The 3 Rs of India: reforms, RBI and (US) rate hikes

Thinking Aloud

It’s been a really busy quarter for reform hasn’t it?

Reforms in India are like buses: none appears for ages and then several arrive at the same time! Well that’s not quite true because change was taking place but it was of the incremental, under-the-radar sort. That’s one reason why India jumped 16 places in the World Economic Forum’s (WEF) latest Global Competitiveness Report to its highest ranking ever (39 out of 139 countries), after advancing by the same margin last year.

India jumped 16 places in the WEF’s latest Global Competitiveness Report to its highest ranking ever.

However, there has been a flurry of important announcements in recent months, indicating that Prime Minister Narendra Modi’s slow-and-steady approach to reforms is making headway; that India’s large, boisterous and often messy democracy isn’t an insurmountable obstacle to change; and that India remains one of the more attractive emerging markets.

Why is GST so important for India?

The upper house of parliament – the Rajya Sabha – approved the long-awaited Constitution Amendment Bill for Goods and Services Tax (GST) in August. This tax has been regarded as a key test of the prime minister’s ability to deliver on his reform pledges.

GST is important for the country because, once fully implemented, it unifies a number of indirect taxes into one levy, enhancing efficiency. Tax compliance is likely to improve resulting in a broadening of the tax base. Moving goods across state lines will be easier, leading to logistical benefits. The economy gains from improved export competitiveness, investment receives a boost from a lowering of the cost of capital goods, while a simpler tax code will make doing business easier. However, these benefits will take some time to materialise so the short-term economic effects are harder to pinpoint.

The RBI has a new boss. What do you think of him?

The choice of Urjit Patel as the new governor of the Reserve Bank of India (RBI) sends a clear signal that it’s business as usual: a commitment to inflation-targeting; and continued adherence to monetary policy discipline.

Patel was chairman of the committee that recommended the adoption of an explicit inflation target. Although the central bank did cut interest rates earlier this month, the first rate decision made by a new-look monetary policy committee (MPC), a fall in consumer prices gives policymakers some room to ease.

We anticipate improved communication between the RBI and the government.

We expect Patel to continue ex-governor Raghuram Rajan’s work in forcing the state-owned banks to address their bad loans. This is important if lenders are to support infrastructure development. Better coordination between monetary and fiscal policy was a key priority for Rajan and we anticipate improved communication between the RBI and the government, partly because Patel has worked with them before. For example, he is a member of a government panel looking at the idea of adopting a fiscal deficit target range (instead of a fixed number).

So what’s behind the new MPC?

The central bank’s new-look six-member monetary policy committee is important for several reasons: it’s an attempt to make interest rate decisions more democratic, less discretionary and more transparent; it supports central bank independence from political interference because the government has resisted the temptation to pack the body with its own yes-men; and it’s also a sign that Modi remains committed to reforms because it would have been easy, after the outspoken Rajan had left last month, to sweep the former governor’s more painful measures – such as cleaning up bank balance sheets – under the carpet.

How would a US rate-hike affect India?

Back in 2013, India was labelled one of the ‘Fragile Five’ emerging economies most vulnerable to capital flight.

Since then the Reserve Bank of India has been building up the country’s defences against the short-term impact of higher US interest rates on domestic growth and financial market stability. Foreign exchange reserves of some US$372 billion are at record levels, while sensible policies have helped narrow the current account deficit to more manageable levels. Inflation is lower, as are interest rates. India is less exposed to external demand than, say, China is. Its financial markets are also better insulated against global volatility. Significantly, the rupee has been stable and foreign direct investment remains strong.


By Adrian Lim, Senior Investment Manager Equities, Asia, Aberdeen Solutions.  This article originally appeared on the Aberdeen Assest Management’s ‘Thinking Aloud’ blog on 21st October 2016