India key to Asian growth, but needs reform

A key driver of Asia's performance is India. It has performed well in the past three years, driven by strong corporate earnings growth, buoyant global liquidity and its status as the world's second-biggest consumer.

Yet market valuations remain inflated by high earnings growth expectations. The market has struggled to maintain momentum, falling significantly as inflation and government price controls, future earnings growth and weak government policy have resurfaced.

The fractious political landscape has curbed the government's ability to reform the country's onerous labour laws, so the economy has focused on higher-skilled industries such as IT. This creates fewer job opportunities and creates a services-led economy, unusual given its stage of economic development. Rapid population growth will put extra pressure on the government to create more jobs for less-skilled people in future.

Attractive GDP growth of around 7-8% is expected for India this year, but it is doubtful this growth can be sustained without significant investment.

The government's five-year plan calls for nearly $500bn to be spent on infrastructure by 2012. Whether this target can be met is questionable, but India clearly needs more infrastructure. Savings and investment rates have increased to nearly 35% of GDP; therefore, some infrastructure progress should be made, which will help underpin growth and lessen inflation pressures over the medium term.

The government has tried to cut inflation by reducing customs duties for some commodities and implementing a ban on the export of others. But the Reserve Bank of India may again have to raise interest rates and cash reserve ratios.

There is a danger that economic growth will slow if vital infrastructure spending does not accelerate, government policy does not improve and interest rates rise. In this case, social harmony may be disrupted and earnings expectations may fail.

KEY POINTS

- Though India's economic growth potential remains strong in the short term, investors have overlooked certain challenges

- Market valuations remain inflated by too-high earnings growth expectations

- India needs additional infrastructure to compete globally.

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