Time to Take Off


In her recent visit to India, IMF Chief Christine Lagarde said that because of the recent policy reforms and improved business confidence in the country,  the USD 2 trillion Indian economy could overtake the combined GDP of Japan and Germany in the next four years. Earlier, in a report, the agency had forecast a growth rate of 7.5 per cent for fiscal 2015-16. There is a general sense of optimism among Indian and global investors, stock indices are booming, inflation is down, growth is looking up and deficits are under control. Broad parameters are therefore looking in shape. But how strong is Indian economy, and what are the challenges that it is facing? More importantly, what should be the reform agenda for the present government to keep the economy firmly on growth path?

Along with corruption, if there is one factor that contributed to the demise of the UPA II last May, it is the economic despair. More than the loss of earning and joblessness, the hopelessness that it had brought for the people at large, contributed to the historic drubbing that the Congress Party got. But this also meant that the expectation from the new government was very high. After nine months in office and first full budget later, while impact of the steps taken by the government could  be months from showing perceptibly, the noises and murmurs are indicating that the confidence of investors and consumers are looking up.

Quarterly growth rate picks up after a sustained deceleration Image source: The Economist
Quarterly growth rate picks up after a sustained deceleration
Image source: The Economist

Even though the growth rate envisioned by the IMF falls short  of the Indian government’s target, the direction and optimism is unmistakable. According to the agency, the economy is reviving on back of “positive policy actions” and lower global crude prices. The new economic survey underscores the revival in the economy after a prolonged period of tardy growth, which many believe was because the past government was indecisive and bogged down by various scams.

Figures show that the economy has bounced from the trough in which it was languishing for almost three years. In a nearly 12-quarter phase of deceleration, economic growth averaged 6.7 percent but since 2013- 14, it has been growing at 7.2 percent on average, the Survey reveals. More importantly, it says that the vulnerability of the economy has come down, which means it is in a better shape to absorb global or domestic shocks. The industrial growth, which is the main driver of urban employment growth, has however, been stuck in low gear with January IIP growing at 2.6 per cent, and has been declining after recoding a jump of 3.9 per cent in November 2014. For eight months till January 2015, the industry has shown sub 5 per cent growth rate.

The Economic Survey has also given other figures to drive home the point that the economy is on path to revival.

It cites inflation which ran in double digit for a sustained period, has come down in lower single digit, thanks mostly to the dogged determination of RBI. While the longevity of the lower prices remains in question because of inefficient supply side dynamics and bad weather, it has given some elbow room to the central bank which has reduced interest rate twice over last quarter.

According to the former Finance Minister, Mr. Yashwant Sinha, a big change since the time the Narendra Modi government assuming office has been that the confidence of investors, both Indian and global, has come back (read Interview). This is reflected in the high portfolio investment of over Rs. 270,000 crores during fiscal 2014-15 (till Mar 20, 2015), which has pushed broad market indices to their all-time highs. The Nifty has scaled up 30 per cent from the beginning of the financial year till third week of March 15, which is among  the best in the world. Experts widely acknowledge that this rise is backed by strong projected corporate earnings.

The government, despite putting an additional ten percent of its revenues in the pockets of the states, has managed to remain within its fiscal constraints. What is more noteworthy is that the current account deficit (CAD) has come down sharply over last one year. For the quarter ending Dec 2014, it came down to 1.6 per cent compared to two per cent a quarter earlier. The Finance Minister Arun Jaitley hopes the figure will stay below one per cent of the GDP for the whole year 2015-16. While slumping global crude prices is a well-known factor for this decline, Sinha simultaneously points towards the massive reduction in the gold imports for the reduction in CAD which has come as a result of the return of confidence in the Indian economy.

Moving forward, though, the country is likely to face volatile global situation which may not be as helpful as was the case in 2014. While declining crude was a crucial factor in keeping deficit figures in good shape in 2014, the prices could have bottomed out and may bounce on a rise in demand from China. The Chinese economy has been slowing down for last few quarters as the government has tried to cool the economy to stave off inflation. Further, its financial system is still in mess because of hidden bad loan problems.

