Over 66 percent of the voting population in the world’s largest democracy cast its ballot in 2014, reflecting palpable electoral dissatisfaction with India’s administrative and economic milieu. The exuberance at the expected change in government was so high that the Bombay Stock Exchange (BSE) surged 15 percent and the rupee gained four percent between March and May 16, 2014, when Narendra Modi was declared victorious in the national elections. The excitement notwithstanding, the fact of the matter is that the new government inherits a beleaguered economy which is rife with poverty, unemployment, unmanageable inflation, fading investment, decelerated growth and lack of adequate infrastructure. Before we get into reviewing what the Modi government can or will do to jump-start India’s economic growth, it is important to understand where the fault lies.
Planting new trees and felling the burnt ones
A couple of years back, normally referred to as the boom period, inept macroeconomic policy paved the ground for the current economic mess. The erroneous fiscal outlook and faulty monetary policy manufactured India’s largest-ever credit rush. This conspicuous failure of India’s economy is rooted in utopianism, which cannot be corrected by a one-size-fit-all solution. Grandiose measures will have to be replaced by complex and involved management of macroeconomic factors such that the current long view of the economy is transformed into a more meaningful short view. Macroeconomic policy in India lacks a deep institutional foundation, resulting in the country bopping from one crisis to another. The return of international markets to normalcy any time soon is a far cry. India will have to deepen its liquid markets to absorb the shock of a stagnating world economy. For this to happen, the country needs to replace its existing regulatory framework with large-scale reforms in the financial sector because without these reforms macroeconomic and financial uncertainty will remain. Reformation of the regulatory framework is essential also to prevent the misgivings raised by the knee-jerk economic interventions that administrators in India tend to make when there is a financial crisis, fiscal crisis and price instability. But these reforms can only be meaningful and effective if there is sustained economic growth; however, with less than five percent growth of the gross domestic product (GDP), the new government faces the uphill task of reviving India’s crippled economy, which has grown at its slowest pace in a decade.
Despite the clear need for economic reforms, the government does not have the fiscal space for far-reaching reforms as the tax-to-GDP ratio has slipped to 10.2 per cent from a peak of 12.5 per cent in 2007-08 and tax revenues are unlikely to recover immediately. The new government plans to tackle supply side constraints, a major cause for galloping inflation.As indicated in the book titled, “Getting India Back on Track” (Bibek Debroy et al., London, 2014) fiscal consolidation, financial sector reform, capital account convertibility, and countercyclical monetary policy are the four components of the reforms that macroeconomic stability and reduction of business cycle volatility beckon. To forestall financial ailments like banking distress, world economic meltdown, bankrupt pension systems, and securities scandals that have plagued India in the recent past, a sound framework for financial regulation is required. In India today, stressed loans aggregate $100 billion, or 10 per cent of all loans. A recently released report of the RBI-appointed P.J. Nayak Committee suggested that banks could raise equity if government stake in them was reduced. The report also recommended that some weaker banks could be merged with strong ones. While addressing a joint parliament session on June 9, 2014, H.E.Pranab Mukherjee, the President of India, said, “We will work together to usher our economy into a high growth path, rein in inflation, reignite the investment cycle, accelerate job creation and restore the confidence of the domestic as well as international community in our economy.” The to-do roster is long, but the vital actions that top the new government’s economic agenda are narrowing the fiscal deficit, making the business climate congenial, introducing anti-inflation measures, and perking up efforts to reduce the current account deficit. All the measures that the government undertakes will have to be linked with its revenues as it does not have enough leeway to make grand plans which require substantial expenditure.
High Inflation and the bottomless pit of India’s fiscal and current account deficit
India’s fiscal deficit may have narrowed over the last two years, but, as of March 2014, it still lingers at 4.6 percent of GDP. When put in context, this figure is alarmingly high, especially if we consider China, which recorded a fiscal deficit of only 2.1 percent last year. Moreover, there is a high chance that the fiscal deficit may actually be higher than the quoted figure, given the probability of statistical jugglery by previous state head honchos. India’s fiscal deficit touched 45.6 percent of the full-year target within two months of 2014-15. While the deficit target slippage is a worry, the underlying source- below par revenue (collection from taxes and duties) – poses a huge concern. The government would have to take cognizance of the fact that stagnant revenues and messy expenditures will pose great difficulties in meeting the 4.1 percent-of-GDP fiscal deficit target set in the Interim Budget.
Foreign Direct Investment (FDI) is likely to be considered a major avenue for raising capital. Additionally, in the upcoming budget the government might consider introducing an aggressive disinvestment plan to reduce the fiscal deficit. This would partly compensate the shortfall in the country’s revenue collections and rein in its deficit proportionately. A larger effect of this will be visible in case these funds are used for funding capital expenditures that would help kick-start investment activity and growth. However, for a healthy investment cycle to be initiated, it is important for the government to harmonize with the central bank’s efforts to restrain inflation. Controlled inflation, which can be achieved by containing high levels of food inflation, is an essential precursor to ensure buoyancy in investments. During his joint parliamentary address, Mukherjee added, “Containing food inflation will be the topmost priority for my government. There would be an emphasis on improving the supply side of various agro and agro-based products by reforming the Public Distribution System. My government will take effective steps to prevent hoarding and black marketing.”
