The Indian tiger

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In what could become the world’s most significant 21st-century strategic alliance, a strengthened partnership is forming between the two largest English-speaking democracies: the United States and India. President Bush and Indian Prime Minister Manmohan Singh cemented bilateral ties in recent White House talks, paving the way for greater trade, investment and technological collaboration. In time and with the cooperation of other friendly powers in the region — notably, Japan and Australia — this new alliance could emerge as an essential counterweight to China. Essentially, it will be an Anglospheric alliance in Asia and the Pacific Rim.

U.S. Undersecretary of State Nicholas Burns, commenting on the multipoint joint statement issued after the White House meeting, declared the two countries had forged “a broad global partnership of the likes that we’ve not seen with India since India’s founding in 1947.”

But the economic front has the greatest potential. The world’s largest democracy, with an industrious and increasingly educated population, is among the fastest-growing economies, with real GDP expanding at an average 5.9 percent annually, seasonally adjusted, over the last eight years, including a 7 percent gain in first-quarter 2005.

However impressive this performance may be, India’s economy has had to endure some stifling restrictions — and in certain cases outright bans — on foreign direct investment. FDI, in fact, hasn’t grown in at least five years, averaging around $1.3 billion per quarter since 2000. In some sectors, such as retailing, mining and railways, FDI is strictly prohibited, In others, like banking and telecommunications, foreign investment is permitted but closely regulated.

The new bilateral accord promises to change this, and there’s every reason to be optimistic. Informal links are being forged every day as large numbers of India-based firms service information-technology (IT) equipment and software in the U.S.

In addition, India’s current stock-market boom owes much to international investors. Foreign portfolio investment in India totaled $3.8 billion in first-quarter 2005 versus $4.6 billion in fourth-quarter 2004 and $3.7 billion in the first quarter of 2004. These inflows compared with a 2000-2003 quarterly average of just $840 million.

The performance of Indian equities has been nothing short of fabulous, with many prices doubling and even tripling in the past two years. The Bombay Sensex 30 Index is up about 150 percent since May 2003, and the broad Bombay Stock Exchange 500 Index has gained around 175 percent. Particularly impressive have been the nearly 200 percent rise in the IT Index and increases of roughly 250 percent in both the Consumer Durables and Capital Goods Indexes.

A small public sector and concomitant low taxes have also aided the economy. In the 2004-2005 fiscal year ended March 31, the Union (or central) government’s net tax revenue amounted to 7.9 percent of nominal GDP and total receipts equaled 10.8 percent. With expenditures running at 17.6 percent of GDP, last year’s fiscal deficit (or total government borrowing requirement) equaled 4.5 percent of GDP, according to the Reserve Bank of India Bulletin.

Prime Minister Singh, as finance minister in the early 1990s, crafted many of the reforms responsible for India’s economic renaissance, including lower tariffs, fewer import and forex restrictions, the lifting of industrial licensing and price controls, and a reduction in the top marginal income-tax rate from a staggering 97.5 percent to a more sensible 35 percent. Sound monetary management nowadays leaves little room for complaint, with consumer price inflation trending around 4.4 percent on a 12-month basis over the past five years.

Monetary stability has helped keep interest rates down, too. Since 2000, 10-year government bonds have yielded 7.8 percent on average, making for a mean real interest rate of 3.4 percent over the period.

But only through an ever-increasing ratio of financial capital to labor capital will labor productivity make the gains necessary for substantial improvements in the country’s overall standard of living. Capital availability will rise with expansion of the domestic economy, of course. But more is needed.

Given its immense labor force, India requires massive injections of foreign capital to make the investments in technology and equipment to augment output per hour. So, of the panoply of potential governmental reforms, liberalizing foreign capital flows is far and away the most important one.

If India becomes more hospitable for foreign investment, its economy can grow 10 percent yearly for the next decade, representing an economic shot across China’s bow. Embracing Anglo-Saxon market economics will strengthen both the Indian and American economies, thereby adding even more power to the new diplomatic entente.

Lawrence Kudlow is host of CNBC’s “Kudlow & Company” and is a nationally syndicated columnist.

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