India's growing middle class, federalism to set tone for economic policies

India's state governments are on the verge of gaining much more discretion in the use of transfers from the central government. Prime Minister Narendra Modi's scrapping of the Planning Commission was a significant step in enhancing the autonomy of the states, says Standard & Poor's Ratings Services in a report published today.

The report, India: The Shape Of Things To Come, said this shift of central policymaking to the states is one of two important trends in the country - the other being expansion of the middle class.

"Fiscal decentralisation should result in more competition between states in attracting investment and promoting growth, setting the stage for further economic reform and modernisation," says Standard & Poor's credit analyst Joydeep Mukherji.

"The government has reduced the number of centrally sponsored schemes and given states more flexibility in using the money in
those schemes. Moreover, scrapping the Planning Commission also allows states to receive more federal transfers without strings attached, giving them scope to determine their own spending priorities."

A bulging young lower-middle income group in large and small cities, with strong aspirations for upward mobility, has swelled the middle class in India.

Poor GDP growth of recent years has made the middle class more favorable toward economic reforms, which they increasingly see as necessary for rapid economic expansion and their own continued prosperity.

"The combination of growing federalism and a rising middle class sets the larger political context for the economic policies the government is likely to pursue in the next five years. We expect the government to seek to improve the administrative performance of the bureaucracy while pursuing gradual fiscal consolidation," Mukherji adds.

Standard & Poor's affirmed its 'BBB-/A-3' long- and short-term sovereign credit ratings on India on 26 September 2014, and revised the outlook to stable from negative (See: S&P revises outlook on India from negative to stable)." The outlook reflects our view that the newly elected government will be able to implement economic reforms that spur growth, which in turn improves fiscal performance," the ratings agency said in a statement.

However, the Modi government is not likely to take dramatic steps to change economic policies. Mukherji says, "Modi will seek to win as many state elections as possible, especially in the next two years, to gain seats in the upper house of Parliament and ease the passage of legislation."

"The Modi government has inherited several weaknesses that will constrain economic growth, at least in the next year or two," he adds. Inflation is likely to remain high, around 8 per cent in 2014 and 7 per cent in 2015, while the general government fiscal deficit is likely to exceed 7 per cent of GDP in fiscal year 2015 (ending 3 March 2015) and remain above 6 pr cent in fiscal 2016.
 
"We believe that India's economic performance will disappoint optimists through 2015 but will likely be better than the fears of pessimists over the long term," Mukherji says.