Rising from the ashes, slowly

Sajjid Z Chinoy is Chief India Economist at JP Morgan. All views are personal
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The three ‘shocks’ that are transforming India. But don’t expect miracles
What a difference 18 months can make. Last May, India was the poster child of emerging market vulnerability. The current account deficit had reached an unsustainable 5 per cent of GDP, gold imports were surging as households—faced with negative real rates of return on financial assets—had moved to gold and physical assets, the current account was increasingly being financed by ‘hot money’ portfolio inflows, retail inflation was stuck close to double- digits, and the Rupee increasingly seemed overvalued. An accident was waiting to happen.

And it didn’t take long. At the first signs that the US Federal Reserve was going to ‘taper’ its asset purchases—the beginning of the end of easy money in the US—capital flows into emerging markets began to reduce, exposing India’s vulnerabilities. This was manifested most clearly in the manner the rupee came under severe pressure—depreciating 30 per cent peak-to-trough between May and August—and easily becoming among the worst-performing emerging market currencies.

But all that just seems like a bad dream at the moment. Fast forward to today, and India has transitioned from a sinner to a saint. Foreign investors cannot get enough of India. Almost $40 billion dollars of foreign portfolio flows have come into India since the start of 2014, and the rupee is now the best performing emerging market currency this year!

What changed? The transformation of India’s prospects over the past year has its genesis in three ‘shocks’ that India has been subject to: first, the macroeconomic adjustment that actually began with the fiscal consolidation in September 2012 and included a complete overhaul of the monetary policy regime by the RBI in January 2014; second, a historic election result that delivered greater-than-expected political stability and a new government that appears fixated on growth, development and reforms; and, third, the plunge in global oil prices over the last three months that has a large and positive impact on commodity importers such as India.

But let’s start with September 2012, which was a key inflection point in India’s recent economic history. The Central Government’s fiscal deficit had surged to almost 6 per cent of GDP the previous year, retrospective taxation in the Budget earlier in the year had vitiated investor sentiment, and implementation bottlenecks (land, coal, iron ore, environmental clearances) had become the binding constraint on investment and growth. All told, India was just a few weeks away from a sovereign ratings downgrade that would have been catastrophic for capital inflows, the currency, investor sentiment and growth.

To his credit, the new Finance Minister at the time jammed the fiscal breaks and brought a sense of sanctity to the fiscal outturn that had been missing since the crisis. The fiscal deficit in 2012-13 was reduced by a full percentage point of GDP (from 5.9 per cent to 4.9 per cent of GDP), and this was the start of a much-needed macroeconomic adjustment in India. Investors around the world finally began to take notice. This was not business as usual.

In addition, the Government at the time realised the gravity of the investment constraints and set up a Cabinet Committee on Investment to centralise decision-making and debottleneck projects on the ground. Bottlenecks are still being worked through, two years later, but these actions laid the foundations for the new Government to build on.

Despite these actions, India could not be saved from the tremors of the taper tantrum of 2013 because too many other macroeconomic vulnerabilities existed. None more pressing than the fact that retail inflation had averaged 10 per cent since the global financial crisis and the rural economy was stuck in a wage-price spiral. Unsurprisingly, inflation expectations had gotten deeply entrenched and inflation was caught in a self- fulfilling spiral: expectations driving inflation, which, in turn, further reinforced expectations.

This cycle had to be broken and, therefore, the second pillar of stabilisation was put in place when the RBI decisively moved to inflation targeting in January 2014, making headline CPI inflation its target and publicly committing itself to reduce retail inflation to 6 per cent over two years. Scarred by the memory of living with double-digit inflation, markets were (unsurprisingly) sceptical that this could be achieved at all, or worried about what the growth consequences would be. But, yet, less than a year into the process, markets now believe that the 6 per cent target will be met ahead of time and the RBI will actually have space to cut rates in a few months! What changed? Tight fiscal and monetary policy has worked in tandem to push down core inflation, even as softening oil and commodity prices have lent a helping hand, and the Government, to its enormous credit, is working hard to push down food prices—which comprise almost half of the CPI basket. Across both the old and new governments, we’ve seen minimum support prices for farmers only go up 3-5 per cent over the last three crop cycles, and the new Government has been more active about selling rice and wheat from its buffer stocks to contain cereals inflation. There is a welcome urgency about fighting food inflation in Delhi, which is helping keep prices in check. And this is not surprising. Guess what the No 1 voting issue in the General Election of May and most state elections last December was? Not governance or jobs or corruption, but inflation. The message was clear: inflation is not just bad economics. It’s terrible politics.

