All tied up

IFR Asia India Report 2012
11 min read

A dysfunctional political environment, serious infrastructure bottlenecks and poor investor sentiment have slammed the brakes on India’s economic growth.

A man stands on a stepladder to fix tangled overhead electric power cables at a residential area in

Source: Reuters/Parivartan Sharma

A man stands on a stepladder to fix tangled overhead electric power cables at a residential area in Noida

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It is the first day of September. Diana, who started work as a shop assistant a month ago in one of the glitzy local malls in the Indian capital of Delhi, is waiting for customers to drop in. She is mystified about the thin crowds on a Saturday evening.

“Last month, there were many holidays. Hence, perhaps, people want to stay at home this weekend,” she muses. Diana is not alone in wondering why customers are either not coming, or are there, but not buying. India’s consumption engine is now showing signs of fatigue.

At the same mall, a large furniture showroom has put up a notice that it has moved to a cheaper part of the city under the guise of taking up more spacious accommodation. It is a sign of the times. Economic activity has slowed perceptibly, and belt-tightening is in evidence at both the corporate and individual levels.

India’s economic growth has decelerated from over 8% only a year ago to just 5.5% in the second quarter of 2012, amid a near collapse of industrial growth and declining exports.

Going on the 5.3% growth in the previous quarter, this is no short-term blip. “This is not a temporary slowdown,” says former central bank governor and parliamentarian Bimal Jalan. “The investment climate is quite pessimistic, even though not all is dark.”

India’s robust economic growth in the past few years has been instrumental in lifting millions out of poverty. For this constituency, inflation exaggerates the impact of any slowdown and threatens to take away their gains.

While the central government’s large social schemes aim to provide some relief, they come with the unintended consequence of adding to the fiscal deficit at a time when tax collections are also falling.

For the middle class of nearly 160m, a slowdown pinches through slower job creation and a reduced capacity for discretionary spending. High interest rates are also dampening the credit-driven boom in real estate and purchases of household goods.

Stubborn inflation and the government’s large spending both on subsidies and social schemes reduce the central bank’s headroom for action, with policymakers facing the difficult challenge of boosting growth without raising inflation.

Policy paralysis

A further deterioration of central finances may well lead to the loss of India’s investment-grade credit rating. Uncertainty and sluggish growth in the global economy are not helping.

Yet, a cyclical slowdown alone does not explain the despondency that seems to be engulfing India. Rather, the extent of the current pessimism stems from the failings of a fractious political system that has not been able to deliver the structural reforms needed to sustain the country’s high growth.

Two incidents in July highlight the impact of that lack of reform. The death of a human resources manager in a violent escalation of an industrial dispute at India’s largest automaker Maruti Suzuki has turned the spotlight on India’s antiquated labour laws, while two consecutive days of massive power outages caused essential services in major parts of the country to grind to a halt.

The lack of political will and parliamentary consensus have stymied reforms in both these sectors. Instead of putting these – or other – urgent items at the top of the agenda, the government and opposition parties have been locking horns over fresh graft charges every few months.

The political capital needed to push through reforms is missing. In the prevailing limbo, even simple measures that can boost sentiment have little chance. This policy drift has left the investment climate a nightmare for any institutional or corporate investor.

There are numerous outstanding issues – telecom licenses need to be re-awarded after a corruption scandal, the allocation of coal blocks has recently come under the scanner with estimates of a US$33bn loss to the exchequer, the government has flip-flopped over increasing foreign investment in the retail sector, and plans for a retrospective tax levy on overseas investors has created months of needless uncertainty.

Regardless of the merits of the graft charges, India Inc is worried about the repercussions on investment and growth.

“Every lender can live with a wrong call, but needs a regime of predictability,” says a Mumbai-based banker. “Here, the risks are untenable. To restart the investment engine, the due process of law that is equitable to all stakeholders should be followed.”

Several leading corporate houses have been caught up in this collision between business and politics, and some are even speaking out – albeit in somewhat cautious tones. Last year, 14 business leaders, among them Wipro’s Azim Premji, wrote an open letter exhorting the government to act. A year down the line, they remain disappointed.

