Tests drown out India's economic big bang

AFTER THE shootings in Tiananmen Square foreign investors paused, held their noses, and plunged on in. China was just too good an investment prospect to allow a little political hiccup like that to unseat their expansion plans. China is - on purchasing power parity calculations - the world's second-largest economy, and for an international company that is a place to chase.

Now what about India? India, on a similar basis, is the world's fifth- largest economy, ahead of France (see left-hand chart). At some stage over the next generation it will almost certainly become the world's most populous country, passing China.

Add in some further bull factors. It has managed to weather the recent Asian turmoil almost unscathed. It has a half century of democratic government, and no economic catastrophes akin to China's great leap forward or its cultural revolution. It has a secure banking system. It has a growing and well-educated Anglophone middle class. Annual economic growth has bobbed around 7 per cent for the last three years. It ought to be very interesting for foreign investors.

But it isn't. It has not attracted much inward investment by comparison with the undemocratic regimes in East Asia, and the nuclear tests now don't help. I don't want to get into the rights and wrongs of that decision, except perhaps to recall that when Britain first exploded its nuclear bombs, the tests were welcomed with the same acclaim here as India's action last week was greeted in the Indian press. Instead let's focus on whether the dismay with which the tests have been greeted in the rest of the world seriously undermines the country's efforts to achieve rapid, self-sustaining economic growth. Does it abort the Indian take-off? Is there really a take-off anyway?

Step back a couple of weeks, before the nuclear tests, and it would have been possible to paint a mildly encouraging picture of Indian economic prospects. No one doubts that India's penchant for obsessive economic regulation has gravely hindered the development of the country's economy ever since independence. The country's share of world trade, at less than 2 per cent, is lower now than it was in 1950.

But by the mid-1980s it had become clear that the combination of protectionism and regulation was condemning the country to very slow growth, and at the end of the 1980s India started a series of market reforms akin to the reforms that began in China a decade earlier. These reforms, which started to be implemented in earnest in 1991, coincided with the early 1990s recession. Nominal GDP - that is, GDP converted into dollar terms at the prevailing exchange rate - shrank quite sharply at the beginning of the decade, as the middle graph shows. (Note that nominal GDP gives a much smaller figure for the size of both the Chinese and Indian economies than purchasing-power parity GDP. If you are interested in the overall size of an economy the PPP basis is the best comparison; if you are looking at current trading performance the nominal figures are of more use.)

But after then, from 1993 onwards, India has done pretty well. Last year it achieved 5 per cent growth and for the previous three years it managed 7 per cent. Indian industry has passed through what for it was a searing dose of competition, with deregulation and reductions in tariffs savaging margins. Many companies went out of business.

A further problem was that a lot of the growth was internally generated. India has been very successful in some areas of exports: software exports have risen from $180m in 1992 to nearly $800m in 1996, and were probably over $1bn (pounds 610m) last year. Merchandise exports, too, grew rapidly in the mid-1950s, rising by up to 20 per cent a year. But the base is small: total exports were only $33bn last year, tiny by comparison with Korea or Indonesia, let alone China (right-hand graph). And in the last year export growth has faltered.

What is needed is continued rapid structural reform: India is perhaps a quarter of the way down the reform path China has followed. This would encourage inward investment, which in turn would boost exports and finance further growth. But the new BJP government is suspicious of foreign capital. To its credit, it is pressing ahead with reform of state industries and says it will continue with privatisation. But an attitude of near-hostility to outside investment is pretty catastrophic.

A survey of foreign fund managers by Burston-Marsteller at the time of the recent election revealed mixed reviews. In portfolio investment terms, investment in Indian companies looks cheap: the market is trading on a price/earnings ratio of about 11. But there is a world of difference between the views of a portfolio manager wanting to buy shares in well- run domestic companies (of which there are quite a few) and a solid commitment by the multinationals to focus more of their attention on India. The country needs the latter if it is to crank back up to the 7 per cent growth level.

It isn't going to get it for a year or two. Much of the talk in the last few days has been of economic sanctions on India - Japan freezing aid, and so on. Viewed from an economic perspective, formal sanctions by foreign governments are much less of a threat than the informal concerns of foreign commercial companies. Whatever the outcome of the moves on sanctions, there will be some pulling back on commercial projects. Worse, the response of the Indian government to the outburst of external anger at its tests, may well be to slip back to the "we don't need foreigners to tell us what to do" attitude which was so damaging during the pre-1991 period.

Further, the Indian economy is going to be affected to some extent by the turmoil in East Asia. Demand for India's basic exports - commodities like cement or petrochemicals - has been depressed by the collapse of the region's construction industry. Most forecasts for GDP growth this year are in the 5 per cent region, with the same again next year, but there is a clear danger that the country will slide back to stagnation.

The nature of the downside is one of the things that makes the Indian economy different from most of East Asia. The dangers elsewhere are of some sudden discontinuity: serious disruption of some sort, such as is now occurring in Indonesia. In India the danger is one of stagnation, a slip back to a rate of growth which condemns the Indian poor to poverty for another generation or more.

So do the nuclear tests abort the take-off? Not really, because the take- off which seemed to be happening a couple of years back had already faltered. What the tests will do is make it much harder for international companies to commit to India for at least a couple of years. Yes, western companies are going to adopt the same pragmatic attitude to India as they adopted to China, so in a sense the tests will do no more harm than the Tiananmen Square massacre - if one can talk about these events in such callous terms.

But the economic reform process is at a much earlier stage and is much more fragile. The hostile response of the world to the tests is liable to tip what is clearly a weak coalition government into a hostility towards foreign investment in general. As foreign opinion has strongly supported the reforms, they may also be undermined.

My guess is that India will experience another run of rapid growth in the next few years, but progress will at best be a two-steps-forward, one-step-back variety. And before the next burst of economic growth there will be another pause, maybe another period of stagnation. The chances of that, sadly for hundreds of millions of India's poor, have increased in the last 10 days.

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