The Dark age

Both the Sensex and Nifty touched all-time highs in December 2013. One of the most quoted reasons for this is the expectation of a change in government in Delhi during the 2014 general elections and the resulting economic reforms that the new government will introduce. Large-scale investment-focused sectors such as industrials, banks and metals have rallied on the back of this expectation. Is this sustainable? Let’s take a look at the impact a new government can have on economic cycles.

First of all, there is little clarity on the ‘economic reforms’ that any new government may introduce. Some suggest that the pension and insurance bills will somehow drive investments and bills for controversial laws such as the ones on food security and land acquisition will be pushed back. These are important topics but not meaningful enough to move the needle on the overall economy.

To get a perspective on what is needed, one must look back at the magnitude of changes that were seen in the first wave of reforms, which lasted until 2003. The government allowed private enterprises into sectors such as telecom, civil aviation, power generation and metal production. Average import duties were cut from 78% in 1992 to 7% at present. Foreign institutional investors were allowed to participate in India’s stock markets. These are just some examples of the many such transformative changes in policy during that period.

The necessary reforms going forward, in my view, would include steps to reduce the proportion of GDP coming from the informal economy; create a truly national economic zone instead of state-level supply-chains (a goal of the proposed and long-delayed goods and services tax); increase private participation in the railways; introduce time-bound clearances of projects; and improve the efficiency of capital allocation in the economy. The list does not end here.

These are not easy reforms. Each of these requires consensus building at an unprecedented level, entails significant planning and demands astute politicking. How else do you get individuals to bargain away their rent-seeking powers in order to build a process that is more efficient and benefits the group? 

Legislation, difficult as it may seem now, may be the easiest step in this process. The mammoth scale of change management for a country as large and diverse as ours means years would pass before the impact on job creation and growth becomes visible. Even in the past, major reforms (e.g., the implementation of VAT and the construction of national highways) have taken six to eight years. This shouldn’t be surprising, as even efficient investment banks with tens of thousands of employees globally take four to five years to properly restructure. Here, the central government itself has 3.2 million employees and state governments likely have three times as many.

But what is encouraging is that economic policymaking in India showed tremendous continuity from 1991 to 2003, a period that saw a Congress-led government, a third front government and then BJP-led governments. There are many explanations for that, with the two critical ones being that elections in India are contested on social and not economic issues and that behind the scenes, the bureaucracy does most of the work, providing consistency. In a perverse way, the focus on caste, religion and local issues during elections liberates the ruling party and coalition to do what is necessary to keep the government afloat.

Thus, in all but one of 23 Budget speeches since 1991, if one just hid the name of the finance minister and the customary quote at the end of the speech, it is impossible to figure out which political party he belonged to. All governments extolled the virtues of low fiscal deficits and then missed their targets. All speeches from 1991 to 2003 had the phrase ‘no room for complacency’. This phrase disappeared from 2004 to 2011, suggesting that the government became complacent. Showing the growing sense of panic in the government, this phrase resurfaced in the 2012 and 2013 speeches. Whoever forms the next government, the process of reforms is likely to pick up, though it goes without saying that under different parties, the pace may differ.

Some critical reforms are already underway, such as in banking and in trade (numerous free-trade agreements). The banking sector is slowly but steadily getting privatised, as government-owned banks (PSU banks) lose market share to private banks: the new bank licences to be issued in 2014 will only accelerate the process. The growth of the local bond market is also hastening the process of disintermediation of banks, as longer term borrowing — especially by healthier corporates — is incrementally moving to bond markets. PSU banks in five years’ time will be a much smaller proportion of the banking system than they are now, making for more responsible capital allocation in the economy. This is not very different from the way the airline, metals and telecom industries were privatised: not through the government selling its stake, but through the government-owned company losing market share. The RBI’s proposed new guidelines on bad debts are also likely to make lending more responsible going forward, though it would do little to solve the current problems.

But the complete lull in reform momentum seen in the last eight years means that the investment cycle and, therefore, the economy, is unlikely to recover meaningfully for the next two to three years at least. Even the often discussed fiscal consolidation is unlikely to happen until the economy reaccelerates.

Another perspective on economic growth is that state governments matter more for growth than the Central government. Not that the latter does not matter at all, but it is only one of the many factors driving the economy. Many critical areas, including land, law and order, rural roads and electrification, agricultural procurement and state highways, are all under the state’s jurisdiction. State gross domestic product (GDP) growth has diverged widely over the past two decades, demonstrating the difference state governments can make. And the national GDP is just the sum of state GDPs.

Therefore, irrespective of the election outcome in 2014, the next two to three years may not see significant changes in the economic cycle. In addition to the misplaced optimism about what a potential change in government may drive, the current rally is just a short-term correction driven by wide divergence in valuation multiples earlier in the year, exacerbated by continued foreign inflows. The current rally may be a window for investors to shift away from large-scale investment-focused companies to exporters and domestic consumption sectors that will continue to benefit from growth at the bottom of the income pyramid.