The aforementioned fiscal and monetary ‘regime changes’ have been critical to India’s macro- economic prospects. Yet, perhaps the defining moment of 2014 was the May election—and the scale of the new Government’s victory. While markets had been pricing in increased political stability in the run-up to the polls, nobody quite expected what transpired on 16 May.

So how does one assess the Government’s first six months in office? Those who were expecting ‘big bang’ reforms have been disappointed. But this was always an unrealistic expectation. The politics of economic reforms necessitates moving in small increments to spread out the adjustment costs and make reforms more politically palatable. Think about the success of diesel-price reform versus the failure of FDI in multi-brand retail. In the case of the former, policymakers moved in such small increments—1 per cent a month—that it did not invite any opposition, and yet, over time, added up to a lot. Over 18 months, 80 per cent of the diesel under-recovery was wiped out, and when oil prices underwent a correction, the new Government was quick to seize the moment and deregulate diesel. Now compare this to FDI in multi-brand retail—a big-bang announcement that become a rallying point for vested interests to coalesce and shoot it down.

It’s no wonder then that the new Government is moving in small increments: inducing states to gradually liberalise labour laws, re-auctioning coal-mines and hopefully setting up a framework for commercial coal mining, announcing its desire to make it easier to acquire land, increasing gas prices (though by less than some has expected), getting closer to an agreement on the proposed Goods and Services Tax (GST), and gradually introducing cash transfers. By itself, none of these has been a game-changing, big-bang announcement of reform. But together, taken to their logical conclusion, they could have a very meaningful and positive impact on the structure of the economy in the medium-term.

One area where the Government has pushed hard has been internal governance reforms to streamline and speed up decision-making. While this may not be visible to markets, we believe it is crucial to India’s economic prospects. We estimate that almost 45 per cent of the nearly 700 basis points slowdown in GDP growth between 2010 to 2013 (peak to trough) has been on account of implementation bottlenecks (land, coal, clearances, raw materials). So if the Government can address these through faster, smarter and better coordinated decision-making, that could be its biggest contribution to India’s languishing investment cycle.

But markets need to be realistic. Any growth acceleration is likely to be modest and lagged. There are real constraints on growth—highly leveraged balance sheets in the infrastructure sector, banks laden with non-performing assets—and these will take time to play out. India will do well to touch 6 per cent growth in 2015-16.

They say people—and economies?— make their own luck. And India seems to have done so. And, so, the third shock that is responsible for India’s attractiveness is the sharp correction in global commodity prices. The global price of crude oil, which is India’s single largest item of import, has collapsed from $115 to less than $80 per barrel over the last few months. If sustained, this serves as a massive, positive terms-of-trade shock for India. It will help the current account, the fiscal deficit, inflation, push down input costs and allow firms to normalise margins (good for investment) without raising output prices (good for core inflation).

All told, India has been on a rollercoaster ride over the last 18 months and gone from the prodigal son to the favoured child in the emerging market universe—helped by a macroeconomic adjustment that was started by the previous Government and carried on by the new one, the thrust on infrastructure reforms, albeit incremental, by the Modi Government, and pure luck on global commodity prices.

But it is critical that the economy does not rest on its laurels or indulge in self-congratulatory behaviour. The capital expenditure cycle is still languishing, challenges abound on the ground, and the slow and modest growth recovery could disappoint markets in the coming months. Therefore, the new Government needs to press on the reforms pedal with continued vigour and enterprise, and all indications are that it is preparing to do so. Reforms must be taken to their logical conclusion and we can’t afford to go back. Because the memory and pain of last summer is still too raw.