India: it’s time to look west

If nothing else, the extraordinary, meticulously planned abolition of high-value Indian currency notes while the US election was in progress demonstrates a government with the ideas and determination to make dramatic change.

"What India Prime Minister Narendra Modi has done with the currency is a piece of central command which even China would consider audacious."
Richard Yetsenga, Chief economist, ANZ

This was a very carefully orchestrated, amazingly stealthy operation to improve tax collection and economic efficiency by removing the vehicle for India’s huge black economy in one fell swoop. It simultaneously eliminated the means of tax avoidance and created the incentive for Indians to move into the formal economy.

India is often contrasted with China and the rise of China has certainly delivered enduring benefits to Australia.

Australia's relationship with India, however, remains much less mature despite the prospect that India will eclipse China's growth in a sustained fashion over coming years.

What Prime Minister Narendra Modi has done with the currency is a piece of central command which even China would consider audacious. It shows India is serious about reform but it is by no means the only program in train.

ENERGY

A perennial limit to India's growth has been the cost of energy. India imports 80 per cent of its crude oil needs.

Historically, a strong global economy has driven up oil prices and, particularly when combined with strong demand in India, India's import bill – in turn spooking markets as India’s fuel subsidy regime rapidly inflated the fiscal deficit.

But the global price of oil is now structurally lower. Moreover, more flexible supply also implies oil prices will be much less sensitive to stronger global demand.

Add in a 50 per cent rise in global LNG supply by 2020 and unhelpful energy prices swings are unlikely to threaten India's growth cycle any longer.

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Another structural benefit is diminished concern about India's relatively immature manufacturing sector.

Manufacturing is capital heavy and requires access to physical resources. India's historically high interest rates and poor access have historically constrained the development of a manufacturing sector.

Services, however, are capital light, people heavy and skill intensive - a much more natural space for India.

Importantly, also, the current global cycle is being dominated by services, with services trade also continuing to grow strongly despite the recession in goods trade. India's manufacturing infancy now seems much less of a handicap.  

FERTILE GROUND

These gains might be fleeting but they have already provided fertile ground for reform. Reform involves adjustment which is often uncomfortable; building reform momentum is difficult.

But there is now an emerging track record of meaningful reform in India. Consider: a BJP government paved the way for a GST; made efforts to reform land use; appointed a genuine technocrat as Governor of the Reserve Bank of India (and a credible successor); adopted an inflation target; made a genuine fist of reforming the bankruptcy process and forced banks to break with tradition and stop evergreening obviously sour loans.

Among these reforms, the adoption of an inflation target and evidence of commitment to it is perhaps the most defining reform. A lower interest rate structure, more stable currency and flatter yield curve will produce substantial and ongoing economic gains.

The investment case for India is becoming more self-evident and India’s position in global investment portfolios has been rising in prominence for more than a decade now.

Foreign investors already own 25 per cent of the equity markets and the bond markets have become much more open in recent years as India has looked to tap additional pools of capital.

More importantly, however, the prospect of a much narrower inflation gap implies the currency depreciation foreign investors have needed to give up against the value of their rupee assets is likely to diminish structurally.

For businesses, tapping India's opportunity has been more complex. A range of issues including access to resources (energy and land); timely and transparent legal rulings and certainty around taxation and regulatory arrangements have tended to discourage commercial investment. The good news is the reform effort is bearing fruit on these and other issues.

As a very broad measure of competitive position, the World Bank’s Doing Business Survey has India’s ranking improving to 130 of 186 countries – nothing to crow about but familiarity and commercial opportunity are often more important than the actual ease of doing business.

Consider China’s ranking at 84 and Indonesia’s ranking at 109: two large regional economies in which Australian business has been commercially entrenched for years.

Familiarity is often a question of human linkages. According to the 2011 census, Australia had just shy of 300,000 residents born in India, up 100 per cent from the 2006 census.

From Asia, only China, with 320,000 residents, was larger. The 2016 census data is likely to show even higher numbers.

Accessing India may currently seem more daunting than accessing China but then accessing China 15 years ago was pretty daunting as well.

India’s black economy was just one challenge for development but the precision strike by the government bodes well for greater advancement.

Richard Yetsenga is chief economist at ANZ

This story was originally published on The Australian Financial Review