“We have excellent people, but no leaders,” quips one of the letter writers, who is baffled by the lack of responsibility in the top political leadership.

TN Ninan was more direct in a recent editorial in the Business Standard: “How much of today’s policy paralysis and economic slowdown are because the state has been captured? And how much of that is a consequence of the prime minister’s Faustian bargain with the kleptocracy?”

Public anger

The current government came to power on promises to improve the life of the aam aadmi, or the common man. For that common man, however, the state is now a harsh master out to collect via multiple means, while abdicating basic governance and responsibility.

In the last 18 months, public anger and resentment have been channelled into sporadic anti-graft protests. Any institution that shows a modicum of propriety and responsibility is feted. The higher courts and, more recently, the Comptroller and Auditor General, who flagged the telecom and coal issues, have emerged as the heroic counterpoints to the despised politicians.

“Specific political reforms can change the situation, but those who can bring about change do not have the will to do so because of the vested interests of multiple parties in power without a shared agenda or ideology,” says Jalan.

India, however, is a land of contrasts. Manthan, or the great churning, is a term that crops up quite often in conversations about India’s future. The term refers to the mythological churning of an ocean of milk, which yields sweet nectar and other treasures, but only after the separation of destructive poison. Optimists believe India’s current crisis will lead to action and reforms once the rot in the system is exposed.

Economists point out that developing countries can still manage to grow without governance at low per-capita incomes, but only up to a point, which is typically around US$12,000 per-capita GDP.

After that they encounter, what is known as, the “Great Wall”, which can only be scaled if institutions improve and strengthen. In India, the clamour for effective governance is becoming louder at only a tenth of this income benchmark. That has to be a good sign.

In the meantime, India will chug along at its new normal growth rate of around 5%. Business ambles along. “The current situation, both globally and locally, may force investors not to make large cash calls, but there is a reasonable amount of business for a start-up,” says Vimal Bhandari, CEO at IndoStar Capital Finance, a private equity-funded company set up last year to cater to the credit needs of Indian companies.

India’s crisis is also an opportunity. Manish Pant, managing director of Luminous Power Technologies, whose office ran as usual even on the day of the large outage, believes his business will expand at a compound annual growth rate 15% over the next decade.

Luminous, which Schneider Electric bought last year, provides power-storage solutions to enable both people like Diana and the mall where she works to access power when needed.

“Even though there is no spike in demand, such outages make the latent need for power storage solutions explicit,” Pant says.

As India electrifies and upgrades, the potential to grow is huge. India’s per-capita consumption of power, at less than 800 units, is far below the world average of around 2500 units. Pant and his company are not alone in betting on India.

At nearly US$2trn in nominal terms and still growing, the Indian economy remains an important part of many global investors’ portfolios.

International investors are already well aware of the country’s problems, yet nearly US$12bn has flowed into the country this year. With growth in Europe and the US slowing, and China’s economy decelerating, there are few alternatives.

“India is the cleanest shirt in the laundry basket,” says Andrew Holland, CEO at Ambit Capital, who has been investing in India for over 15 years. Unlike other emerging economies, Holland believes India’s failings are now out in the public domain, and that valuations have become cheap.

In a market searching for hope, even minor measures will boost sentiment. The deferral of anti-avoidance tax rules for three years has already helped.

“Despite the overall pessimism, there is hope that the new Finance Minister will usher in some momentum on the reform front. Although largely ignored, small steps like the formation of a monitoring committee for projects over Rs10bn have a large potential for impact,” says Sonal Varma, executive director and India economist at Nomura. Varma maintains her forecast of 5.8% growth for the 2013 fiscal year.

Hope is in the air, but it is up to the government to deliver.

“Yes, there is hope, but it is fading fast. Maybe a rating downgrade will not be such a bad thing,” says Holland. “Perhaps, it will focus everybody’s attention on what needs to be done.” That sounds plausible. India, after all, does well during a crisis.