Because of subdued economic conditions in key markets, Indian exports have not realized strong growth of late
Because of subdued economic conditions in key markets, Indian exports have not realized strong growth of late

Elsewhere, the recovery in the US is still looking shaky, though the IMF has revised its projected growth rate upward to 3.6 per cent for the year 2015. This is good news for Indian tech companies who can look forward for some improvement in the US demand. In the year ahead, a crucial area to watch for would be stance of Fed on monetary policy. So far it has maintained a low rate regime to foster growth. But if it starts to tighten up this year, which is likely, the interest rate differential between Indian and American assets would reduce fast, making debt investment in India less lucrative. This is especially true as Indian interest rates are likely to dive south this year. This could be bad news for debt portfolio investments in India which, according  o the Economic Survey, has been a major component of overall foreign investment in the country in 2013-14. Some economists anticipate some outflow on this account this year.

The euro area growth outlook is not rosy. The pressure on euro because of continued Greek problems can nip the nascent recovery that was seen in 2014. Already Greece and Spain are staring at deflation. In the east, easing oil prices allowed the Japanese economy to expand at 0.4 per cent in the last quarter of 2014 after two successive shrinking quarters, but the overall health of the economy is still weak.

The crude prices, which have been the common explaining factor in global economic performance could bounce back this year on two factors. If the Chinese growth picks up this year or tensions rise in the Middle East, be it on Iran or ISIS issue, the prices could firm up which would not be a good news for India, which benefited immensely in 2014 because of low crude prices.

However, experts say are the real source of worry for the Indian economy’s problems are mostly self-created domestic ones and not exogenous in nature. An economic analyst at a leading brokerage house in Mumbai said that the gargantuan regulatory structure prohibits and frustrates entrepreneurs rather than encouraging them to invest. He cites the case of land acquisition lamenting that it is nearly impossible to acquire land and other approvals without greasing palms or closeness with officials. Lack of power increases the cost of productions. On top of all, the compliance is too weak, especially at state level.

The archaic labor laws is a crucial area which requires immediate attention. It is very hard to hire and fire in tune with the market demand. To close or lay off workers, a unit has to take government permission if it has more than one hundred workers. To avoid such intrusive regulations, companies prefer to stay small, which is bad for the company, economy and ultimately to the workers as well, who are deprived of many benefits which accrue to workers in a large unit. Larger companies use temporary workers to avoid regulatory problems. Because of such inefficient norms, more than 80 per cent of the country’s workforce has no legal job security.

Over last three years, the Indian banking system has come under much duress. The pump-primming undertaken during last regime, to avoid a recession had led banks to provide loans to many undeserving projects which just could not pay back, stressing the balance sheets of banks. With deteriorating asset quality, banks started to cut on fresh loan which according to Sinha has been a major factor for industrial slowdown.  He further points out that to boost the economy, it would be important to get the stalled projects off ground, which got stalled primarily because of lack of approvals, lack of money and lack of environmental clearances. While the amount of money locked in these projects has come down because of approvals in last one and a half years, the lack of financial connectivity still haunts many projects. As for banks, they cannot wait for the stalled projects to start paying before starting to make fresh loans. They need capital infusion to have the capital adequacy to make fresh loans. While the government has made a Rs. 95.55 billion provisions in the budget for refinancing of state owned banks, the amount is just loo less to make any significant impact; banking system as a whole needs over Rs. 1.5 trillion (one trillion is equal to 1000 billion). Unless banks are healthy and are entertaining investors, industrial recovery cannot take place.

Pressing the Reform Button
• Cooking gas subsidy provided through direct transfers on a national scale
• Deregulation of diesel prices
• Setting up of the Expenditure Management Commission
• Charting the GST implementation map
• Jan Dhan Yojana for opening of bank accounts to ensure financial inclusion
• Increasing FDI in defense and Insurance
• Ordinance to make land acquisition less onerous
• Innovative and cost effective social security schemes
• Passing the Coal and Mining bill

It is not that the government is sitting idle. Since assuming office, government has taken multiple reforms towards structural reforms. Right from the beginning, the government has worked to tone up the bureaucracy which is legendary for its unprofessionalism and sluggishness. It has also been working on bringing the various processes and procedures online so that the scope of errors, delays and corruptions is minimized. For example, it has successfully migrated the auctions of coal and spectrum, which were the two biggest scams of last government, online. Further, the highly convoluted fuel subsidies have been rationalized and the prices of diesel been completely freed of government controls.

