General Political Environment & Its Impact

Democracy is well entrenched within India’s political system, but is complicated by tensions over religion, ethnicity and a deep-rooted patronage system. The extreme diversity within India’s socio-economic environment is highlighted in the varied political cultures and ideologies across the country. The legislative environment from state-to-state differs considerably as states enjoy significant autonomy.

Coalitions led by either the Indian National Congress (Congress) or the Bharatiya Janata Party (BJP) have traditionally dominated federal level politics. The surprising strong electoral success of the Congress-led United Progressive Alliance (UPA) in 2009 alleviated some of the concerns observers had raised over regional fragmentation within India’s political environment. The UPA which had been in power since 2004, secured a near majority in the legislature in 2009. It further strengthened its position by several electoral successes at state assembly elections.

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The opposition coalition led by the BJP finished a distant second. The UPA was expected to implement important and much anticipated reform programs given its strong position; however large-scale reforms have been elusive due to the complex nature of Indian coalition politics. Furthermore, the government has had to spend a considerable amount of time and energy managing the political fallout over several high profile corruption scandals and controversial pieces of proposed legislations including attempts to reduce subsidies through much of 2010.

India’s much talked about corruption woes were put on the world stage due to high profile investigations and arrests related to irregularities concerning the 2010 Commonwealth Games and auctioning of 2G wireless spectrum. These scandals have tarnished the government’s image and emboldened the BJP-led opposition groups to challenge the government. For example, calls for a joint parliamentary investigation into these allegations paralyzed the winter 2010 parliamentary session. Controlling rising costs of essential food items has also been a challenge.

The UPA came to power on a pro-poor platform and therefore has to balance liberalization efforts with the immediate needs of segments of the population most vulnerable to price shocks. Anti-government protests over rising costs of living have been common-place. Several state assemblies will hold elections throughout 2011/12; the UPA is therefore likely to refrain from unpopular reform including subsidy cuts. Investment Environment: Despite India’s foreign investment policy allowing 100% FDI in most sectors, India has thus far failed to reach its full potential as a destination for FDI.

Government attempts at increasing FDI inflows have been hampered by several impediments including pervasive corruption, an unwieldy bureaucracy, and a critical infrastructure deficit. Corruption in India is widespread especially in the public sector. The deep-rooted patronage systems, bureaucracy, and weak governance contribute towards these high levels of corruption. India’s Supreme Court of late has been taking an active stance in fighting corruption. The judiciary especially at the higher levels is considered competent and fair, recent judicial sector reforms are said to have reduced the huge backlog of cases and increased efficiency.

Regulatory uncertainty, both at the federal level and between federal and state levels continues to pose challenges. South Korea’s POSCO’s five year struggle to start a steel mining project in Orissa was emblematic of this lack of regulatory clarity between the Federal government and states. The eventual approval of the project in February 2011, albeit with strict environmental conditions may prove a way forward for large high profile projects. Political Violence: Several terrorist attacks in recent years in several major cities highlight the threat posed by Islamistmilitant groups within India.

The latest – the November 2008 Mumbai attack – resulted in over 180 deaths. Though there have been no major attacks since 2008, warnings of pending attacks are becoming increasingly common and future attacks in major cities cannot be ruled out. Tensions with Pakistan have threatened regional stability since 1947. Several years of peace talks on the disputed Jammu -Kashmir territories have resulted in little progress. The Mumbai attacks led to deterioration in Indo-Pakistani relations due to Indian government allegations of Pakistani government agencies involvement in the attacks.

The ongoing Maoist (Naxalite) insurgency – named the single biggest threat to internal security by Prime Minister Singh – is growing increasingly violent. New Delhi may be forced to take on more responsibility in tackling the Naxalites, an issue that has hitherto been considered an internal matter for individual states to deal with. Hindu/Muslim based communal political violence issues remain as well throughout certain parts of India. MARKET SPOTLIGHT: GDP growth remained slowed to 8. % in Q4, largely as a result of the slowdown in government spending and private investment. The pace of import growth has slowed markedly in recent months, in line with weaker industrial activity. The FY 2011/2012 central government budget is soft on fiscal consolidation efforts, but reinforces the commitment to infrastructure and education. With inflation remaining above target and an acceleration of bank, the central bank has returned to a tightening stance by raising interest rates early in the year and is expected to do so again in coming months.

March 2011 ECONOMICS Recent performance: Real GDP growth slowed to 8. 2% in Q4-10, bringing overall growth in 2010 to 8. 6%. On a seasonally adjusted basis however, real GDP fell 2. 1% an annualized rate from 15. 5% in Q3. Despite a greater contribution from net trade, a decline in government spending and a sharp slowdown in investment took the momentum out of the Indian economy. Across sectors, the slowdown was widespread,with only agriculture and finance showing a pick-up in growth.

Industrial activity stood at a near standstill in Q4, rising 0. 2% , as spending on capital goods and intermediate goods fell. Consumption spending rose slightly but remains well below potential, expanding 0. 4% . Fiscal policy: Plagued by various scandals, the government presented a budget for FY2011/2012 that is weak on reforms and consolidation. At the same time, the government has maintained or increased a number of populist measures, such as price subsidies on sensitive items as well as the rural workers guaranteed employment program.

The forecasted improvements over the next 2 years rely on optimistic growth assumptions and improvements in tax collection, as well as the capacity to contain spending within the allocated budget. On the positive side, the budget reinforces the government’s commitment to infrastructure and education development and highlights some progress in key changes in the tax systems (direct and consumer taxes), both of which are impediments to unlocking India’s growth potential. As a share of GDP, the central government deficit is expected to reach 4. % of GDP in FY2011/2012 (excluding off-budget food, fuel and fertilizer price subsidies and the deficits of state governments), from 5. 1% in FY2010/2011. Monetary policy: After a lull in Q4, inflationary pressures picked up again early in 2011, pushing the Reserve Bank of India (RBI, the central bank) to return to a tightening stance, raising interest rates by 25 basis points The move was prompted not only by resilient inflation pressures,with inflation remaining stubbornly high at 8. % for both the CPI and WPI in January, but also strong demand for credit, which accelerated to 22. 5% in December from 18. 2% in November. While the increase in prices is partly driven by food shortages, the ramping up of growth and non-food inflation since are also of concerns. As such, additional tightening is expected early in the year. External sector: Despite strong export growth and remittances inflows, the current account balance continued to expand as a share of GDP in Q3, rising to 4. 3%. In Q4 however, the trade surplus shrank to US$21. billion in Q4, after averaging over US$30 billion in the first 3 quarters of the year, driven by resurging exports, up 28. 4% y/y, and a sharp slowdown in imports, up 1. 8% y/y, a sign of the slowing economy. With rising oil prices and the capital account vulnerable to outflows, the balance of payment and rupee are expected to weaken in 2011. However, the level of foreign exchange reserves remains stable at US$274 billion, up from US$254 billion in May 2010, and sufficient to cover 7 months of current account debit.

Outlook: The lagged impact of monetary tightening and the pullout of fiscal stimulus will slow real GDP growth to 8. 2% in 2011 from 8. 6% last year. While infrastructure spending will accelerate, tighter credit conditions will result in a slowdown of private sector activity. Of concern for the medium-long term business environment are the current corruption scandals, such as those of the Commonwealth Games and the 2G licenses, that have engulfed the Indian Parliament, putting the reform agenda on the sideline for the moment.