Modi-Led Government on the Right Track, Despite Formidable Challenges

The Narendra Modi-led government came to power with an overwhelming mandate in May 2014 and, broadly speaking, seems to be on the right track.

The Narendra Modi-led government came to power with an overwhelming mandate in May 2014 and, broadly speaking, seems to be on the right track. It has adopted a prudent, steady, bottoms-up and incremental (rather than ‘big-bang’) approach to structural reforms (some of which have been path breaking) which is aimed at creating a conducive environment for growth and setting the stage for the next round of substantially more daunting economic reforms that are an imperative to usher in transformative change and put the Indian economy on a high, yet sustainable, growth trajectory of 8-8.5% in the medium term and 9-10% in the long term.

Despite the fact that durable economic recovery yet remains elusive and meaningful private  investment cycle has not take-off (with no turnaround in fixed capital formation), this government’s economic management and related policy decisions have until now, in my opinion, been quite commendable and deserve a rating of 7/10.

There has recently been a chorus of vitriolic criticism from financial markets, sections of international and national media and some experts with reference to the incumbent government’s inability to bring about an expeditious economic revival and about the agonizingly or frustratingly slow pace of reforms.  

Such criticism is possibly a reflection of unrealistic expectations that had touched or orbited the stratosphere. It disregards the challenging economic backdrop that the government inherited (a sputtering economy (with growth falling to multi-year lows) which was hobbled by policy paralysis, lack of decisive leadership, economic mismanagement, falling investments, high inflation and spate of corruption scandals coupled with decelerating global economic growth).

It faced two key challenges from the outset.  First, stressed corporate balance sheets that prevented kick starting of the private investment cycle.  Second, public sector banks saddled with high and rising bad debts acting as a serous constraint to economic recovery and growth.

Resurgent political obstructionism was on its reform agenda; particularly on major structural reforms such as the land acquisition bill, (legislative clearance of this bill is essential for accelerating growth, enhancing the share of manufacturing sector from 16% to 25% of GDP by 2022, expediting ifrastructre development and it needed to attract greater foreign direct investment)

The government also had to deal with often fractious centre-state relationships, labyrinthine complexity of bureaucracy (which is well entrenched and remains highly fragmented) that slows down decision-making, antediluvian labour laws (changing which is a formidable challenge for any government) and agriculture sector distress (this sector contributes approximately 14-15% of India’s GDP and employs around 49% of the work force). Agrarian distress led to a marked downturn in rural consumer demand and acted as a drag on growth.      

Against this exacting economic backdrop, this government deserves approbation on four counts.

First, creation of sustainable macroeconomic conditions (i.e. there is far greater macroeconomic stability now than a year ago.  The economic downturn has ended and the economy seems to be going in the right direction.  Inflation has decelerated significantly (with superlative monetary policy and plunging oil prices playing a vital role in the taming of inflation).  Spiraling fiscal and current account deficits have been curbed.  FDI inflows have risen substantially (27%, according to official data) year-on-year (2014-2015).  Foreign exchange reserves have surged and the domestic currency (INR) has been relatively stable). Second, policy paralysis has ended. Third, initiation of quite an impressive array of reforms, policy measures and announcements undertaken over the past one year (listed below). Fourth, a substantial increase in public investment on infrastructure (roads, railways and rural infrastructure) occurred in April 2015 when compared to a year ago and consistent increase in the number of infrastructure projects and FDI proposals cleared by the government.

Such front-loading of infrastructure spending by the government is likely to have a multiplier effect and should help to jump start the growth engine, rekindle a new demand cycle and cement an investment recovery.

If macroeconomic conditions continue to remain sustainable, government persists with public spending on infrastructure and if reforms are sustained and accelerated, then real GDP growth should accelerate to around 6.5% in 2015-2016, 7% in 2016-2017 and 8%-8.5% by 2017-2018 – based on the old method of calculating India’s GDP (i.e. old GDP series).  

Recently, according to official data (based on a new method to calculate India’s GDP (i.e. new GDP series)), the Indian economy grew by 7.3% in fiscal 2014-2015 (and by 7.5% in January-March 2015, compared to 6.6% GDP growth in previous quarter).

Seven key indicators show disappointing growth.

* Core infrastructure sector (which accounts for around 38% of overall industrial production)

* Index of industrial production (IIP)

* Bank credit to industry

*Corporate profitability

* Exports

* PMI (Manufacturing sector and car sales)

* Corporate Earnings

Added to the above, there is low capacity utilization in various sectors.

I am in a state of bewildered perplexity or highly skeptical, as many economists are, about these GDP growth figures.

Data on these 7 key indicators and low capacity utilization belie or seem to be out of sync with these impressive GDP growth figures. The annual GDP growth figure is probably somewhere between 5-5.5% (old GDP series).

