going on, and who thereby created massive value for their firms (the profits of financial firms in the US have grown to account for 41 per cent of all US corporate profits!) while earning fat bonuses for themselves, have to explain why they and their firms have to be saved by the American taxpayer. The US fiscal giveaway is already $150 billion, and the Fed has shelled out more and more money to keep the financial wheels greased while crashing interest rates despite the risk of inflation — all this to salvage the wreckage created by Manhattan’s ‘masters of the universe’.

So why is India safe amidst this turmoil? Because the Reserve Bank has done the things that people laughed at. It issued market stabilization bonds and absorbed dollars; now if overseas investors suck out dollars after selling shares, there is no shortage of dollars to sell to them; and, there will be no domestic liquidity crisis because the RBI can buy back those bonds and pump rupees into the market. Further, the RBI has made banks keep 7.5 per cent of their deposits in cash, and another 25 per cent of their deposits in government bonds. So even if there were to be a run on a bank — as with Northern Rock and Bear Stearns—they would have the liquidity to tackle the situation, so long as they are solvent; and bank solvency has improved because of financial reforms over the past 15 years.

…

This is therefore playing out as a repeat of 1997 — India was seen then as being free from the East Asian virus because it had not fully integrated with the region, on trade or capital flows. Now, the lack of sophistication in the Indian financial market is providing protection in a world marked by financial contagion. Hastening slowly when it comes to financial innovation seems to be a wise rule.”

This indicates the benefits of an economy maintaining some level of controls, without fully integrating into the global economy. I am also reminded of arguments of the same nature made by Joseph Stiglitz (a Nobel-prize winner for economics) in his book “Globalization and its Discontents”. Specifically, in the context of the East Asian Crisis of 1997, he demonstrates that countries like Malaysia that were quick to impose capital controls suffered less than others like Thailand and Indonesia that did not impose such controls.

On a more specific aspect of the Indian economy, i.e. the idea of establishing an Indian sovereign wealth fund (SWF), Swaminathan S. Anklesaria Iyer considers an interesting dynamic in a Times of India column. While the establishment of a sovereign wealth fund by the Indian Government will augur well in the longer term (a matter that we have argued too earlier on this blog - here and here), the incumbent Government may have scored a political victory by avoiding the establishment of an SWF that could potentially have lost value of its investments in the current market crisis. Iyer says:

“Sonia Gandhi should thank Finance Minister Chidambaram for resisting proposals to put part of India's foreign exchange reserves into a Sovereign Wealth Fund, which would buy equity shares in top global companies. Such a Sovereign Wealth Fund (SWF)—an idea backed by eminent economists, the Prime Minister and the Planning Commission—would have suffered huge losses because of the collapse of global stock markets since January. Neither Opposition politicians nor the public would have been satisfied by explanations that stock markets yield high long-term gains, notwithstanding short-term fluctuations. The Left Front would have accused Chidambaram of gambling away the country's precious assets in casino capitalism. Others would have accused top Congress politicians of having been bribed or arm-twisted into making dubious investments.

…

However, Chidambaram and RBI Governor Y V Reddy opposed any SWF for India. Reddy said SWFs were appropriate for countries with mineral windfalls (such as oil exporters), but not India. Indeed, India ran a modest current account deficit, and so needed to import dollars. Now, the world had flooded India with far more dollars than it could absorb, but this was not a structural surplus. Chidambaram took refuge in a further technical argument. He said that SWFs made sense for countries with excess savings, reflected in a fiscal surplus. But India ran a large fiscal deficit. However, these technical economic arguments pale besides the political ones. The stock market is seen by both Opposition politicians and the general public as a dodgy place full of crooked manipulators (remember Harshad Mehta and Ketan Parekh). Making money on the stock market is seen as risky, if not actually sinful. Indeed, the Left front has stymied attempts to put pension/provident fund money into Indian equities. In these circumstances, Chidambaram has shown sound political judgement in refusing to set up an SWF. This might in the long run yield some financial gains. But it carries short-term risks, as has just been demonstrated by the slump in stock markets. So, it needs to be avoided in the run-up to the next general election.”

