India: Finding new feet through reforms Global Economic Outlook, Q4 2016

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While sluggish investment, mining and construction activities, and farm output in Q1 raised concerns about the Indian economy, recent reforms, such as the bankruptcy code and the goods and services tax, are expected to improve business sentiments and ease of doing business.

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India is hailed as a bright spot amid a slowing global economy.1 That said, sluggish investment, mining and construction activities, and farm output in the first quarter of the current fiscal year (FY)2 raise concerns about the economy’s ability to generate jobs, increase income, and reduce poverty at a sustainable pace.3 India maintains a medium-term (five-year) growth expectation of 8.0 percent, which requires strong growth in investment and rural income. However, both areas have failed to grow at an impressive rate in the past few quarters.

While a close-to-normal monsoon has improved the prospect of rising rural income in the coming quarters, private investment needs to see a sustainable uptick. Recent reforms, such as the passage of the bankruptcy code and the goods and services tax (GST), are expected to pave the way for improved business sentiments and greater ease of doing business. Not to mention, the recent institutionalization of the monetary policy and the setting up of a panel to review the Fiscal Responsibility and Budget Management (FRBM) Act are likely to go a long way toward improving macroeconomic stability and boosting investment. The impact is already evident as India moves up 16 places and now ranks 39 in the Global Competitiveness Index, 2016–17.4 The gain has been broad based, with reform efforts on improving public institutions, opening the economy to foreign investors and international trade, and increasing transparency in the financial system aiding in improving India’s ranking, which has gained the most in the list.

The recent institutionalization of the monetary policy and the setting up of a panel to review the Fiscal Responsibility and Budget Management Act are likely to go a long way toward improving macroeconomic stability and boosting investment.

Growth softens as weak investment raises concerns

India witnessed a slight moderation in growth in Q1 FY 2016–17; gross value added (GVA) grew 7.3 percent year over year in Q1 FY 2016–17 compared with 7.4 percent in Q4 FY 2015–16, while GDP grew 7.1 percent compared with 7.9 percent in those respective quarters.5 GDP is arrived at by subtracting subsidies net of taxes from GVA. Since the adoption of the new methodology to estimate GDP, the net subsidy component (subsidies net of taxes) has resulted in significant variations between the two measures of growth, not to mention the methodological concerns about the way this component is deflated.6 For the first time in the past six quarters, GDP growth fell below GVA growth, primarily due to a rise in subsidies and a fall in union excise duties and services tax (figure 1).

Figure 1. The two measures of growth

The services sector, led by the public administration, defense, and other services sector, helped retain the growth momentum, while the construction as well as the mining and quarrying sectors performed poorly. On the expenditure side, the strongest thrust to growth came from government consumption expenditure, which grew a substantial 18.7 percent (figure 2). Exports for goods and services turned positive for the first time after five consecutive quarters and were the second-biggest contributor to growth. On the other hand, private final consumption expenditure growth, which had underpinned growth thus far, fell relative to previous quarters. But what concerns investors and analysts the most is the contraction in gross fixed capital investment for the second consecutive quarter.

Figure 2. Expenditure as a component of GDP

In July, the industrial production index fell, negating almost all the gains of the previous two months. The contraction in the capital goods sector, which has been in negative territory since November 2015, was the biggest drag. While the government is trying to push public investment expenditure up, private sector investment remains weak. That said, the GDP estimate suggests a high subsidy outflow in Q1; the fiscal deficit during the period April–July 2016 was already at 73.7 percent of the budget estimate. In other words, there will likely be very little room for the government to spend on capital expenditure for the rest of the year.

Easing monetary policy may not be enough

The economy has heavily depended on private consumption spending for growth. However, to ensure sustainably strong and noninflationary growth in the long run, stepping up fixed capital investment will be crucial. Can the Reserve Bank of India (RBI) use monetary policy instruments to provide the desired thrust to capital expenditure and, thereby, economic growth?

Inflation continues to remain low and may decrease further owing to a good monsoon, in turn leading to falling food prices.

Inflation continues to remain low and may decrease further owing to a good monsoon, in turn leading to falling food prices. The external sector’s health has improved considerably in the past few quarters. At 0.1 percent of GDP, India achieved the lowest current account deficit in Q1 FY 2016-17 since 2004. Foreign direct investment remains strong, and foreign exchange reserves are at record-high levels. Institutional investment inflows turned positive in Q1 after registering a net outflow in FY 2015–16. Low inflation and comfortable levels of the current account balance and currency provide a window for the new RBI governor to cut policy rates in order to accommodate growth concerns. Accordingly, the RBI announced a policy rate cut of 0.25 percent in its latest monetary policy statement, suggesting that it is willing to boost credit growth and demand in the economy.

However, a policy rate cut may not be very effective given that banks are not yet willing to pass on the benefits of rate cuts to consumers. Short-term liquidity concerns and high bad loans are keeping banks cautious of undertaking lending activities. Recent reforms such as narrowing the liquidity adjustment facility corridor (the excess of repo rate over and above the reverse repo rate) and introducing the marginal cost of fund-based lending rate (this is a modification to the existing base rate that factors in the repo rate while deciding the lending rate by commercial banks) will likely ensure better transmission of benefits. That said, borrowing rates are only one of the factors that feed into investment decisions. For businesses to feel confident and then spend, there is a need to improve the financial inclusion of small-scale investors and access to funds.

