Indian tiger fights to regain its bite

The subcontinent has opened its stock market to foreign investors in an attempt to counteract a steep decline in equity prices as growth falters

Not so long ago, India looked like it might even outdo China. Indian companies, led by the Tata Group, were swashbuckling their way around the world, buying up established Western brands such as Jaguar Land-Rover and the Corus steel maker, while the country had bounced back nicely from the financial crisis, recording a 10.1 per cent jump in gross domestic product in 2010.

But a cocktail of temporary and longer-term economic and political issues conspired to drag down India's benchmark Sensex stock index by a quarter last year, making it the worst-performing equity market among the world's major economies.

The decline has largely been blamed on an exodus of foreign investors in the past few months as they became increasingly concerned about India's economic outlook. Overseas funds withdrew a net $380m (£245m) last year, after record inflows of $29bn in 2010.

After a year it will be glad to see the back of, the Indian government, whose indecision is cited as a contributor to 2011's equities decline, is fighting back. This week it overturned a long-standing rule which had prevented individual foreigners from directly investing in its public companies, in the hope of regaining much-needed investment from overseas.

Previously, foreign individuals had only been able to invest in Indian companies indirectly, through unit trusts, pension funds and other institutions. From 15 January they will be able to invest direct.

Pranab Mukherjee, India's Finance Minister, said: "We decided to allow qualified foreign investors to directly invest in the Indian equity market in order to widen the class of investors, attract more foreign funds and reduce market volatility. The steps that the government is taking should hopefully help restore some confidence in the market."

Analysts argue that the government's long-overdue move is sensible. Samiran Chakraborty, head of research at Standard Chartered in India, said: "The new role is an extension of the gradual process of the liberalisation of India's capital markets. But the big question is, how much money will actually come through this channel? Technically, there is huge potential, but it's a question of timing. India looks quite challenging at the moment, and that might deter foreign investors, at least in the short term."

Mr Chakraborty argues that India's fall from economic grace stems from the high inflation that resulted from 15 years of strong growth, as cash and resources poured in, although rising prices are by no means the only culprit.

As India's economy has shown signs of dangerously overheating, the Reserve Bank of India has raised rates 13 times since March 2010, leaving them at a hefty 8.5 per cent. Inflation, however, remains stubbornly high at around 9 per cent.

The rate rises increased the cost of capital, reducing the appetite of business to borrow and pushing investment down in the third quarter of 2011.

This is a rare occurrence in a country which saw average annual investment growth of 15 per cent between 2004 and 2008, and it helped push India's budget deficit considerably higher than the government forecast, in a move that further spooked investors.

The other big "timing" issue India faces is that now is a bad time for everyone. India's exports have soared in recent years to the point where they account for a quarter of its economy, in a positive development that none the less makes it more susceptible to the eurozone debt crisis and sluggish US economy. It is hard to blame India too much for economic woes that relate to its prolonged and rapid growth or the slowdown in the west. However, it is less easy for the country to sidestep deep-seated "structural" issues, some of which appear to have become even more entrenched in the past year.

Analysts say two events have done much to undermine the confidence of potential investors in the country.

The first concerns corruption, which came under the spotlight in 2011, in the form of an alleged $39bn telecoms scandal that has embroiled Ravi Ruia, chairman of Essar Energy.

India's Central Bureau of Investigation accused him and his nephew, Anshuman, an Essar director, of using a small firm, Loop Telecom, to buy a mobile licence for which it was ineligible. Essar already held one through a joint venture with Vodafone. Mr Ruia has stepped down "temporarily" as chairman but denies all wrongdoing.

Last week the Indian government had the chance to pass a new bill that would have addressed the growing wave of opposition to corruption that has been engendered by a series of high-profile cases. However, having passed the lower house of parliament, the proposed crackdown on corruption failed to clear the upper house, at the very least kicking the legislation into the long grass for several weeks.

The second significant event concerns a last-minute U-turn by the government on reforms that would have finally allowed foreign supermarkets into India. However, the government changed its mind following vehement street protests. Throw in other issues – the poor infrastructure, high levels of red tape surrounding labour and buying land, not to mention a 16 per cent decline in the value of the rupee against the dollar that will further erode returns – and getting foreign investors back into India is looking to be a hard sell.

Andrew Kenningham, senior international economist at Capital Economics, said: "It is unusual to have a restriction like this on foreign investment in the first place, so it certainly makes sense to remove it.

"But lower growth and a higher deficit is likely to affect confidence and potentially the rupee," added Mr Kenningham, who forecasts that India's economic growth fell from 10.1 per cent in 2011 and will stay reasonably flat for the next two years.

With a rapidly growing and youthful population of 1.2 billion, most economists agree that anything below 7 per cent growth will put pressure on a population being squeezed by high food and energy prices and an increasingly noticeable disparity of wealth as the very richest become more prosperous. Some Indians believe this is an explosive concoction that could lead to huge social unrest.

"It looked like India came out of the global crisis in good shape, but that no longer looks to be true. A lot of the emerging markets are slowing, but India is slowing noticeably more than the others," Mr Kenningham said.

Mr Chakraborty also expects a slow start to the year, with economic growth running at an annual rate of about 6 per cent. But, he says, the central bank said it was more concerned with growth than inflation, indicating we could be in for a bout of rate-cutting with all its economic benefits.

In the longer term, the government needs to get to work on its structural issues. It could start by resuscitating its anti-corruption Bill.