India – Be Cautiously Optimistic

Indian newspapers are pretty gloomy right now – inflation, laggard growth, and a falling Rupee don’t make for a great  diet. Before I tell you why to be optimistic, I should define my terms. Optimism could be a resurgence to double-digit growth rates. That seems unlikely without a robust recovery in China, America, and Japan. Optimism could be a rapidly falling poverty rate. But that’s a really low bar for poor countries in India’s convergence club. To many here, it could be about India’s relative position to China. But that’s boring. I’ll loosely define optimism as the confidence that a good number of pundits short on India today will be be seen as myopic in five years.

Many standard economic indicators – government surplus, growth, and balance of payment – flatlined or dropped during the crisis and its aftermath. However, these are cyclical trends that have little bearing on future growth. In contrast, China has done exceedingly well in all of the above. But India has, to use a technical term, kicked ass in one indicator: real credit depth.

According to the World Bank, domestic credit provided by the banking system has grown from just over 60% of GDP in 2007 to almost 75% today. For reference, Brazil has flatlined around 95% and China at 140%. India has a long way to go, but the domestic banking system’s resilience to financial crisis and inflation makes a strong case for its structural health. 

India’s relatively shallow credit markets means we have a long way to go, and that’s cause for celebration. Further, India’s credit position relative to Brazil is more a reflection of a gradual, rather than immediate, liberalization of the capital account. Deep and liquid credit markets dampen entrepreneurial barriers to entry and hence encourage competition and innovation. That India’s savings rate has remained steadily high throughout an increase in credit suggests a more efficient allocation thereof. This, a secular trend, is rather more important than a volatile growth rate.

The government has further demonstrated a commitment to price stability, contrary to popular belief. The reason is subtle – the time at which India started offering inflation-indexed bonds (IIBs). There are three main “clubs” of countries that issue such bonds. First, Latin American countries with runaway inflation found IIBs the only entry into long-run capital markets. Second, countries like Britain and Australia which issued IIBs in the 80s and 90s as deliberative action to signal creditworthiness. Finally, America, issued the TIPS only as recently as 1997 as a means to long-run investor welfare. 

People are quick to place India in the first category but, as late as April, the wholesale price index (WPI) had fallen below 5%, less than half its double-digit peak. It’s curious, then, if the government were concerned about the inflation risk premium, why it didn’t issue IIBs in the heyday of price instability. By anchoring expectations before the first auction, India is best approximated by the second group, signaling a willingness to control prices in the long-run.

Relative to other developing countries, India’s vibrant democracy will reinforce bond market confidence as a welfare state emerges. The biggest guarantee American bondholders have against default are its pensioners, and the electoral bloodbath that would result. Therefore, there’s both an economic and political incentive not to default. Most Indians don’t own much wealth, at least not linked to its bonds. However, once a formal savings-based welfare state emerges, India is in a far stronger position than countries like China, which have only an economic incentive to avoid default.

Obstacles to this in the near-term include a deeply underbanked country, but that serves as reason for confidence not pessimism. With emerging electronic money transfer technologies, the financially-excluded are becoming more a low-hanging fruit than a pariah of the country. (This is a big bet, but in the long-run its one I’m more than willing to make. If a majority of the country remains excluded by 2020, call me out). 

Despite political instability in this government, it is likely that in the medium-run India will liberalize retail and finance to a much greater extent. The benefits of retail freedom are immense, as we know from Japan, mostly via indirect “knockback” effects. Larger and scaled firms like Walmart will invest in a deeper supply-chain providing India the cold-chain system which it desperately needs. Furthermore, competitive retail markets demand efficient input markets, thereby “percolating” efficiency through the system. 

Financial liberalization is trickier – even ardent free market economists like Jagdish Bhagwati note that capital accounts are precarious (they learn from 1997, and Indian resilience therein). Most importantly, a clearer statutory central bank independence is necessary. By many stalwarts (including India’s chief economic adviser, Raghuram Rajan), the Reserve Bank of India (RBI) is seen complicit in runaway deficits, by keeping capital reserve requirements high and thereby creating a captive demand for debt.

Recent success in taming inflation convinces me that smarter independence is on the horizon. It’s not unreasonable to expect that India will end preferential lending schemes, thereby capitalizing on the deepest benefits of a liberal economy, which are indeed self-reinforcing. 

Ultimately, a 4.5% growth rate is pretty shabby, and for many the outlook seems bleak. In five years, I imagine (and hope) that all the BRIC bears will wrong. But there’s cause for reason that India’s will be wrongest of all.