While these political arguments may support short-term policies, they may overshadow the longer-term benefits of creating an Indian SWF.

India Business: A Few Updates

1. Indian Acquisitions in the United States

One of our regular readers, Mohit Gogia, who is a lawyer currently based in New York, brings to our attention a report titled “US-Bound Acquisitions by Indian Companies” that has been prepared by Virtus Global Partners.

This report contains a snapshot of Indian acquisitions of US companies, both quantitatively and qualitatively. The gist of their findings is that Indian acquisitions in the US are growing despite the economic slowdown. The deals in the last few years have been on a steep growth trajectory as can been seen below from the numbers reported:

Year: No. of Deals

2005: 23
2006: 48
2007: 83
2008 (first 2 months): 10

The reports states that the cumulative deal size for the transactions in 2007 aggregate US$ 10 billion. Unsurprisingly, the industry that takes the cake is IT, which bagged 51% of the deals by volume.

The report sets out various factors fueling US-bound acquisitions and also key considerations for cross-border acquisitions in the US.

From a corporate lawyer’s standpoint, it seems to me that the principal aspects in such transactions would involve navigating through the local requirements that govern the target company (e.g. due diligence), the structuring of the acquisition (particularly from a taxation standpoint), and the financing of the transactions by the acquirer. Since the guidelines prescribed by the Reserve Bank of India as to overseas acquisitions have now become quite liberal, such transactions usually tend not to face too many impediments at the Indian end.

This is especially because (as the Virtus Global Report observes), most of the transactions are acquisitions for cash. Deals tend to become more complex if they are stock transactions, as the Indian acquirer company would then have to issue shares or other instruments (such as ADRs or GDRs) as consideration to the shareholders of the US target company, and these could involve compliance with various requirement of SEBI and Ministry of Finance that would require careful structuring. As transactions become larger in size and leverage may become difficult to obtain (due to declining market conditions), it might well be the case that stock transactions will become more common.

2. The World in 2050: Beyond the BRICs

A report by PriceWaterhouse Coopers that looks at emerging market growth prospects provides a bullish outlook for India and China. It notes: “China is expected to overtake the US as the largest economy in around 2025 in these updated projections, while India is now assessed as having the potential to nearly to catch up with the US by 2050.” This report is an update of PWC’s earlier report in March 2006.

What comes as a surprise in this report is that India tops the growth league tables among all emerging economies, even ahead of China. The factors that emerge from an India-China comparison are as follows:

“- significantly slower labour force growth in China due in particular to the effects of its one child policy; this will lead to a rapid ageinig of the Chinese population over the next 45 years and a projected decline in its working age population, while India’s working age population is projected by the UN to continue to growth at a healthy rate …

- the fact that average productivity and education levels across the population are currently lower in India than in China, giving the former greater scope to catch up with the OECD countries in the long run, provided that India can maintain the right kind of institutional policy framework to support economic growth (and also gradually overcome cultural barriers to female education in rural areas of India in particular); and

- China’s growth to date has been driven by very high savings and capital investment rates, but experience with Japan and other earlier ‘Asian tigers’ suggest that such investment driven growth eventually runs into diminishing returns once income levels approach OECD levels; as China ages, it is also likely that its saving rate will drop as assets are ‘cashed in’ to pay for the retirement of its ageing population, though we still assume its saving and investment rates remain somewhat above the OECD average in the long run.”

The outlook for Indian economic growth is indeed optimistic, judging by this report.

Hat tip: US-India Friendship

3. India: Growing @ the Speed of Thought

… is the theme for this year’s India Business Conference that is organised annually by the Columbia Business School. This year’s conference will be held on April 19, 2008 at the Columbia University, New York, NY.

The conference may be of particular interest for lawyers and other business professionals based in the US who are interested in Indian business and economic matters. I attended this conference last year and found it to be useful.