India's economic outlook 'brightens'

Promising to revive India's flagging economy and bolster growth and employment opportunities, PM Narendra Modi came to power after a resounding election victory in May last year. The strong electoral mandate gave rise to optimism that the Modi-led administration would introduce much-needed reforms to boost Asia's third-biggest economy.

While investors pumped money into the country's stock exchange pushing the benchmark index Sensex ever higher, many expected the government to move fast and further liberalize the nation's markets in a bid to attract more foreign investment.

But the initial high hopes began to evaporate as India's GDP growth continued to fall; to 5.3 percent in third quarter of 2014, down from 5.7 percent in the previous quarter. Furthermore, despite announcing a host of business-friendly measures, such as easing restrictions on foreign investment in sectors such as defense and insurance, Modi's reform agenda has so far failed to address the rigidities of India's labor and product markets.

In a DW interview, Shilan Shah, India economist at Capital Economics, says that as no elections are due to take place in any of India's states until November 2015, Modi has a window of opportunity to push through important, but potentially unpopular, reforms that proved elusive in his first few months in office.

DW: Many investors say Narendra Modi's government has so far failed to implement any big economic reforms since it came to power. What is your take on this?

Shilan Shah: PM Modi appeared keen to avoid any contentious reforms in his early months in power in order not to jeopardize his ruling party BJP's chances in some key state elections that took place late last year. The electoral calendar over the next 12 months is much clearer. Indeed, no further elections are due to take place in any of India's states until November 2015.

As a result, Modi has a window of opportunity to push through important, but potentially unpopular, reforms that proved elusive in his first few months in office. There were signs at the end of 2014 that the reform process was gathering steam. Diesel subsidies were scrapped in late October, and restrictions on foreign investment were lifted in a few sectors of the economy in December.

Perhaps most significantly, the BJP finally tabled a bill last month regarding the implementation of the controversial, but potentially hugely beneficial, uniform goods and services tax in parliament. The key now is for the government to build on this momentum, and there is unlikely to be a better opportunity to do this.

What impact will lower commodity prices have on India's economy and the government's finances?

Falling commodity prices should brighten the outlook by providing a boost to consumer spending and helping to improve the fiscal position. Admittedly, given that India is one of the world's largest net importers of oil, the direct boost to the economy might not be as large as expected.

Domestic consumers might only see a small portion of their income "freed up" as the government's increase of excise duties on diesel and petrol mean that retail prices haven't fallen by as much in India as they have elsewhere. But the benefit through other channels is substantial. Firstly, the windfall for the government could mean that there is less need to cut spending in other areas as it aims to consolidate fiscal policy.

There have long been expectations of an interest rate cut by India's central bank. How crucial will the rate cut be in boosting India's economy?

The Reserve Bank of India (RBI) kept interest rates on hold in December, but Governor Raghuram Rajan signalled that cuts could take place soon if the current disinflationary trend continues.

With this appearing to be the case, we expect 100 basis points of cuts in the both the repo and reverse repo rates over the next 12-15 months, to 7 percent and 6 percent respectively.

We think the first cut (of 25 basis points in each rate) could come as early as the RBI's next policy review in February. This should provide a timely boost to demand through greater bank lending and investment. This should help to support growth in the near term, but over the longer term, the onus on lifting India's trend rate of growth lies entirely with the government's ability to push through structural reform.

India is widely regarded to have a cumbersome tax system with every state government having its own separate tax regime. What can the government in New Delhi do to simplify the tax structure?

The most effective way of simplifying the convoluted tax structure would be via the introduction of the goods and services tax (GST). In our view, a uniform GST could lead to substantial economic gains as it should encourage greater inter-state commerce.

At the moment, firms have to pay multiple taxes at both federal and state levels. Dealing with excessive tax regulation leads to a loss of productivity for both the private and public sector.

A uniform GST would also help to broaden the tax base and ensure a more stable flow of revenues. But passing the bill looks to be a stiff task. A number of state governments (with whom federal government will need to co-operate on the matter) are opposed to a uniform GST as it would severely limit state revenues.

It is likely that a number of large concessions or heavy compensation will be offered to state governments when the bill is discussed in the next parliamentary session.

What measures can the government take in 2015 to encourage foreign investment into the country?

The most obvious measure would be to reduce limits on FDI in key sectors of the economy, as it has done with the defense, railways and construction sectors. But this needs to be complemented with much wider reform to encourage investment.

In particular, progress needs to be made in simplifying land acquisition laws and making the labor market more flexible. But these are politically contentious issues, and the pace of reform, if indeed there is any at all, is likely to be slow.

How could international developments such as the crisis in Russia or other emerging markets affect India in 2015?

Uncertain international developments do of course provide risks that could derail India's economic outlook. Arguably the most significant one is a bout of financial market turbulence akin to the "taper tantrum" seen in mid-2013. In particular, a sharp sell-off in the rupee would mean that policy would be kept tighter than we expect.

Some of the potential triggers for another sell-off in the EM financial markets this year would be contagion from Russia's crisis, or uncertainty surrounding the timing of the first rate hike in the US. But India would stand a good chance of riding out further EM market turmoil, given the reduction in the current account deficit since 2013.

Shilan Shah is India economist at Capital Economics, a UK-based economic research consultancy.