Back down to earth

IFR IMF/World Bank Report 2014
14 min read

Expectations of Narendra Modi soared into the stratosphere when he gained power – but was the hype that he will pilot radical reforms justified?

While expectations of India’s new prime minister Narendra Modi were initially as sky-high as the rocket to Mars launched last year by the country’s space agency, reality is bringing them back down to earth.

Stratospheric hopes of a radical economic transformation under the new leader, who took office in May with the strongest parliamentary majority in 30 years, are now being reined in.

Early signs suggest that Modi is already sticking to what he is good at – delivery – and appears to be taking a long-term view of reform in Asia’s third-largest economy.

The head of the Hindu-nationalist BJP secured power with an image as a decisive leader determined to end years of policy drift and confront slowing growth and high inflation.

He inherited a rudderless economy from the previous Congress party government with growth – at 8.5% four years ago – lagging at 4.4% in 2013. Inflation, fuelled by a fiscal deficit bloated by costly subsidies, has hovered at 10%.

But hopes that the landslide by Modi’s National Democratic Alliance coalition would end the multi-party gridlock that has hampered growth prompted economists to raise forecasts. A consensus projects 5.4% growth this year, rising to 6%–6.5% by 2016.

Rohini Malkani, chief economist for Citi India, said: “The Indian economy may be turning a corner, as reflected in recent macro data trends. Industrial growth has picked up, exports have been rising at double digits and CPI inflation has slowed to a 30-month low.”

Modi’s victory had an immediate effect on the capital markets, fuelling expectations of an investment-led turnaround.

Casey McLean, portfolio manager and analyst at AMP Capital in Hong Kong, warns that a lot of the inflows in anticipation of a Modi victory were fast money fuelled by hype.

McLean said: “Since the reporting season kicked off in India that fast money is now looking to become more defensive, and I think that will be ongoing for a while – but if Modi is going to be a success it’s not going to be in a few months, it’s going to be in a few years, and this sort of correction is the opportunity to get in for the longer term.”

Jan Dehn, head of research at Ashmore, believes that higher valuations were already priced into the Indian equity market in anticipation of the election.

Dehn said: “A lot of people sat on their backsides for way too long and then when they saw the election outcome they piled in – but by then the smart money had already invested and the rally had to a large extent already happened, and that money is just going to sit there and think ‘When are the fireworks going to happen?’ and is going to get impatient.”

The hype is giving way to questions about how Modi will confront persistent weaknesses: a common view already emerging among analysts is that he has not articulated a particularly distinct – or emphatically clear – economic vision.

Mark Williams, chief Asia economist at Capital Economics, said: “The problem is that people are so disillusioned with the past government that the new administration has been able to come in and be cast in a very positive light simply by saying that they are going to do things differently; but they haven’t really specified what.”

Jahangir Aziz, chief economist for India at JP Morgan, says the government has not articulated clearly its understanding of what it sees as the binding constraints to growth.

“If Modi is going to be a success it’s not going to be in a few months, it’s going to be in a few years, and this sort of correction is the opportunity to get in for the longer term”

“The collapse that has happened over the last three or four years in growth, the virulent inflation, the depreciation of the currency – this is the closest India has come to a crisis-like situation since the debt crisis of the early 1990s. So if there was a moment when you could step up and say ‘India needs a different direction of reforms, a different world view of how it is organised, and a fundamental view of how economics needs to be organised’, this was it,” said Aziz.

Aziz says this could mean that far from articulating a new economic vision, policy will be distinguished more by continuity than by rupture.

Dehn at Ashmore believes Modi is pursuing a considered political strategy and is unlikely to communicate his agenda in detail in these early days of his administration.

“He’s not going to communicate it yet because the moment you tell people you are going to do all kinds of reforms then you get their backs up. This is all part of the strategy – you wait, you deliver some low-hanging fruit, you build your political capital while you are strong, while you can get people to commit. And then once the political backdrop is really solid, then you do the reforms – so I think it makes sense that there is not a very public commitment,” Dehn said.

Jerome Booth, an EM expert and author of Emerging Markets in an Upside Down World, says the lack of a clearly articulated vision may in fact be an advantage to the government.

“I don’t think it’s necessarily a bad thing, because if you have a government that’s not constantly looking over its shoulder at surviving the next half an hour, you are much more likely to get non-ideological and sensible economic policies,” Booth said.

Expectations of Modi derive from his record in Gujarat, where as chief minister he forged a reputation as a stellar administrator – piling pressure on him now to be radical.

However, most analysts agree that there are both cyclical and structural elements to India’s slowdown.

There is, nonetheless, an appetite for the standard fare of structural reform. The new government hit the ground running, outlining a 10-point plan to revive the economy – but this gave few clues to Modi’s philosophy.