Another expected measure for reducing the fiscal deficit and eliminating, not just alleviating poverty, is rationalisation of central subsidies. Subsidies can be divided into productive and transfers. The latter has averaged around three percent of GDP, almost double the levels of the past decade. Such subsidies have become unviable as economic growth has stagnated over the period. Welfare policies impact inflation and growth, thus it is imperative that India’s archaic policies are revised to reduce inflation and accelerate economic growth. Since agriculture is the means of livelihood for over 67 percent people in India, far-reaching changes in that area are expected. The government is expected to increase both public and private investment in agriculture. The government could consider allowing private sector to build storage and stock- gain, and shift from physical transfer of grains to consolidated cash transfers. Agri-infrastructure will be one of the major avenues of investment in agriculture. Farming can be made profitable through scientific practices and agro-technology. One of Modi’s biggest achievements in Gujarat was the revival of agriculture, and he is likely to mirror that across the nation. The agricultural value added in Gujarat grew at double the rate of that in India, and was among the fastest rates recorded anywhere in the world. Thus, at the national level a market stabilisation fund for farmers to get the optimum price for their produce is very much in the offing. Modi is likely to give attention to every state and see how agriculture can be boosted there. For example, he is expected to recharge the sugarcane industry in Uttar Pradesh by giving sugar mills incentives to clear their arrears of over INR 7,500 crore. Bad subsidies do not augment the output, but good subsidies do. If the non-merit subsidies on fuel and fertilisers are phased out over a period of time and direct cash transfers are introduced, then the genuinely poor and vulnerable households stand a chance of directly receiving the much needed financial relief. Decontrol of oil is expected to continue in the new regime, and oil subsidies, which total INR 1 lakh crore, could be restructured. However, scrapping or revising a subsidy is a politically contentious decision and might take more time and effort than expected.
In the past, the current account deficit (CAD) was reduced through artificial means as all the expenditure in the fiscal deficit had not been accounted for. The CAD was reined in by almost halving gold imports, thus reviving gold smuggling. The new government is likely to review gold import duties within three months of coming to power. Another way to keep the CAD under control is to boost manufacturing exports. Modi, who has turned around the manufacturing base in Gujarat, is expected to appoint a commission to advance manufacturing in the rest of the country.
To re-ignite growth, the government would need to up the capital expenditure, which has reduced from four per cent of GDP in 2003 to 1.7 per cent today. Despite it being a tough task, high volumes of expenditure would be needed to start rebuilding infrastructure. In order to step up its revenue collection, the government is expected to rationalise and simplify its tax regime to make it conducive to investment, enterprise and growth. Tax evasion is also an area which is likely to be addressed through tax reforms. The July budget is likely to set a deadline for the implementation of two key tax reforms – the Goods and Sales Tax (GST) and Direct Taxes Code (DTC) – which till now did not get consensus from all the states. It is estimated that with GST in place, India’s GDP will shoot up by a minimum of 1.5 to two percentage points, and the DTC will positively impact compliance.
Growth steered forward by a congenial business environment
It is important to address the environment that characterizes investment in India. Improving the business climate should be the anchor of the new government’s agenda. The reforms that the new government pushes would pivot around making infrastructure available and giving precedence to resource-based industries. The share of the manufacturing sector in India’s GDP is around 16 percent, which is abysmally low when compared to other Asian countries. The foremost thing that has plagued the manufacturing sector is government policy which leads to a difficult business environment, rigidities in deployment of labour, insufficiency in infrastructure, regulatory delays and absence of transparency, high cost and unavailability of bank credit. While keeping land costs at acceptable levels and reforming labour laws such that employers can hire and fire are important policy level changes, the most critical is addressing issues related to the business environment. The business environment stands to improve if India replaces the multitude of forms with a combined application form for getting the mandatory clearances. Currently, in India, businesses need to file over 100 returns; doing business in India would become much easier if a system of one common return was instituted. The business environment would perk-up if the time taken to start and exit a business is reduced significantly. Reducing the compliance burden would help remove the clutter from India’s business environment. Uniformity across the country in terms of registrations would ease the business environment in the country. Modi’s government has introduced a deadline on every process of regulatory clearance. This would help remove red-tape and bring about more transparency. Cost of commercial credit could be reduced by introducing more competition in the banking sector by issuing fresh licenses on a regular basis. Modi has already mobilized efforts in the direction of making the business climate congenial in India. For example, with respect to the mining industry, he is keen on a model similar to Ultra Mega Power Projects, by which mining rights would be awarded as a package, with all clearances in place. This is directed towards reducing the time spent on obtaining permissions.
And the verdict is…
It has been nearly three decades since Indian voters delivered such a momentous verdict. Whether Modi and his team will be able to stand up to their promises and agenda of hope is yet to be seen. Among the first indications will be the soon-to-be announced Union Budget of 2014 in which Modi might have to take some tough decisions to jack up the process of India’s economic recovery.