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Markets and economy: The stumbling blocks!

Sep 22, 2006

'India is not on autopilot to greatness. But it would take an incompetent pilot to crash the plane'. These words of Mr. Edward Luce very aptly define the contours of the Indian economy. The economy has been growing at an average annual growth rate of nearly 6% since the 1980s, and at over 8% during the last three years. Besides, India has also shown considerable resilience during the recent years and avoided adverse contagion impact of several shocks. This has precipitated to increased confidence in the country's financial markets with a consistent increase in gross domestic investment rate from 23% of GDP in FY02 to 30% in FY06. The gross domestic saving rate has also improved from 24% to 29% over the same period, contributed by a significant turn around in public sector saving. A case in this point is that the inflows into mutual funds alone have multiplied 10 times in the last decade and is currently at all time highs!For this buoyancy to sustain, the country will have to tide over several stumbling blocks.

Inherent flaws...
First, the poor state of the physical infrastructure, both in terms of quantity and quality. While with the healthy fundamentals of the domestic financial sector and the enhanced interest of foreign investors, funding should not pose a problem, issues relating to regulatory framework and rapid execution need to be addressed by the government.

Second, fiscal consolidation. The recent budget of the central government targets a gross fiscal deficit of 3% of GDP by 2009. This requires fiscal empowerment, which is possible through two routes (i) elimination of subsidies or (ii) elimination of tax exemptions. While in any economy fiscal consolidation is hard, it is particularly so in our setting

Third, India is set to remain one of the youngest countries in the world in the next few decades. This 'demographic dividend' cannot be used to the economy's advantage unless prerequisites such as skill-upgradation and sound governance to realise it are put in place.

Fourth, there is a need to shift the emphasis from foreign institutional investment to attracting foreign direct investment, which is less volatile. This requires a more favourable investment climate in general both for domestic and foreign capital.

Global Imbalances...
As India does not depend on the international capital market for financing the fiscal deficit, the extent of adverse consequences of the global developments would be muted. However, there could be a spillover effect of global developments on domestic interest rates and thus on fiscal position. Also, a faster rise in rates overseas could lead to a shift in investor confidence to the international markets. Further, should there be a reversal of capital flows, asset prices may decline. With this there is a risk that rise in interest rates in general could impact the housing market and expose the balance sheet of the households to interest rate risk, increasing the risk of loan delinquencies for banks. Banks in India have invested significantly in government debt and other fixed income securities. If a rise in international rates gets reflected in domestic interest rates, banks will also have to mark down the value of their investment portfolio.

Multilateral confidence...
Finally, there needs to be the confidence of the investor community on multilateral aspects such as political stability, terrorism combating ability and significance at global economic platforms (such as the IMF and World Bank).

While we do not intend to sound pessimistic about the continued resilience of the economy to global and internal shocks, investors investing in the India story should assess these grounds before judging the 'market risk' to be assigned to a stock. Weighing this with the premium expected to be earned over and above the risk free rate (10 year GSec yield), will help you correctly align your portfolio as per your risk profile.

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