Fortunately, economic activity seems to be picking up early in fiscal 2015-2016.  Recovery should be on firmer ground in the next 2-3 quarters.  Likely, its drivers will initially be public spending on infrastructure and government reforms and duly supported by recent monetary stimulus measures (the policy rate has been lowered from 8% at the beginning of 2015 to 7.25% (on 2^nd June) by the RBI after three reductions) and spike in FDI.      

Having stated the above, let me now turn to some of the key economic reforms, policy measures and announcements undertaken by the government in the past one year (the full effect of which will be felt in subsequent quarters and years, rather than immediately).

The launching of the ‘Make in India’ manufacturing initiative to make India a global manufacturing hub, raise FDI and provide employment to millions languishing in the agriculture sector.

Taking steps to boost coal production (such as end of government monopoly over coal and successful and transparent coal block auctions (coal generates about 60% of India’s power supply)) are vital for rapid industrialization and economic growth.  It will also bring down high dependence on coal imports

Transparent telecom spectrum auctions have been undertaken.

Also, the announcement in the Budget 2015-2016 of reduction in the corporate tax rate to 25% (currently 30%) over four years; increase of FDI limit in the insurance sector from 29% to 49% ( which should result in a very substantial influx of money into the Indian stock market and enable firms to access long-term funding for infrastructure projects.  This will require investment of around $1 trillion in the next five years.

The push to get GST (a single unified tax system) ratified when the parliament reconvenes in the monsoon session and implement the same by April 2016 (implementation of a properly designed GST could add to 1-2% to GDP growth and improve ease of doing business in India and enhance export competitiveness in due course).

The announcement of setting up of a National Investment and Infrastructure Fund (NIIF) in Budget 2015-2016 to provide boost to infrastructure.

Laying down of a credible path of fiscal consolidation in Budget 2015-2016 (the government is keen to reduce the fiscal deficit from 4.1% of GDP in fiscal 2014-15 to 3.9% in fiscal 2015-2016, 3.6% in fiscal 2016-2017 and 3% in 2017-2018)

This will help to bring down yields on government bonds, help check inflation and inflation expectations, encourage higher capital inflows, lead to lower interest rates (imperative for higher investments) and result in appreciation of the domestic currency (INR).

The commitment to cooperative federalism, like accepting the 14^th Finance commision’s recommendations to devolve 42% of share of union taxes to states (from 32% earlier).

A muted rise of minimum support price (MSP) for agriculture crops is imperative to keep food inflation in check.

Deregulation of diesel prices and changes in the subsidy regime (and plunging oil prices) have helped the government to reduce the fiscal deficit to 4% of GDP in fiscal 2014-2015.

The enactment of stringent legislation to crack down on black money (for example, the government has passed the Undisclosed Foreign Income and Assets Act).

A landmark agreement signed between the government and the central bank (RBI) for a new monetary policy framework that led to RBI adopting ‘Inflation Targeting’ as a guide to monetary policy recently this year. As per this policy, the RBI will aim to bring inflation below 6% by January 2016 and the inflation target for 2016/2017 and subsequent years will be 4% +/- 2%.  Inflation has to stay within the 2-6% band from 2016-17.  The Budget 2015-2016 vowed to rise public spending on infrastructure by $11 billion in the current fiscal year.

Foreign direct investment limits raised in manufacturing (100%), defense (49%) and construction (100%) sectors.  Reform oriented and pro-growth railways budget for 2015.  For example, laying out of a road map for attracting private investment in railways through tapping insurance and pension funds that should help revitalize the railways sector and improve ease of doing business in India

Initiatives undertaken to shift households penchant for savings in the form of physical assets (land and gold) to savings in the form of financial assets (banks deposits, stocks, bonds mutual funds, pension funds and insurance funds).  This will help to lower the cost of capital for firms and substantially enhance flow of funds into the stock market and enable higher capital expenditure by the corporate sector (currently only around 1/3 of household savings are in the form of financial assets)

A new five year foreign trade policy (FTP) for 2015 – 2020 was unveiled and, most importantly, an unremitting resolve is being demonstrated by the government to get legislation enacted with reference to the Land Acquisition Bill.

Hopefully it will happen by the end of the monsoon session of Parliament.  Land acquisition is pivotal to the government’s thrust on manufacturing and infrastructure development.

From a 3-10 year perspective, India will in all probability emerge as the most exciting or promising economy in the world for investors if the government is able to sustain and accelerate the momentum of structural reforms (that it has initiated over the past one year) over the next two years; overcome resurgent and continued political obstructionism to its reform agenda; tackle the serious bad debt problems beleaguering the banking sector; and, successfully unlock  stalled projects in infrastructure, manufacturing, mining and other sectors (estimated at 7% of GDP at the end of December 2014 – according to the Economic Survey 2014-2015).

The road for the Modi-government is long and arduous, fraught with challenges, yet its commitment to a very strong development agenda coupled with the resolve that it seems to be demonstrating in moving forward, augurs well for India.