Manmohan Singh is no stranger to economic reform. In 1991, following the balance of payments crisis, Singh, then India’s finance minister, freed his country from the so-called Licence Raj, the tangle of regulatory red tape that had long been the cause of economic stagnation.
More than 20 years later, after a period of rapid growth and numerous bumps in the road, prime minister Singh has underlined his credentials as a reformer by unveiling measures aimed at enhancing India’s global competitiveness.
The moves include the opening of the aviation and retail sectors to overseas investors and the sale of stakes in state-owned companies. Specifically, the new measures would allow up to 51% foreign direct investment in the retail sector, 49% in civil aviation and power trading exchanges, and 74% in broadcasting.
The reforms came shortly after a 14% increase in local fuel prices – a crucial change to the government’s fuel subsidy policy that should also contribute to fiscal consolidation.
The actions of Singh and the government were broadly welcomed by the international community but caused controversy at home.
According to Alliance Bernstein, the euphoria created by the announcements was short lived. A rally in the rupee/dollar exchange rate was almost immediately cancelled out as criticism of the measures spread both within and outside the United Progressive Alliance (UPA) coalition government. The All India Trinamool Congress (Atic), a member of the coalition, threatened to pull out of the administration. Although the government stressed that there would be no rolling back of the reform policy, it also considered providing some leeway for local state governments on the retail foreign direct investment reform so that they could minimize the impact on small businesses.
|A trader with mock chains around his wrists and a gag tied around his mouth protests in New Delhi at the end of September against the government’s decision to allow FDI in the retail sector|
Anthony Chan, Asian sovereign strategist at Alliance Bernstein, sounds a cautionary note as the market digests the reforms. "Heightened political rhetoric and policy uncertainty are keeping the risk for Indian assets high," he says. "Depending on whether the government plays tough and continues a reformist path or it makes a retreat, the outcome for financial markets would be almost binary."
He adds that the middle-ground outcome – a diluted reform programme – might not result in a complete loss of investor confidence.
"In addition, the impact of QE3 on India remains unclear," he says. "It could affect oil prices and capital flows, which are likely to play a key role in shaping the country’s balance-of-payments landscape in the coming year. Here, too, progress in the reform programme could support a positive outcome."
In announcing the changes, Singh admitted that the challenge for India was that "we have to do this at a period of time when the world economy is experiencing great difficulty".
Citi said in a research note about the reforms: "The measures tick a lot of the boxes that investors had been expecting of the government, and collectively have surprised the market in scale and the aggressive nature in which they have been projected. Following this, the Reserve Bank of India cut its cash reserve ratio by 25bp, thus injecting Rs170 billion [$3.2 billion] liquidity into the system. Although there has been some political backlash against these reforms, our economists feel that the government should be able to withstand it."
Economic growth in India has slowed to an annual rate of 5.5% compared with 8% two years ago.
Shortly after the reforms were announced, a government panel said in a report that the Indian economy was precariously balanced and subsidies in diesel and petrol should be slashed urgently to curb a budget deficit that might hit 6.1% of GDP in this fiscal year.
The panel said that a failure to curb subsidies would lead to a flight of foreign capital and a potential downgrade.
Failing to tackle the deficit means India might face a worse situation than the crisis in 1991, when the country was bailed out by the IMF and Singh began his reform initiatives.
"The Indian economy is presently poised on the edge of a fiscal precipice, making corrective measures aimed at speedy fiscal consolidation an imperative necessity if serious adverse consequences stemming from this situation are to be averted in an efficient and timely manner," the government panel report said. "We cannot overemphasize the need and urgency of fiscal consolidation. Growth is faltering and inflation seems to be embedded. The external payment situation is flashing red lights."