Indian taxation system is known world over for its complexity, exemptions and loopholes. Not only there are innumerable taxes and laws that govern them at central and state level, the rates are also very high. The retrospective tax impositions of last government had baffled investors who are always in dark about the certainty and longevity of tax structure. The government has started working on the tax problems in two fundamental ways. First, it has pursued the Goods and Services Tax (GST), which has started being implemented from April 1, 2015. This would simplify the tax system in a big way besides removing massive bottlenecks in establishing India as a single market for goods and services. Secondly, in an effort to bring predictability in Indian tax system, the corporate taxes have been clearly set on a path to 25 per cent from existing 30 per cent over a period of four years.

Inflation is perhaps the single biggest robber of purchasing power for Indian population. High and persistent inflation over last three years has forced the RBI to keep interest rates high. This month, the government inked an agreement with the central bank to formally keep inflation in check. This would  spare the RBI from constant hankering from politicians to drop interest rates besides bringing predictability in inflation and the interest rate movement, going forward.

India has demography on its side. Half of its 1.25 billion population is under 25 years old. The data show that for next couple of decades, it would continue to be a young country, even as other emerging markets would see large fractions of their population cross the upper working age limit.

Over next decade, about 100 million young Indians are expected to join the work force. This presents India with a huge opportunity. It also presents a colossal policy challenge which is how to accommodate such a large workforce in the economic machinery. Because of poor social and educational infrastructure, majority of this workforce would be ill prepared to undertake high value addition work. As such, the government would have to create relevant job opportunity for this work force. While India does have a big and thriving IT services and allied industry, it is highly skill intensive which can obviously not accommodate so many people.

The government has undertaken the make in India initiative to unleash the manufacturing potential of the country and compete with China in global manufacturing market. But here is the catch. As technology evolves, manufacturing requires lesser number of hands and more of infrastructure to be competitive. Adding people on assembly line is no longer a ticket to prosperity. That is why it is important to undertake multiple reforms simultaneously. Massive investment is required to create world class physical infrastructure in form of highways, ports, power plants etc. to facilitate entrepreneurship. But even more important than creating physical assets is to ensure ease of business for which laws, regulations, procedures and norms would need to be simplified to such extent which do not frustrate investors. Entrepreneurs need to be encouraged to invest and small units need to be incentivized to scale up on size and productivity. This would be the key to generating jobs and making India competitive at the world stage.

The Indian stock markets have generated best returns among emerging market over last one year
The Indian stock markets have generated best returns among emerging market over last one year

However, all of these efforts may yet come undone if the quality of human resource is not improved. Studies after studies have shown that Indian public education system is in shambles. A country as large and as poor as India cannot leave entire education on the private school system. Southeast Asia has shown how basic education, backed with decent universal healthcare can transform economies.

India needs to realize there is no way to bypass this grind. The government has to ensure sound basic healthcare and free basic education at the farthest corners of the country. Only then can it dream of having a workforce which can adopt new technologies and ratchet up productivity.

By serendipity, India is finding itself in a comfortable position when other emerging markets are in trouble. China is slowing, Brazil and Russia are stuck in low growth. For the first time in over three decades, India has got a single party majority government with a decisive figure at the helm, who is supportive of free market led growth, vouches for reforms and is not bogged down by the socialist legacy.

From here, India has two choices. First is that of moving on the old path of half-hearted reforms which tolerates private entrepreneurship, but frustrates it in the name of saving poor. It treaded this path for long. The reforms of 1991 were half hearted and therefore generated only partial profit of free market economy. The second option for Indian government is to boldly embark upon next generation of tough reforms, which may at times create short term discomfort but yield very high returns over long term. Pumping investment in creating healthy and educated work force, removing infrastructural bottlenecks, opening up protected areas of businesses, creating social security network,ensuring transparent government  procurement and bidding processes etc. constitute such reforms. So far, the government has shown spine in reeling out reforms on crucial areas such as land acquisition, FDI in defense and insurance etc. It needs to push through more. It has been proven globally that government can pull people out of poverty by redistributing wealth only when wealth has been created by providing conducive environment.

India stands at a unique point in history. As a young, but poor nation, it has a lot of catching up to do which it is well capable of. The key is to believe in itself and push through what needs to be done. Indian entrepreneurship is known for its thrift, alacrity and prudence. It is time the government provides right environment so that the Indian economy can roar and leap like a lion, as the Make-in-India envisions.