Can the next government build on India’s economic potential?

Modi looks set to return amid continued infrastructure spending

About a billion Indian voters will head to the polls this spring to determine the direction of the world’s most-populous country over the next five years. The new government will manage an India that is rising in economic and geopolitical stature on the global stage. Still, challenges abound, particularly how to create jobs for the vast numbers of people entering India’s labour force in the coming years.

To sustain this momentum, there are critical tasks for the next government in further pursuing economic reform and reducing fiscal weaknesses. Improved health of corporate and bank balance sheets, if matched with sustained improvements in the regulatory environment and fiscal management, should pave the way for a positive private investment cycle, driving growth and creating job opportunities.

Polls point to Modi’s re-election

Voters appear likely to return the popular incumbent Prime Minister Narendra Modi and his Bharatiya Janata Party-led National Democratic Alliance government to power. Opposition parties have largely coalesced into a united coalition, the Indian National Developmental Inclusive Alliance. INDIA has seen some momentum in the polls, but continues to run well behind the NDA. Barring major surprises, the main question appears to be around the size of the NDA majority.

The Modi government’s first two terms were marked by some notable reform successes, namely the 2016 Goods and Services Tax implementation, the 2016 Insolvency and Bankruptcy Code and further opening of the economy to foreign investors.

Overall progress has been mixed, however, with some missteps, including demonetisation, periodic tariff hikes, the withdrawal of landmark 2020 agricultural reforms and 2020 labour reforms still languishing at the state level.

Reform momentum will be modest

In the likely case that Modi is returned to office, we expect broad economic and fiscal policy continuity. This will mean continued prioritisation of infrastructure spending and steady improvements in the business environment. Ambitious reforms in Modi’s third term seem less likely with the focus shifting towards solidifying reforms from his previous two terms.

Much of the action on labour and land reforms, which hold the most potential for unleashing growth, are likely to be led by state governments. Competition for attracting investment has spurred a renewed focus on reforms by states. Nevertheless, the national government can play a large role in facilitating and encouraging states’ reform momentum.

Initiatives like the national government’s Production-Linked Incentives Scheme could play a role in facilitating manufacturing foreign direct investment flows under multinationals’ China+1 strategies. But without fundamental factor market reforms, prospects for boosting the manufacturing sector appear constrained.

The central government will play a key role in driving robust infrastructure spending, which appears set to continue regardless of the election outcome. Public capital expenditure spending has risen to around 3.3% of gross domestic product from around 2% a few years ago. Filling India’s large infrastructure gaps not only gives a fillip to near-term prospects, but should facilitate stronger private sector growth in the medium-term.

Improving fiscal metrics will be a heavy lift

Addressing fiscal weaknesses and rebuilding buffers will be a key challenge for the next government, but it is unclear how much priority this will be given. There have been positive advances in spending quality and transparency, but weak fiscal metrics remain a vulnerability. Getting the fiscal house in order could improve the country’s ability to meet large development spending needs, including in infrastructure, and give flexibility in responding to future economic shocks.

Fiscal challenges were exacerbated by the pandemic years. We estimate India’s general government fiscal deficit to be 8.6% of GDP (BBB median: 3.5%) and debt level at 82.7% (BBB median: 56%) in the current financial year, compared to 6.4% and 70.4% in FY19. Nearly a quarter of India’s fiscal revenue (BBB median: 8.5%) goes to servicing the interest on its large debt burden, crowding out other spending priorities. High deficits contribute to a crowding out of private investment.

Providing a comprehensive medium-term fiscal strategy in the post-election budget, likely to be presented in July, would be a critical step towards rebuilding buffers. The central government, where most of the fiscal deterioration has occurred, has targeted reducing its deficit to 4.5% of GDP by FY26 from 5.9% in FY24. But few details have been offered on how this might be achieved. Further revenue-enhancing measures, including an asset monetisation pipeline, could help meet the target. Stronger revenue-raising efforts would support fiscal sustainability while allowing space for development spending.

Jeremy Zook is Director, Asia Sovereign Ratings, Fitch Ratings.

The economic impact of the Indian election will be further explored in ‘India’s 2024 general election and the economic outlook’ roundtable on 14 March. Register to attend here.

This article was published in the Bulletin, Q1 2024 edition.

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