India: Slow and steady may not be enough to win the race Global Economic Outlook, Q3 2016

Two years into the new Indian government, how has the economy fared? It has been a mixed bag so far: Much-needed reforms have been initiated, but their progress has been slow. Uncertainty in the tax environment, poor implementation of structural reforms, and the lack of an assertive stance to improve trade are among the problem areas.

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It has been two years since the Narendra Modi government came to power with a historic win in the national elections. It was expected that the new government would embark upon much-needed economic reforms and radically restructure the Indian economy. The actual performance record of the government, however, has been a mixed bag.

Several macroeconomic fundamentals have improved in the past two years. Even if one sets aside the discrepancies in growth data, there is hardly any doubt that India is among the better-performing nations in terms of growth and stability. Inflation has come down, thanks to falling oil prices. Although food inflation has remained vulnerable and the recent firming of oil prices has pushed up consumer prices, the overall inflation expectation remains anchored. The current account deficit has narrowed, and the government has pursued its commitment to adhere to fiscal consolidation.

While it can be argued that global conditions, by way of low oil prices, have helped improve the key economic fundamentals, the government deserves some credit for its efforts in ushering in transparency in system and procedures; emphasizing good governance; undertaking initiatives to improve the investment climate; and taking a few bold initiatives, such as showing restraint in raising minimum support prices, which play a key role in food inflation.

According to the 2016 Deloitte India CFO survey, business leaders continue to remain optimistic about the Indian economy: Not only did 90 percent of the CFOs express optimism about the mid-term economic outlook, 94 percent expressed long-term economic confidence. Close to 60 percent expressed satisfaction with the timeline and effectiveness of government initiatives.1

Government spending on infrastructure (roads and railways) and a revival of private investment in response to rising domestic demand will likely be the key determinants of investment growth.

However, there are a few areas where the glass remains half empty. These include uncertainty in the tax environment, poor implementation of structural reforms and regulatory impediments, slow reforms in the banking sector, the failure to transform historically weak relations between the center and the states, and the lack of an assertive stance to improve India’s trade, especially exports.

Economic performance

GDP growth in Q4 of FY 2015–16 accelerated to 7.9 percent year over year.2 The full-year growth in FY 2015–16 (the year ending March 2016) accelerated to 7.6 percent from 7.2 percent in FY 2014–15. Although methodological concerns continue to cast doubts on the buoyant growth data, there is no doubt that the economy is growing at a steady pace despite global uncertainty.

Expenditure data show that the improvement in GDP growth in Q1 was largely driven by higher private consumption, indicating that domestic demand is holding up well. Lower inflation has also helped improve households’ purchasing power (table 1).

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However, investment declined for the first time since Q1 of FY 2013–14. Growth momentum had started to slow in Q3 of FY 2015–16, and growth contracted by 2.4 percent in the following quarter, primarily due to a reduction in fixed investments (-1.9 percent). This probably reflects the slowdown in capital expenditure by the center and the state governments as they try to adhere to the targeted fiscal consolidation. That said, growth in inventories slowed in Q4 of FY 2015–16, which bodes well for investment in the coming quarters. Government spending on infrastructure (roads and railways) and a revival of private investment in response to rising domestic demand will likely be the key determinants of investment growth. While exports continued to contract for the fifth consecutive quarter, the drag on GDP from net exports was relatively small due to falling imports as oil prices remained low. Slowing global growth and poor demand in an uncertain global economic environment have adversely impacted Indian exports. Consequently, the manufacturing sector, which accounts for 60 percent of the export basket, has failed to take off despite the government’s efforts to push the sector through various initiatives.3

Instead of introducing the reforms at the center, the government has encouraged states to implement these reforms. The possible logic may be that once states start implementing reforms and see the benefits, there will be little resistance to accepting reforms at the center.

The current account deficit fell 1.1 percent of GDP this fiscal year to the lowest level in nine years, primarily because of falling oil prices.4 There has been a significant improvement in foreign direct investment (FDI) inflows, which grew 31 percent in FY 2015–16. However, the overall capital account more than halved from $90 billion to $41 billion due to negative net portfolio investments, which reversed from an inflow of $41 billion in FY 2014–15 to an outflow of $4 billion in FY 2015–16 (figures 1 and 2).

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The government is expected to meet the fiscal deficit target of 3.9 percent of GDP in FY 2015–16, and has pledged to reduce it further to 3.5 percent in the next year.5 By adhering strictly to the fiscal roadmap, the government has sent out a clear message that the goals are to accelerate growth and ensure macroeconomic stability.

Glass half full: Major initiatives and reforms

The government has undertaken several initiatives and reforms in order to propel India to a higher growth path. Various programs and schemes such as “Make in India,” “Digital India,” “Smart Cities,” “Startup India,” and “Skill India,” among others, were launched with the intention of improving the manufacturing ability of the country, promoting innovation and entrepreneurship, creating job opportunities, and improving infrastructure and skills.

