clear skies ahead?

India's economy reaches the "takeoff" point. But will tumultuous politics put it in a holding pattern?

By Jason Overdorf/New Delhi
(Newsweek Web extra - November 24, 2007)

India's politics may be in turmoil, but so far the chaos hasn't put a crimp in the country's economy. Last quarter, GDP grew by more than 9 percent, a huge improvement over the 3.5 percent the country averaged in its first 30 years.

The explanation for the disconnect, according to a recent report by Lehman Brothers, is that India's economy has reached what experts call a "takeoff" point where the "old blocks and resistances to steady growth [have been] finally overcome." The report predicts that India's economic momentum has become virtually unstoppable, thanks to two main factors: an average 6.9 growth rate in per capita GDP since 2003, and a trade-to-GDP ratio that has doubled over the past seven years.

The surge in per capita GDP to about $800—from less than $350 in 1995—has more than doubled the size of India's middle class to about 50 million, increasing demand for consumer goods and stimulating manufacturing. The increase in the trade-to-GDP ratio shows that India's economy has finally opened up to the world as dramatically as China's and South Korea's did before it. Meanwhile, a boom has boosted India's investment-to-GDP ratio into the 30 to 40 percent range, from about 15 percent in the early 1990s—hitting the level many analysts believe was essential to the rapid growth experienced in other parts of Asia. And the trends, according to Lehman Brothers, suggest that India is just getting started. If it continues to make economic reforms, such as simplifying taxes, loosening labor laws and changing the pension system to help build a healthy corporate bond market, the economy could soon hit China's mythic 10 percent annual growth rate.

But that's a big if. Prime Minister Manmohan Singh's reforms—most of which he made as finance minister between 1991 and 1996 (one reason he doesn't get credit for them now)—succeeded so well that they eliminated any sense of urgency. In this sense, the prime minister may be a victim of his own achievements. The problem, says Subir Gokarn, chief economist at Crisil, a credit-rating agency, is that "when the economy is doing so well, you cannot create a constituency for reform." The ability to make big changes, he explains, is "independent of the individual, independent of the party, independent of the system. When there's a widespread perception of crisis, then reform happens. When there isn't, it doesn't." In 1991, such a crisis atmosphere came from an exchange-rate drop that nearly depleted India's foreign-exchange reserves. But the country has faced no similar threat since 2004.

Thus reform has slowed dramatically. Singh's government has failed to take steps like relaxing India's stringent labor laws and selling off state-owned industries. That said, it has managed to make some important improvements in recent years—despite fractures within the governing coalition and the lack of an outside prod. For instance, after becoming prime minister in 2004, Singh, despite local opposition, began measures to allow foreign direct investment in the retail sector and to facilitate the creation of large domestic retail chains. He also moved to encourage public-private partnerships in infrastructure projects—potentially bringing more money and better management to one of India's biggest laggards. And he unleashed what could be the biggest stimulus for India's manufacturing sector since 1991, setting up a huge number (386) of special economic zones last year, where industry will enjoy preferential tax policies and government assistance in acquiring land. (Between 1965 and 2004, by contrast, India established only eight.)

The alignment of economic agendas between India's two largest political parties—Congress and the BJP--is perhaps the best sign of all for the country's economic future. Politics in India can prove unstable; four different governments ruled during the 1990s; the BJP-led alliance held sway from 1998 to 2003, and a coalition led by the Congress Party has ruled since 2004. But as the politicians have traded seats, economic reforms have continued apace. This suggests that despite some resistance and reluctance to make further changes, both of the major parties believe there's no going back on reforms already undertaken. Moreover, as the Lehman Brothers report points out, "The general pattern in democracies worldwide is that governments find it easier to push through reforms—and other potentially controversial legislation—earlier in their term of office." That means the 2009 general elections might give the Indian snowball another push, bringing 10 percent growth into view at last.
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