Faculty Diaries: India – Railway to Heaven?

An Article By Prof. Leonardo Etro

 India is forecasted to grow 7.5% in the year 2016, overcoming China’s expected 6.5% growth.Since autumn 2015, shares on India’s S&P BSE Sensex overcame Shanghai Composite Index, up on the nearly 20% gap they had in spring 2015. Profits in companies on the Sensex were forecasted to climb approximately 40-50% through March 2016.

5-YR Sensex Index, compared with MSCI Emerging Markets and World Indices. Source: Bloomberg

For Standard and Poor’s, the current 10-year Government bond credit rating sits at BBB-, just one notch below investment-grade, with a stable outlook, like Indonesia. India has grown faster than similar peers over the last decade, thanks to favorable demographics, economic diversity, high savings and investment rates.

India’s growth and rating outlook benefited from the confidence that the Reserve Bank of India’s Governor Rajan built to ensure that inflation – whose March 2016 value is 4.83% – stays in check, given that food prices account for almost 50 percent of the CPI basket. As nearly other 30 central banks did, India eased monetary policy in the last years. The central bank rate is now 6.00%. Capital infusion into state-run commercial banks is in the way too, so that credit flows to productive sectors.

The yield on India, China, US, and Euro Benchmark Sovereign Curves. Source: Bloomberg

It looks like a rosy picture. but there are also clouds around.

Exports are trying to recovery from a steep drop in 2014-2015, which led to a negative current account. Factory output is forecasted to grow nearly 5% this year, while banks’ bad loans are a clear issue, given that they recently reached the highest level since the beginning of this century. Corporate balance sheets seem to be high-leveraged, I some cases even over-leveraged. Private investment as a percentage of GDP fell by more than 7 percentage points between 2007-08 and 2014-2015, while public investment stood still at the same level.Global Economic Watch. Source: Bloomberg

Foreign investors have been cutting positions in Indian equities in 2014 and 2015, as enthusiasm slowed down over the Prime Minister’s ability to push forward major economic reform proposals. Two years ago, newly-elected Modi was expected to foster subsidy cuts, higher investments, and a simpler tax scheme, including goods and services tax and a bill to make it easier for companies to buy land. Since then, these have been substantially stalled by the opponent parties. So, there are worries around – or even skepticism – about the speed of change and the ability to execute reforms.

What’s down the road? Roads and – most of all – railroads.

In fall 2014, the International Monetary Fund endorsed the Indian infrastructure spending plan, which has the potential to attract private investment – which slowed down to 23% of GDP in the year ended in March 2014, from 28% of the previous year – without putting at risk India’s public debt. There is a strong case for channeling resources to transport infrastructure in India, given both the clean fuel governmental program that started this fiscal year and the effects of transport networks in linking markets, reducing costs, and improving the economic competitiveness, especially manufacturing. Such initiatives heavily depend on public investment, and the large state-run companies can act as triggers.

10-YR Historical and Forecasted Key Metrics about the Indian Economy. Source: Bloomberg

Public investment – which accounted for some 32% of GDP in the year ended in March 2014, down from north of 38% of the previous year – faces two big challenges: financial resources and implementation ability. The road ahead is long, and neither very traveled too: in per-capita terms, China has invested on average ten times as India did over the period 2005-2014, even though both countries have similar populations. As a consequence, traffic congestion and low speed are everyday issues. Regarding network productivity, India still lies way behind Russia too. Moreover, passengers represent nearly two-thirds of network usage, thus leaving limited room for heavy freight.

Nevertheless, studies around provide evidence that a shocking surge in public investments in roads and railways has a notable positive effect on both manufacturing and aggregate output, and these effects are permanent as well. However, any public support should be clearly linked to serious reforms: of the structure of roads and railways; of adoption of commercial practices, and rationalizing fee and tariff policies; and through improvement in technology.