At the heart of his agenda is infrastructure development, and the government has already taken steps to revive private investment and recycle capital, unveiling draft rules for infrastructure trusts (InVITs), a new asset class introduced in this year’s budget (see sidebar).

Booth believes implementation is key when it comes to infrastructure development.

“There has, like for many countries, been a focus on the public financing of infrastructure, which is not fit for purpose on its own,” he said. ”What is required is trillions and trillions of dollars going into infrastructure development and affordable housing. The government has in many infrastructure segments had PPP arrangements, which are very laborious, a bit heavy-handed; and I think there needs to be a big opening, a big freeing up of the process of getting private money, both domestic and international.”

Dehn at Ashmore believes three things need to happen in terms of capital market reform: there is a need to get the banking system on a completely solid footing by, for example, addressing FX mismatches on corporate balance sheets; second, the nightmarish cross-border trades settlement process has to be brought in line with international standards; and last, capital controls need to be removed on many securities so they can be traded freely by foreign investors.

While India has not formally committed to removing the cap, it has increased it over the summer by transferring a US$5bn allocation away from sovereign wealth funds towards portfolio investors.

Seen in the round, there seems to be little disagreement about what needs to be done.

Frederic Neumann, HSBC’s co-head of Asian economic research, has outlined a roadmap of reforms – from improving administrative efficiency, tax and financial sector reform to the need to streamline land acquisition and liberalise the labour market – that he says, if fully implemented, could raise growth to 9% or even double digits over the next five years.

Yet despite Modi’s victory, politics will still determine the pace of change: the BJP-led coalition lacks a majority in the upper house and runs only eight out of 29 states, and it is also likely that Modi will encounter political and bureaucratic obstacles to his agenda.

What this suggests is that reform may be slower than the enthusiasts have bargained for, and will require time and fancy footwork in New Delhi.

But Dehn at Ashmore believes the Modi reform timetable is in fact much more clever than a lack of obvious signals might suggest.

“The cyclical outlook in India is pretty good, the political momentum is pretty good, the strategy is pretty good, but it does not deliver on reforms early on, there is a sequence here: political consolidation, low-hanging fruits and then reforms. Modi is not just gunning for a one-term premiership, there’s a longer-term plan here and I think that’s actually the right way to run policy.”

Modi’s first budget: big bang or dull thud?

Modi’s maiden budget on July 10 has so far been the only real window into his economic vision and all eyes were on Finance Minister Arun Jaitley. It may have been one of the longest budget speeches in India’s history, at two hours, but contained little drama and generated mixed reviews, with key points including:

  • A pledge to reduce the fiscal deficit to 4.1% of GDP for FY 2015.

  • A promise to act on or target better key subsidies, such as those for urea.

  • Promises to boost infrastructure developments, especially roads and railways.

  • New vehicles and measures to boost investment and bank lending.

  • New rules allowing state-owned banks to approach retail investors for capital.

  • An ambitious target for divestment of equity in state-owned enterprises.

  • A pledge to press ahead with a Goods and Services Tax.

Nimesh Chandan, Indian adviser to Robeco Indian equities in Mumbai, was bullish, calling it a development-oriented budget that also pledges fiscal discipline.

“There was something for everyone in that budget – whether you are from a rural or an urban area, whether you are a business or a consumer – and there was a step taken or an allocation made or a committee set up for each and every promise that Modi made during his election campaign,” he said.

Chandan pointed to what he believes are clear signs of delivery.

“I think if you expect that somebody who is as efficient or as smart as Mr Modi can deliver a baby before nine months, your expectations will be unrealistic,” he said. ”But this government has been working at a pace that India has not seen. Its mandate is something that India has not seen for the last 20 years. What the government did in its first 60 days was much more than the previous government had done in almost five years.”

Amitabh Dubey, of independent EM consultancy Trusted Sources in New Delhi, believes the budget scored low in terms of strategic vision.

“The budget mixes good signals with few specifics, without sketching out a larger economic vision for the future, inevitably disappointing inflated expectations,” he said. ”Key measures expected on subsidy reform, energy prices, bank privatisation and coal denationalisation are still absent… Rather than presenting the outlines of a new economic vision, India’s first single-party government in three decades has so far signalled broad continuity with past policies, albeit with some change in emphasis.”

But Dubey agrees that there are clear signs Modi will make policy-making more effective.

“The Modi era’s first budget was largely positive, though it fell short of a big bang,” he said. ”The budget suggests Modi is shifting gears from electoral promises to executing specific actions to improve the efficiency of the state and economy. The budget process also reconfirms the imperative to closely monitor the politics of reform, and assess the economic and sectoral impact of what the government can achieve in the face of political resistance.”

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