Indian Economy doesn't look rosy !!! :(

The Cato Institute's annual Economic Freedom of the World (EFW)
ranks nations on relative economic freedom and this has relevance for India's policymaking.

The EFW analyses data related to size of government relative to economy; legal structures; security of property rights; access to sound money; freedom to trade internationally; the regulation of credit, labour, business, etc. EFW also looks at quality of life indicators like life expectancy, income inequality, crime rates, etc.

Some correlations are obvious. Economically free nations ( those with small governments, strong legal enforcement of contracts and protection of property rights, commitment to free trade, relatively little regulation of credit) are much more likely to be rich.

Another finding consistent with the Kuznets Curve (http://en.wikipedia.org/wiki/Kuznets_curve) is that income disparities widen during the early growth phase in poor nations. This may be due to education gaps. Less-educated, lower income groups are less able to exploit new opportunities. An illiterate farm labourer can't switch to a factory job, let alone a white-collar occupation. Widening income disparity is also often associated with rise in violent crime. Once education filters down, income disparity usually starts narrowing.

Variables like "access to sound money" and "freedom to trade internationally" are linked to overseas investments. Poor nations are capital-starved and don't have the savings to fund infrastructure creation and business, in general. Where it's easy for capital to flow in, which in practice means also easy for capital to flow out, growth accelerates since funding is easier to find.

EFW findings can be translated into broad policy objectives. The governments of poor nations should enable easy overseas investment; improve primary education in both quality and breadth of access; amend laws for better protection of property rights; improve judicial processes; enable frictionless trade; etc.

This Budget does a little on some of these fronts. It increases allocations for judicial services, and for education. But it hasn't freed up controls on education, or removed judicial bottlenecks. It's also become easier to bring money into India but not much easier to take it out. The easing of controls on outflows has been very gradual. Overseas investors, indeed all investors, are much more inclined to reach for chequebooks, when they can book profits as they choose and exit painlessly

In the 1993 Budget, the Finance Minister of the time, a certain Dr Manmohan Singh promised the rupee would "soon" move to full convertibility. Have faith! It's still headed in that direction. While FDI can enter India, many sectors are still "protected", meaning inflows are controlled. Banking for example, has portfolio (FII) investment limits; sectors like retail and telecom have caps on FDI.

Moving large sums in or out of India legally is both difficult and irritating. Forex transactions can however, be done instantaneously and painlessly via hawala agents, who accept rupees and hand over hard currency. About $136 bn has left India this way since 2002, according to official estimates. Most of that cash is stored in tax-havens, where it earns little or zero interest.

It would be a win-win situation if controls eased in both directions. Overseas acquisitions like Corus, Zain, Jaguar, Novelis, coal mines, copper mines, crude and gas concessions, dozens of small pharma and IT acquisitions, etc., demonstrate the success of rupee investments abroad.

Where FDI has come in, it's accelerated growth - not least because it's accompanied by technical and managerial skills. Take a look at the intellectual property created through India-based research driven by overseas MNCs.

The elephant in the bedroom is the political involvement in capital flight. Since the 1950s, when India clamped down forex controls and started hiking tax rates indiscriminately, there's been massive tax evasion and flight. Estimates of cash shifted abroad run to well over USD 1,000 bn. Most of that moved out at the behest of politicians, or with their connivance.

Politicians of all hues would prefer any easing of controls to be selective. They would like their own transgressions to be forgiven and forgotten, while putting their political opponents through the wringer. Hence, deadlock.

The pragmatic thing would be to offer some kind of amnesty for hawala cash inflows, easing exchange controls in both directions, open more sectors to FDI, etc. Then some of that hawala cash could come back since it could earn high returns. This so-called "round-tripping" helped the Chinese in the 1980s, when almost all the FDI the PRC received came from overseas Chinese. .

Some hawala cash already returns via portfolio investments made through the Participatory Note route. Some returns via shell companies headquartered in Mauritius and other tax havens. The 2011 Budget opens a new route by allowing individual foreign nationals to invest directly in domestic mutual funds. This may be a big deal since it not only allows possible round-tripping for hawala assets but also easier entry for legitimate cash.

The return-risk equation for say, an American, investing in India seems excellent. The Nifty has a dollar-denominated CAGR of 11.3 per cent since January 2000 (neglecting dividend yields). In that same period, the Dow Jones Industrial Averages had a CAGR of 0.4 per cent. Even allowing for higher Indian inflation and potential currency risk, that's a fantastic spread. The spreads for Eurozone and the Japanese, Swiss, etc., are also very attractive.

However, it'll take time to translate deregulation into assets under management. Sebi, RBI, and Finance Ministry mandarins, not to mention the security boffins of the Home Ministry, will have to work out and notify details. After that, the domestic funds will have to create marketing channels and sell the concept abroad. Impossible to tell how soon there will be a tangible effect or to even guess how much money could come in through this new route.

It may not have much impact in the 2011-12 fiscal. Some experts project FII inflows will drop to about $10 billion in 2011-12, down from around $29 billion in 2010-11. There's a RBS estimate to that effect. If the FIIs find India unattractive, the chances are, so will foreign individuals.

The reason is diminished return expectations. In February, Macquarie said consensus EPS growth estimates for 2011-12 had dropped to 18.8 per cent from an earlier 20.5 per cent in January for the Morgan Stanley (MSCI) India basket. This was before crude prices started climbing.

The short-term and medium-term outlook therefore, doesn't look exciting for the Indian economy, or the stock market. The long-term outlook looked reasonable before the Budget and it has improved incrementally but not dramatically since. My inclination would be to steadily accumulate Indian equity, and maybe, go overweight in infrastructure. But I wouldn't put the housekeeping money into the pot.