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What is Causing the Cooling of India’s Economy?

What is Causing the Cooling of India’s Economy?

KIM Jung-Dae

July 30, 2013

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Recently, the BRICs economies, which accounted for much of the world's growth since the outbreak of the global financial crisis, have shown signs of a slowdown. Foreign capital flight from the BRICs economies has accelerated despite global quantitative easing. India in particular recorded its lowest economic growth rate since 2002. Its growth rate in 2012 was 5.1%, a decline of 2.4 percentage points from the previous year. This marked the sharpest drop in growth rates among the BRICs countries. The key cause for the decline was India's sharp investment slowdown. In the Indian economy, consumption has kept pace with growth rates, thanks to increased government spending. Fixed investment, however, has been trending down since 2009 (excepting a minor 0.8% increase in 2012). This has been blamed most on the FDI slump. India's FDI inflows in 2012 dipped 38% to US$22.423 billion on a year-on-year basis.

There are three major causes for the decline in FDI in India. First, the Indian government, striving to rein in its fiscal deficits, has increased taxation on foreign companies operating in the country. In 2012, its fiscal deficit rose to as high as 5.6% of GDP, largely a result of swelling subsidies and economic stimulus measures after the global financial crisis. Against this backdrop, the government proposed the GAAR (General Anti-Avoidance Rules) as a way of tightening tax enforcement on foreign companies, with a view to increase revenue generation and reduce fiscal deficit. India's financial markets however, lost confidence from overseas investors due to fear of taxes and inconsistent policy in implementing GAAR provisions.

Second, India has adopted highly protectionist measures to shield its domestic industries from global companies. The Indian pharmaceutical industry, driven by low production costs and a highly skilled workforce, has become a hub of the global pharmaceutical market. With a spate of acquisitions of local drug manufacturers by foreign firms however, the Indian government tightened restrictions on foreign investment in the pharmaceutical industry. This move triggered a contraction in FDI inflows to the industry, which constitutes 65.3% of total FDI in India.

Third, EU investment flows to India plummeted in the wake of the European fiscal crisis. Member countries of the EU, the major trade partner of India, embarked on significant cost reductions in services (especially in the IT sector) in order to survive the fiscal crisis. This was followed by a steep decline in EU outward FDI flows to India.

With a firm resolve to spur FDI inflows and restore robust growth, India's government is expected to step up efforts to achieve fiscal consolidation, further economic reforms and openness and improve the investment climate. However, the potential remains for India to change policy along populist lines. In addition, India's relatively poor investment climate and worsening corruption index remain risk factors. Accordingly, before entering the Indian market, Korean companies need to prepare thoroughly to deal with policy changes in a flexible manner. Korean companies also need to devise appropriate measures in response to GAAR which will take effect from April 2016.

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