Why India Struggles to Deliver Its Growth Potential

India is going to deliver its third quarter growth numbers on Friday and expectations are running low as Asia's third largest economy has had a disappointing year so far, with gross domestic product (GDP) growth languishing around 5.5 percent.

Why India Struggles to Deliver Its Growth Potential
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The world's largest democracy, which boasts of a burgeoning domestic market coupled with a youthful population, has seen much better days – just two years ago it was growing at a robust 8-plus percent.

But today it's faced with the prospect of being the first BRIC (Brazil, Russia, India, China) nation to have its credit ratings cut to junk as investors begin to lose faith in India's growth story.

(Read more: Does IMF's Dismal India Forecast Signal a Hard Landing?)

Uncertainty surrounding government policies - despite recent reforms to attract foreign investment - a ballooning deficit, sky-high inflation and a currency that has slumped over the last year, have all added to India's growth woes eroding investor confidence, said experts.

"The key factor that has led to the deceleration in GDP growth from above 8 percent levels to the last quarterly print of 5.5 percent is a near collapse in investments," Rohini Malkani, economist at Citi, wrote in a report.

Growth in capital formation, or the transfer of savings from households and the government to businesses, has fallen from double-digits in the 2005 fiscal year to single-digits in 2011, according to Citi data.

Difficulties associated with acquiring land, lengthy approval processes for large projects and infrastructure bottlenecks, particularly in the area of power, have contributed to the slide in investment activity leading to poor growth.

The most optimistic view puts India's GDP growth in the September quarter to 5.7 percent, while the most bearish expect growth to come in at 5 percent.

"The slowdown in India has been supply-led. There is a lack of basic infrastructure, roads, power, which are needed to meet the demands (of businesses) and allow the economy to grow as fast as it should," added Leif Eskesen, chief economist, India & ASEAN at HSBC.

Unlike in the West, where a slump in consumption has contributed to slower economic growth, Eskesen said in India, there is not enough supply to meet demand.

"Demand in India is firm – consumption is growing because of stable demographics and more people entering into the middle income range," he said, adding "manufacturers say they aren't able to produce enough because there are power outages."

At the end of July, India witnessed it's biggest ever power outage which left more than half of India's 1.2 billion population without power.

Borrowing Costs

Robert Prior Wandesforde, head of India & Southeast Asia economics at Credit Suisse argues that the slowdown has also been associated with monetary tightening that took place over 2010-2011, when the Reserve Bank of India (RBI) lifted interest rates by 525 basis points.

At the current 8 percent, India's benchmark interest rates are among the highest compared with other major economies. Despite growing calls for monetary easing, the central bank has kept rates on hold since April due to growing inflationary pressures.

"That combined with global weakness, and high oil prices – explains a vast bulk of the slowdown in growth," said, Prior Wandesforde.

A weaker rupee combined with elevated oil prices, which have risen 30 percent over the last 24 months, has contributed to the widening of the current account deficit. Crude accounts for almost one-third of the country's overall imports.

Can India Return to Days of 8%-Plus Growth?

Despite the negatives, India has the potential to return to robust growth given its strong consumption base, said economists. However, it may take 2-3 years, according to HSBC's Eskesen, who forecasts India's economy to grow 6.9 percent in fiscal year 2013-2014, and 7.9 percent the following year.

"If India continues with reform implementations, and they step them up after the elections in 2014, then by the end of the decade they could be at 9 percent," he said, referring to the slew of government policy initiatives announced in September-October, including approving foreign investment in multi-brand retailing and aviation.

(Read more: India Declares, We're Back in Business)

Prior Wandesforde, who sees India's GDP rising to around 7 percent next year, agrees that the country will be able to achieve the high growth levels seen over most of the past decade.

"I think India can return to those levels – but I think it would require substantial easing of monetary conditions – the economy is more sensitive to interest rate changes than most think," he said.

Credit Suisse forecasts the RBI will cut interest rates by 125 basis points next year, which Prior Wandesforde said will likely be sufficient in pushing growth above 7 percent in late-2013.

Credit Rating Risk

A failure to prop up growth, however, would place India at high risk of a credit rate downgrade, added Prior Wandesforde.

"Growth is very important here in the decision of ratings agencies. The reforms have bought the government a little bit more time, but another year of 5-5.5 percent growth would substantially increase risks of a downgrade," he said.

Rahul Bajoria, economist at Barclays added that credit ratings agencies are unlikely to change their assigned ratings before the country's budget which will be presented at the end of February next year.

"At this point, we don't think anything will change. After March, the focus will increase on what's happening on the credit rating side," he said.

Moody's on Tuesday reaffirmed its stable outlook for India's Baa3 rating, citing its large, diverse economy and strong savings and investment rates. However, the credit ratings agency pointed to the "poor" social and physical infrastructure, a high government deficit and complex regulatory environment as constraints to the rating.

In April, Standard & Poor's cut its credit rating outlook to negative. The lowered outlook jeopardizes India's long-term rating of BBB-, which is the lowest investment grade rating. It assigned a one-in-three chance to an actual downgrade within the next 24 months.

By CNBC's Ansuya Harjani