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Marcuard's Market update by GaveKal Dragonomics
Following India’s dramatic national accounts revision, images of a turbo-charged elephant overtaking an exhausted dragon are becoming tiresome. We are upbeat on India’s secular growth outlook, but struggle to reconcile last year’s purported 6.9% expansion with other indicators. Our concern is that for all Narendra Modi’s reforming zeal, capital spending remains near its post-2009 crisis low. With the annual budget unveiled over the weekend, the key factor for India to genuinely kick-start a new growth cycle must be the adoption of policies to boost capital formation.
With the ruling Bharatiya Janata Party having recently suffered a bruising political loss in Delhi state elections, the government must regain the initiative. The problem for finance minister Arun Jaitley is that neither the public nor private sector is especially well placed to do his bidding. Corporate India has high leverage, while banks are undercapitalised and continue to struggle with bad debts which have not been properly acknowledged. The government remains in a fiscal consolidation phase, with a plan to reduce its deficit from a likely 4.1% of GDP this fiscal year (ending March) to 3.6% next year and then 3% of GDP by March 2017.
In recent months, fiscal doves have argued that the government should ease up on its fiscal targets so long as money goes into investment rather than recurrent spending. After all, state coffers have benefitted from lower oil prices as subsidies for most fuels have been stopped. What has complicated the picture is a recent settlement between the federal and state governments in how public money gets dispersed. Under the plan state governments will get to spend 42% of all centrally raised taxes, up from 32%. As a result, Delhi suddenly has much less scope to engage in large scale discretionary spending, but must rely on states to do the job.
To understand the significance of this shift in governance, it is worth recapping the cause of India’s economic sclerosis over the last five years or so. Government is set up in India such that Delhi sets policy and dictates the terms of big projects, while state governments do the implementation. The problem is that state governments have lacked the resources to actually deliver the planned roads, bridges, power stations and industrial parks. Perverse as it may seem, the political incentive for such local governments has been to create bureaucratic hindrances that ensure such “unaffordable” projects never get built.
A key plank of Modi’s campaign in last year’s national election was to remedy this dysfunction. He committed to transfer more powers to state governments in a broad platform dubbed “competitive and cooperative federalism.” The idea was for states to have the capacity to deliver on projects rather than be incentivised to look for excuses. And having been given the power, and funds, to do the job, a process of competition would hopefully ensure that states engage in a race to the top, rather than the bottom. This devolved approach to policy implementation is indeed one of the key reasons we became so bullish on the Indian secular outlook in the middle of last year.
The fiscal rebalancing between Delhi and the states is also part of a carrot and stick exercise that it is hoped will pave the way for a simplification of the tax code and adoption of a single national goods and services tax in place of multiple federal and local levies. This should improve the business climate and hopefully spur private sector investment. The problem with such reforms is the time horizons over which they work. Unlike a centrally-administered demand stimulus (of the type that has typically been adopted in Indian budgets) the new funding structures are not suited to quick-fix solutions.
The new funding settlement between the federal and state governments envisages a way around this problem. Not only will state governments get more money, but the proposal is to increase their borrowing capacity by 0.5pp of a state’s GDP on the qualifying proviso, among other factors, that debt levels are less than 25% of a state’s GDP. State’s are legally mandated to keep their fiscal deficits below 3% of GDP and presently the average level stands at 2.4%.
The point is that very few of these new funding structures are yet in place so Saturday’s budget was not expected to produce glowing headlines and cure-all solutions. Rather, the Indian government has initiated potentially powerful reforms which—if implemented—should have the cumulative effect of signaling to business that a substantially changed business environment is right around the corner. We remain extremely hopeful that India is headed in the right direction, but are cognisant that a number of pieces still need to fall in place for the effect to feed through to a substantially improved cyclical outlook.
