It's a ritual test for Indian governments -- the annual budget, which this year Finance Minister P. Chidambaram will unveil on Feb. 28. Investors usually await the budget anxiously, fearing tax and spending hikes that could wreak havoc on the financial markets. But this year, Indian businesspeople expect no unhappy surprises. Indeed, they're giving Prime Minister Manmohan Singh high marks for his first nine months in office, and they expect the coming year to bring still deeper reform. "All the indications suggest that India is moving in the right direction," says Sunil Mehta, insurer AIG's India country head.
Despite fears of a reform slowdown when the communist-backed, Congress Party-led coalition took office in May, Singh & Co. have kept up a steady pace of structural changes in the economy. Now hopes are rising of new moves that could strongly boost both domestic and foreign investment. Analysts expect Chidambaram's budget measures to include a sharp increase in allowed foreign ownership in Indian banks, from 49% to 74%. The cap on outside stakes in Indian insurance companies will likely rise from 26% to 49%. For the first time, foreigners could be allowed into the construction industry. Major tax reform is in the cards, too. A myriad of income-tax rates ranging from 10% to 35%, along with complex exemptions, will be simplified to two flat rates of 20% and 30%.
Singh, the architect of India's first economic liberalization in 1991, and Harvard Business School-educated Chidambaram aim to keep deregulating the economy while boosting spending on the rural poor. Even before Chidambaram's budget presentation, he set the tone with a series of pre-budget moves. Both the aviation and telecom industries were opened to more foreign ownership. And the government announced that on Apr. 1 it will replace state sales taxes, which are as high as 22%, with a new value-added tax of 4% for raw materials and 12.5% for finished goods. This is expected to bring in $10 billion a year in new revenues -- money the government will use to cut the budget deficit, which is running at 10% of gross domestic product.
If the tax overhaul works, it could make a big difference in India's overall economic picture. Once Singh gets the deficit under control, India's credit rating could be raised to investment grade for the first time, says Fitch Ratings' chief executive in India, Amit Tandon. "It's a critical psychological barrier that, if breached, will draw a greater number of heavyweight investors to India," he says. A big challenge will be reining in profligate state governments, whose share of the budget deficit has been rising as they hand out goodies to voters.
Singh's reforms are making India a hot market. Foreign investment in Indian equities could top $10 billion this year, up from last year's $8.7 billion. If the reforms work, foreign direct investment should rise well above last year's meager estimated $5 billion. In February, for example, Korean steel giant Posco (PKX ) said it would invest a total of $8 billion in building a steel plant in the eastern state of Orissa.
Of course, obstacles, such as creaky infrastructure, remain for investors. But prospects are brightening. Local electricity operators are adding capacity. The government is building thousands of kilometers of highways and plans to privatize five key airports and add six ports in the next three years.
With the tech sector on a roll and manufacturing looking up, Singh and his team are blessed with an economy that's now growing at 6.5%. They want to boost GDP growth to 10% within a decade. Some analysts are skeptical. The demands of leftist coalition partners and high-spending state governments "could seriously constrain India's competitiveness down the road," warns Ajay Sondhi, vice-chairman of Goldman, Sachs & Co.'s (GS ) Indian affiliate, Kotak Mahindra Capital. Singh needs to keep up his combo of skillful leadership and steady reforms.
By Manjeet Kripalani in Bombay