Despite a surprise election result, the Indian markets have rallied since mid-May, but investors still appear uncertain about how much will change under the new Congress-led government. Will it be business as usual?

Recent improvements to India's economy partly reflect "good" monsoons and favourable global economic conditions, but they are mainly down to very strong expansion in India's service sector, which has benefited from the outsourcing of technology-related "back office" functions from some of the world's major economies.

Economic growth in India has accelerated to a forecast 8% a year in 2004, which is about the same as real gross domestic product (GDP) growth in 2003. It's also a substantial improvement on average growth of around 5% a year in the 1990s.

India is also now seeing the benefit of other factors like the liberalisation reforms of the 1990s, which have finally boosted competition, demand and employment in a wide range of service sectors, and especially in telecommunications. Lower interest rates have also boosted demand for consumer credit.

Protest voting
The good news is that the BJP (Bharatiya Janata Party) defeat wasn't a vote against free-market economic reform, and neither does it herald a shift towards more interventionist, state-led development policies. Rather, India's economic progress has not filtered through to rural areas and the voters that make up three quarters of India's population.

But the Congress Party did make some ambitious promises that may keep markets nervous. These included increasing health and education spending by close to 10% of GDP, which would add to India's already enormous government deficit. Increasing taxation revenue will be essential to prevent a worsening fiscal situation - India collects less than 16% of GDP in taxes, against around 30% in other Asian economies.

Implementing the long-delayed VAT (value-added tax) scheme would certainly help but other revenue measures, or savings elsewhere, will need to be found if the new government is to fulfil its promises. It has targeted economic growth of 7% to 8% a year, but for that to happen, or for growth to match the 9% or 10% a year seen in China, two further reforms are necessary.

First, the investment rate must be lifted. Investment in India, at around 25% of GDP, is too low, mainly because of the government deficit, which absorbs too much of India's savings and chokes private investment. Second, though India will never have China's high savings rate, better use of available resources would still bring faster economic growth. In the government sector, subsidies and transfers need reducing and more of the burden of improving infrastructure needs to be shifted to the private sector.

Can India deliver? The government will be able to rely on some already well-formulated reports on changes to direct and indirect taxes. But the bad news is that it will be very difficult for the government to pursue reforms with much commitment or vigour.

THIS ARTICLE IS REPRODUCED COURTESY OF SMART INVESTOR MAGAZINE