State Spending Masks Weakness in Indian Economy

As countries around the world saw their economies crumble in the past year, Indians took solace in the fact that their country had escaped relatively unscathed. With two successive quarters of 5.8% growth, India's economy bested much of the world by expanding 6.7%—a low number for its once red-hot economy, but far better than those of the U.S., Germany and even Japan, who all saw their economies contract. And with optimism growing about a turnaround in the global economy, many Indians are confident that things are looking up.

But don't pop the corks just yet, economists warn. Instead, a deeper look into the Indian figures reveals a worrying trend, they say. Since October, India's economic growth has been mostly buoyed by government spending, not by actual private-sector growth. In the last quarter of 2008, for instance, increased government expenditure made up almost all of India's growth, according to estimates by Singapore-based HSBC (HBC) economist Robert Prior-Wandesforde and by BusinessWeek. Without the government spending, the growth figure would have been a paltry (and stock-market melting) 0.1%.

Between January and March, as the country prepared for nationwide elections and politicians went off to campaign, things were only marginally better. India's gross domestic product would have grown by less than 2% if not for money from previously announced stimulus packages flowing into the economy. "If we take these numbers at face value, the private sector has suffered more than the headline numbers would have suggested," says Prior-Wandesforde. "If we stripped out the government contribution, then the degree by which India outperformed other nations would be much less significant."

To some extent, this trend of increased government spending is true worldwide. Both the U.S. and China, for instance, have announced stimulus packages that are far bigger than India's $50 billion to $80 billion in new spending and tax cuts. (China's stimulus was about $586 billion.) But because India's economy is still relatively small (about $1.1 trillion), and the private sector is still small except for the large, publicly traded companies, the government's role in the economy is much greater than in the U.S. or China. In most years since 2000, spending by India's federal government has made up more than 10% of India's economy; that number has recently shot up to 13%. (China doesn't release data the same way the Indian government does, making such comparisons difficult, says Prior-Wandesforde.)

A Soaring Deficit

One thing India has in common with the U.S.: a budget deficit. (That's much less of a concern for China, with its world-leading stash of foreign reserves.) During this slowdown, the government has announced three different stimulus packages that cost approximately $80 billion, not all of which has been spent so far. New Delhi is also committed to spending approximately $14 billion on a rural loan waiver and a rural employment guarantee, and before his Congress Party won a smashing victory last month in the elections, Prime Minister Manmohan Singh promised to spend more if re-elected. On June 6 the government announced it would provide free and subsidized food to its poor, a program that economists estimate could cost as much as $10 billion.

India's deficit has soared as the government has borrowed to pay for these expenses, to 10% to 12% of the country's GDP if one includes state-level borrowings, compared with 6% to 8% in January 2008. Bond yields on the 10-year note climbed to a six-month high last week as the government said it planned to borrow $11.3 billion in June, higher than it had previously decalred. When India announced its last stimulus package, Standard & Poor's changed the outlook on India's BBB- debt to negative from stable.

Still, the newly elected Congress coalition government has promised to make big-ticket expenditures for the rural voters who swung the party to a near absolute majority. "We certainly don't begrudge the government spending this money," says Moody's (MCO) sovereign credit analyst Aninda Mitra, who watches the Indian government closely to decide on its credit ratings "Given how the global economy has slowed down, one could say that the government spending came at the right time. The key concern is how does one wind down these expenditures in the future, especially if the rural sector has come to expect this kind of spending."

Foreign Investor Confidence

In India, the deficit is largely ignored by voters. But GDP numbers are often obsessed over, with newspapers and television news trumpeting the figures, comparing them with China's. Strong GDP growth figures are what has made India's economy such an attraction for foreign investors; so far this year, partially because of the confidence these figures create, foreign institutional investors have poured more than $1 billion a month into the stock markets, almost double what they did in the previous 12 months.

As a result, the Indian stock market's benchmark index, which is dominated by fund-buying and selling, is up almost 50% for 2009, a spectacular leap at a time when earnings growth is still anemic, exports are down 33% at least for the last two quarters, and most Indian corporate houses are loaded down with expensive debt. Earnings for all but the oil and gas companies listed on the Bombay Stock Exchange fell 20% in the last quarter of 2008 and only grew 4% between January and March. (The outliers, not included in this analysis, were oil and gas companies, which saw their profits grow by nearly 275% for the January-March quarter.) However, India's pharmaceutical industry's earnings dropped as much 800% during the same period, according to an analysis by Macquarie (MQG.AX).

To a large extent, the expectation is that as India's private-sector growth picks up again, the Indian government will slow down this expenditure. Already, in mining, infrastructure, cement, and auto, lower input prices have resulted in increased profitability and capacity. The Indian government says India's economy may grow as much as 7.5% in 2009-2010, and other economists peg the growth potential within one percentage point of that estimate.

However, since the Indian government is increasingly constrained in how much it can continue to borrow to make these expenditures, the timing has become key. One more quarter of slow private-sector growth combined with slowing government spending and India would need to worry about a problem it so far has avoided: GDP growth figures that grab headlines for the wrong reason.

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