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Why It's Not All Gloom and Doom for India's Economy

Recent news out of India has given investors little to cheer about as Asia’s third largest economy grapples with slowing growth, stubborn inflation and fiscal inefficiencies that threaten to strip it off its investment grade rating.

India, Mumbai, Gateway of India, view across harbor
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But Deutsche Bank’s chief economist writes in a report titled, "India – It’s Not All Gloom and Doom" that the pessimism surrounding the country’s economy is overdone and there may be some positive surprises for investors this year.

"Our recent trip to Delhi where we met with policy advisors left us with the impression that there may be an undue concentration of pessimism which may be ripe for some upside surprise," Taimur Baig, Chief Economist, Deutsche Bank, wrote in the note.

The investment community has been concerned about the country’s growing fiscal deficit and the lack of policy response by the government to bring it under control. A combination of these factors prompted ratings agencies Standard and Poor’s and Fitch to downgrade India’s credit outlook to negative from stable earlier this year. (Junk Rating for India a Done Deal?)

But Baig says, "Policy is not in total paralysis, there is movement in Delhi to get infrastructure spending going and provide further investment incentives." He added that a number of ministries have been instructed to pick up the pace of project approval and execution.

India's Finance Minister P Chidambaram said in August that bottlenecks to infrastructure projects will be removed for quicker implementation after India suffered its worst power outage in July that cut electricity supplies to half its 1.2 billion people.

"Beyond domestic investment…government studies are proposing wide ranging incentives to bring in more foreign investment…the expectation is that as public investment picks up, private investment would follow to," he added.

In an attempt to restore investor confidence, a government panel earlier this month proposed that the General Anti-Avoidance Rules (GAAR) - a controversial rule that aims to clamp down on tax evasion - be postponed by three years. The GAAR, introduced in this year's budget, targets firms and investors routing investments through tax havens.

Besides indications that the government is beginning to step up on the policy front, there are also some positive economic pointers.

- a key determinant of monetary policy in India - declined to 6.87 percent in July - the lowest level since 2010 – helped by a fall in food and oil prices. Food inflation declined to 10.06 percent from 10.81 percent in June.

"Food prices seem to have stabilized, while the government is clearly on a comfortable footing with respect to food grain stocks to offset short-term supply side risks," he said adding that the recent weakness in resource prices will also help cool inflation.

This in turn could help India’s central bank, which has cited inflation as its top priority, to ease policy. Baig forecasts the Reserve Bank of India (RBI) will next cut interest rates either in December or January. The RBI last lowered rates in April by 50 basis points to 8 percent.

Besides decelerating inflation, economic growth also seems to have bottomed out, with gross domestic product expansion in the second quarter ticking up after hitting 5.3 percent in the previous three months - the slowest pace in nine years.

"The Indian economy remains characterized by strong consumer demand, nimble business owners, and continued goodwill from foreign investors, hence job creation has not abated, nor have capital inflows. A few policy victories could add further momentum to this," Baig writes.

Foreign investor flows into the Indian stock market have helped push the benchmark Bombay Sensex, up 15 percent year-to-date, making it one of the best performing indices in Asia.

Since the start of 2012, foreign institutional investors (FIIs) have pumped almost $12 billion into the country’s stock market – the highest inflows among Asian, ex-Japan, markets so far this year, according to HSBC. This compares to a net outflow of $358 million last year.

"The doom and gloom with external demand probably is going to be seen as unfounded…we’re seeing some bottoming out in the U.S., improving sentiments out of EU. and Asia. External demand as well as domestic drivers of growth may have seen the worst," Baig said.

By CNBC's Ansuya Harjani