The recent spate of reforms

The other issue is the poor ease of doing business in India, caused by bottlenecks in infrastructure and manufacturing investment, tax issues, and the lack of investment in priority sectors. In several of my previous analyses, I emphasized the need to address structural and institutional weaknesses, and argued that addressing them effectively would go a long way in boosting investors’ confidence and creating a business-friendly environment.7

Over the past two years, the government has undertaken several measures on the economic policy front, a few of which are mentioned in table 1. Although the progress on reforms has been gradual, the recent passage of the bankruptcy law and the GST bill, among others, is among the landmark reforms that are expected to change the way India does business and support its growth outlook.

Table 1. Recent reforms

The bankruptcy code: Currently, India ranks low in resolving insolvency (136 out of 189 countries); according to a World Bank report, resolving bankruptcy in the country could take more than four years.8 The passage of the bankruptcy code is expected to help lenders and creditors recover their money within a year, aid banks and lenders in recovering their loans from big businesses and willful defaulters, and discourage big corporates from defaulting. The code will likely ensure a quick release of productive assets that are locked in sick business units, allow failed businesses to wind up faster, and help entrepreneurs to make a quick exit. All these will likely aid in improving India’s corporate bond market.

In addition, to address the growing issue of nonperforming assets in the banking sector, the government has taken steps to deal with willful defaulters and those in trouble during economic hardship. Amendments are being made to the existing law to ensure that the recovery process is more efficient and expedient. Various measures are being undertaken to revive stressed sectors, such as steel, textiles, power, and roads, and capitalize banks to allow them to correct their balance sheets.

The goods and services tax: This law replaces a plethora of taxes—central, state, interstate, and local—as well as multiple rates, thresholds, and exemptions, with a single and uniform tax for goods and services across the country. The law is expected to create a common market with seamless transfer of goods and services across the country, increase resource allocation efficiency, and plug leakages.

The GST law will likely give a boost to foreign investments and the Make in India campaign because of the potential of the unified common national market. As tax rates stabilize and cost efficiency improves, prices for consumer goods will likely come down in the medium to long term. It will likely increase consumer spending, growth, and employment opportunities in an economic virtuous circle. In addition, revenue collection for the government will likely improve over time through better tax compliance and higher profits as businesses save on tax administration costs.

Labor market reforms: The government is now gearing up for bold reforms in the labor market by considering the labor ministry’s proposal to introduce two legislations covering industrial relations and wages. These are aimed at enhancing the ease of doing business and generating employment. It is expected that freeing up the labor market from dated laws will also lure foreign investment and encourage small firms to expand.

These reforms, ranging from infrastructure development to ease of doing business to labor, are imperative, but the real key to the success of these wide-ranging reforms will be in the details. For instance, the real test of the GST reform lies in the way it is implemented. The very first challenge would be to decide the GST rate: Too high a rate could send inflation out of control, while too low a rate could result in revenue losses. Also, the mechanism to resolve disputes needs to be clear. Flawed implementation of the GST could result in little or no benefits in terms of higher economic growth.

The very first challenge would be to decide the GST rate: Too high a rate could send inflation out of control, while too low a rate could result in revenue losses.

Institutionalization of the fiscal and monetary policy frameworks

Fiscal consolidation: While remaining committed to fiscal prudence and consolidation, the finance minister announced during the FY 2016–17 Union budget that the government would initiate a review of the FRBM Act.9 The reviewing panel will be responsible for examining the need and feasibility of aligning fiscal expansion or contraction with credit contraction and expansion, as well as changing the fiscal deficit target from a fixed number to a range.

Institutionalization of the monetary policy: During the budget, the finance minister also initiated the amendment process of the 1934 RBI Act along with setting up a monetary policy committee (MPC). The preamble in the RBI Act, as amended by the 2016 Finance Act, now states that the primary objective of the monetary policy is to maintain price stability, while keeping in mind the objectives of growth and meeting the challenges of an increasingly complex economy.10 This will help anchor inflation expectations, improve monetary transmission, and reconcile any conflict between the RBI and the government, which usually wants lower interest rates to lift economic growth. The center brought into force the provisions of the amended RBI Act regarding the constitution of the MPC on June 27, 2016, so that the statutory basis of the MPC is made effective. Urjit Patel, who succeeded Raghuram Rajan as the RBI governor in September and is also one of the key architects of the new monetary policy framework, kept the ball rolling on the monetary policy by finalizing the six-member MPC.

The government’s reform initiatives, commitment to fiscal consolidation, and the monetary policy institutionalization are bolstering macroeconomic fundamentals, which, in turn, are augmenting the economy’s ability to deal with external shocks. For instance, India has been able to brush aside the impact of Brexit: The effect on India’s stocks, bonds, and currencies has been minimal; equity market indices have been on the rise; and sovereign bond yields have continued their downward trajectory. The depreciation in the Indian rupee has been contained as well.

The reforms’ impact is expected to be reflected in investments. The devil lies in the details, and once businesses are confident about their effective implementations, capital spending is likely to pick up at a sustainable pace.