In 2003, Jim O’Neill, a global economist at Goldman Sachs proposed a term BRIC for four emerging markets – Brazil, Russia, India and China. O’Neill believed that these countries possessed immense potential which would ultimately materialize and result in them becoming the most dominant economies by 2050. For India specifically, he opined that the country’s huge domestic consumer market and availability of cheap labor would allow it to become the leading supplier of manufactured goods/services along with China. However, no matter how glorious these conjectures sound, at the end of the day, these are just conjectures. Plus, the Indian rupee’s recent free fall against the US dollar seems to be pushing the country further into recession. Hence, the question arises – how did the country that was projected to be the next big thing suddenly lose its luster.

The answer to this question can only be understood if India’s current failings are analyzed over two time horizons.

Short-Term View

In the short run leading up to the intense decline of the rupee, India was facing issues such as drying of exports from countries like US and Europe due to weakened global consumer demand and the increasing costs of imports like crude oil due to tensions in the Middle East. And, while all these two factors did widen India’s current account deficits to around US $88 billion, they also exposed a major flaw in India’s economic governance i.e. heavy reliance on foreign capital.

Developing countries like India offer foreign investors a chance to invest in high yield securities. However, the risk involved with investments in these countries is also high because of corruption and some structural deficiencies. Consequently, when Ben Bernanke, Chairman of the Federal Reserve, announced on June 19th this year that the Quantitative Easing (QE) program might be tapered off slowly, a shockwave went through the emerging markets like India. Emerging markets had been the real beneficiaries of the Federal Reserve’s stimulus program via which there were a lot of capital inflows into these countries. However, with the interest rates set to rise, investors saw countries like India as high risk due to their heavy reliance on foreign capital. As a result, they started to embrace more risk averse assets; this drove money out of India, thereby creating huge troubles for the government who used this capital to finance their Current Account deficits.

Plus, the inflation being imported from abroad didn’t matters much either. Inflation decreases the real value of money and forces people to look for hedges to safeguard their monetary interests, which in this case was gold. Investments in gold further drove money out of the country, worsening the country’s already fragile situation.In the short term, this exacerbated India’s woes and led the currency to fall almost 25% from January this year, with the rupee touching a record low of 68.85 versus the US $ in August.

Long Term View

Currently, the Indian economy is on the mend. The Reserve Bank of India has taken steps such as raising the interest rates to curb imported inflation which has adversely affected food and fuel prices. The government, for its part, has increased the import duty on gold which reduced the Current Account deficit drastically from around US $21 billion last year to US $5.2 billion this year. So, the outlook for the Indian economy is definitely improving.

However, this is just a temporary fix. The structural problems that plague the Indian economy still remain and, essentially, are the long term issues that the country will need to overcome to remain competitive.

India is a socialist country with a tightly regulated economy and stringent labor laws. Regulations ensure that businesses will find it difficult to perform basic activities like company incorporation, obtaining business licenses and laying off non-performing workers. This becomes a huge issue for a country with unemployment and growth problems because it stifles fresh investment and hence, harms the economy.

Secondly, the Indian government hasn’t fully acted on its massive cheap labor advantage. India possesses abundant skilled and un-skilled labor, yet the government for the past two decades have only focused on enhancing the skilled workforce for it services sector. Consequently, India’s service sector has flourished with 10% since the 90s while the manufacturing sector, which depends on un-skilled labor grew by a meagre 5.7%. This is one of the major contradictions of the Indian economy whose young and massive population make it the perfect place to have a burgeoning manufacturing sector.

Lastly, the government must seek to improve its record on inefficiency and corruption. India, since 1991, has been trying to make the transition to LEDC (Less Economically Developed Country) to MEDC (More Economically Developed Country) and due to its immense potential, problems like corruption were ignored. However, now due to the rising of land use, electricity production and other basics, it has become mandatory for the country to address these issues. Recently, an Indian court indicted several politicians including ex-Chief Minister and MP in a US $64 million scam; so it is possible to be optimistic about the future. Plus, with the elections on the horizon, a fresh start for the country is also likely to happen.

To sum it all up, it is time that India dropped this veneer of mediocrity that has been cloaking the immense potential that the country possesses. Issues like stringent regulations, inefficient labor allocation and corruption are threating to drive out the comparative advantage; so it is important the politicians set up out to rectify these problems. All hopes have been pinned on one man – Narendra Modi, the current Chief Minister (CM) of the state of Gujarat and quite likely, India’s next Prime Minister (PM) in 2014. He has promised change and right now, a better part of a billion people are feeling optimistic.