The government also undertook several difficult structural reforms, such as the passage of the bankruptcy code and bills to foster fair play and transparency in the allocation of natural resources.6  Rationalizing existing laws, encouraging FDI, increasing governance efficiency, and, most importantly, the government’s willingness to seek feedback from industries on challenges in doing business have improved the overall business environment. According to the World Bank’s Doing Business report, India moved up four spots and now ranks at 130 out of 189 countries in ease of doing business.7 Although moderate, the improvement in the investment climate is reflected in the rise in FDI in the past year (figure 1).

While the lack of cooperation between the two houses of parliament has been an important reason for the delay, the lack of assertion and internal political conflicts are also impeding the ability of the government to take up bold reforms.

The Indian government has taken advantage of the oil price windfall to reduce subsidies by deregulating fuel prices and increasing excise taxes, which have improved the fiscal balance. The government is also exploring how to ensure subsidies go to only those who need them, and thereby checking waste and leakages. Total subsidies are now less than 2 percent of GDP.8

The government has also started initiating labor market reforms in a prudent manner. Instead of introducing the reforms at the center, the government has encouraged states to implement these reforms. The possible logic may be that once states start implementing reforms and see the benefits, there will be little resistance to accepting reforms at the center. Some states such as Rajasthan, Madhya Pradesh, and Maharashtra have already started amending labor laws.

According to the 2016 Deloitte India CFO survey, business leaders are highly optimistic about the economic outlook (figure 3). The survey suggest that many CFOs support these initiatives and reforms, and are upbeat about the expected outcomes, although they agree that the effectiveness of these can fully be assessed only after a while.9

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Glass half empty

However, the survey has pointed to several challenges that are impacting CFOs’ risk-taking ability and investment growth. Regulatory impediments, concerns over uncertainty in the tax environment, and delays in clearing goods and services tax (GST) bills and land acquisition bills are eroding business confidence. Structural reform progress in three areas—GST, banking, and trade—has been significantly delayed.

Goods and services tax: Different Indian states have different and complicated regulations, licensing schemes, and tax systems, which has impacted investment decisions and the business environment across India. The GST bill is expected to streamline the process of taxation and make it more effective. The bill, which was supposed to be functional this fiscal year, still needs to be passed in the upper house, where the government lacks majority. The government is expecting to bring the GST bill for consideration during the monsoon session in July–August 2016. If passed, it will likely boost business sentiments.

The banking sector: Reforms in the banking sector have remained unimpressive. The sector continues to be dominated by public sector banks (PSBs), which account for over 70 percent of the total banking system assets. This is not consistent with the modern banking system and the growth model for India.

Gradual reforms in the banking sector is one of the primary reasons for the decline of banking and poor credit growth in recent years (figure 4). Despite relatively high real interest rates, growth in aggregate deposits for all scheduled commercial banks fell to a historic low of 9.9 percent in FY 2015–16. Growth was 19.5 percent in FY 2009–10 and has steadily declined since then. On the other hand, bank credit growth, which was as high as 25 percent in FY 2009–10, declined to 9 percent in the past fiscal year. While loan growth in all sectors has declined after the 2008 global financial crisis, the industry and services sectors have suffered the most due to rising corporate leverage and the concentration of risks in a few stressed sectors, such as iron, steel, power, and communication.10 This is reflected in the increase in nonperforming assets in banks’ balance sheets.

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When the Modi government came to power two years ago, banking conditions were still good, and a move to privatize the PSBs might have gone a long way in overhauling the entire banking system. That window of opportunity is probably gone now, given the high proportion of nonperforming assets, banks’ low profitability, and poor operating environment. The valuation of these banks is currently low, and there are not many investors interested in these PSBs.

Trade: India has been signing trade agreements at a blistering pace in recent years. However, the purpose of these agreements is not being met. Rising trade agreements have resulted in a stronger presence of enterprises from partner countries in the Indian market. Consequently, India has witnessed a sharp rise in imports following these agreements. On the other hand, exports have failed to gain momentum. Poor export competitiveness, a weak manufacturing sector, infrastructure bottlenecks, special economic zones not reaching their full potential, and India’s poor link to global value chains are hurting India’s export ability. Moreover, poor domestic infrastructure and lack of awareness among industries and exporters, especially those in the medium and small-scale enterprises, have limited the benefits of trade agreements. In addition, India’s delay in taking firm action in participating in new forms of trading arrangements and deciding on the pace and extent of such participation is hurting trade prospects.

In the right direction, but lacking pace

The Modi government has undertaken a few landmark reforms since it came to power two years ago. However, the pace of reforms remains slow. Systemic infrastructure bottlenecks, lack of transparency, and uncertainty in corporate governance rules continue to impact the environment for doing business and business sentiments. While the lack of cooperation between the two houses of parliament has been an important reason for the delay, the lack of assertion and internal political conflicts are also impeding the ability of the government to take up bold reforms. The modernization of India that Modi promised during the 2014 election is mired in challenges. If the government wants to fulfill its election promises, it has to be more assertive in speeding up reforms. The government has three more years, and only time will tell if it can make a meaningful change in its stance to drive the economy on the path that Modi had promised.