A year into his tenure, Prime Minister Modi faces a rather bizarre situation with respect to the economy. All the key macroeconomic indicators are looking up. Growth has revived. Inflation is under control. Fiscal consolidation is on in right earnest. The current account deficit is at its lowest in years. In its most recent report on the Asia-Pacific region, the IMF pronounced India ‘a bright spot in Asia’.
And yet, there is a sense that the government has failed to provide the necessary momentum to the economy. Former NDA minister Arun Shourie said recently that the government was ‘directionless’ in respect of the economy. How do we reconcile the improvement in the macroeconomic numbers with a certain discontent on the state of the economy?
One reason surely is that the government can’t take much credit for the turnaround that has happened in the last year. The credit for the improvement in the growth rate goes to the Central Statistical Organisation, which revised the national income statistics in January this year, using 2011-12 as the base year instead of 2004-05 and a different measure of GDP.
The growth rate of GDP at market prices for 2012-13 was revised to 5.1% from the earlier 4.7%; for 2013-14, it was revised significantly to 6.9% from the earlier 5.0%. Thanks to these upward revisions, the economy is estimated to grow at 7.4% in 2014-15. Looking ahead, the RBI expects the economy to grow at 7.8% in 2015-16 and 8.1% in 2016-17. It should be evident that growth had begun to accelerate before the Modi government came to power in May 2014. If India’s economic growth will be of the order of 8% in the near future, the credit belongs to the UPA government.
Can the government take credit for the improvements on other counts? The inflation rate has fallen in the past year – the RBI is confident of meeting its CPI inflation target of 6% for January 2016. Here again, a major factor is something extraneous to the NDA government’s polices: the sharp decline in crude oil prices internationally.
Domestic policies have certainly helped. The fiscal deficit has fallen – the government is on course to meet the fiscal deficit target of 3% of GDP in 2017-18- and monetary policy has been tightened. Both these actions preceded the NDA government’s coming to power although Modi can claim credit for persisting with these policies. The NDA government’s particular contribution has been to refrain from sharp increases in the procurement prices of food.
The RBI expects the current account deficit to be -1.3% of GDP in 2014-15, which is the best performance since 2008. Most forecasters expect the current account deficit to be closer to -1.0% in 2015-16. This is well within the safety zone of -2.5% of GDP that economists prescribe for India.
Businessmen and ordinary people alike see that the improvement is not really the work of the Modi government. More importantly, expectations today are running high. People have seen the 9% plus growth rates achieved in 2006-08. Modi’s past record and his election rhetoric too have raised expectations sky high.
What investors want
This is not just a matter of being macho about growth rates. India needs growth in the range of 9-10% in order to generate enough jobs. As the latest Economic Survey has pointed out, the employment elasticity of growth appears to have declined in the 2000s, meaning a given rate of growth generates fewer jobs than before. In the present economic model, a growth rate of 9-10% is required in order to make a material difference to the lives of ordinary people. In trying to convince investors and the electorate that it is doing what it takes to get there, the Modi government has its work cut out. The problem is as much one of influencing perceptions as of taking concrete measures on the ground.
Investor perceptions are heavily influenced by how the government acts in relation to a pre-conceived set of ‘reforms’. The Modi government has done quite well on this score. Apart from fiscal consolidation and monetary tightening, which investors have been clamouring for, the government has pushed through several measures that would win applause:
- Deregulation of diesel prices
- Substituting cooking gas subsidy with direct cash transfers
- Increasing FDI caps in insurance and defence
- Selling coal blocks through auction
- Giving a significant impetus to financial inclusion through the Jan Dhan Yojana scheme
Some measures which investors wanted have not come through: amending labour laws to allow easier retrenchment, a dilution of the provisions of the land acquisition act introduced by the UPA government, privatisation of government-owned banks and complete privatisation of industrial enterprises. But these cannot be cause for investor sentiment turning sour. Reasonable investors could not have expected these to happen in the very first year of the government.
Reasons for gloom
If the general sentiment has turned somewhat negative, it is for more proximate reasons:
- The imminent rise in interest rates in the US means that emerging markets as a whole are not as attractive as before for portfolio investors.
- Foreign Institutional Investors (FIIs) have been hugely rattled in recent weeks by the news that Minimum Alternate Tax (MAT) would be applicable to them. The tax impact is estimated at Rs 40,000 crore. (Finance minister Jaitley first offered relief from MAT with effect from April 1, 2015 but not retrospectively. The matter has since been referred to a panel).
- Corporate earnings growth has been below estimates for the past two quarters
- There is uncertainty over the monsoon and rural distress appears to be mounting
- It is not clear that the Goods and Services Tax, which has been approved by the Lok Sabha, will go through the Rajya Sabha as well.
These proximate factors apart, there is no escaping the short-term costs imposed by macro-economic stabilisation. Fiscal consolidation has been achieved by not meeting budgetary targets on social sector spending in 2014-15 and by niggardly increases in spending in 2015-16. Monetary policy tightening has had its impact on industry, especially the vulnerable small and medium enterprises. Investors may be pleased but the man on the street has reason to grumble.
This would not matter much if we could be sure that, once the process of stabilisation is completed, the economy would be on track to reach a growth rate of 9-10%. Unfortunately, the prospect of this happening in the medium term does not look very bright. For two reasons.
First, the global environment remains challenging, with modest recovery in the US but stagnation in two other large economic blocs, the Eurozone and Japan and a deceleration in growth in China. It is hard to see India achieving a growth rate of 9-10% purely on the strength of the domestic economy alone and without strong export growth.
The burden of debt
Secondly, private investment, which drove high growth in UPA-I, is today held down by high levels of debt in the private sector. The Economic Survey says that debt to equity ratios of India’s top 500 companies are amongst the highest in emerging markets. This has happened because in key sectors, such as infrastructure, projects are stalled. During the period of rapid growth, companies borrowed heavily to finance investment. Many of the projects are now stuck for a variety of reasons (such as difficulties in completing land acquisition, lack of environmental clearance, non-availability of fuel, etc). In many completed projects, the earnings expected have failed to materialise. As a result, companies lack the cash flows to service debt.
To salvage projects, several things need to happen. Banks and other lenders will need to write down debt. Some of the debt has to be converted into equity at a fair valuation. Interest rates have to come down so that corporate bottomlines improve and the debt to equity ratios of companies fall. The government has to infuse capital into public sector banks (PSBs), the principal lenders to the stalled projects.
Negotiations between borrowers and PSBs are bound to stretch out in the very nature of things. In the present fiscal situation, the government is not willing to infuse cash into PSBs. The RBI’s tight monetary policy means that corporate bottomlines cannot improve and alleviate high leverage in Indian companies. In general, resolution of what is called a ‘balance sheet’ crisis of the sort India faces is not easily achieved.
Prime Minister Modi sustained Gujarat’s record of rapid growth over a long period by having a business-friendly regime. At the centre, he now faces a reality check. Merely pushing through reforms and easing rules of business cannot return India to a growth rate of 9-10% in quick time. An adverse global environment and structural factors in the Indian economy come in the way. Mr Modi now faces a bigger challenge than he had bargained for: how to tweak the growth model so that growth of 8% in the medium term itself is better able to meet popular expectations.
TT Ram Mohan is a professor at IIM Ahmedabad. Email him here.