The Economic Road Ahead For Team Modi: A Set Of Reforms That Should Be Looked At

The 2019 election verdict is a watershed moment – the first time since 1984, a party has been re-elected on its own strength. The vote share of the Bhartiya Janata Party (BJP)-led National Democratic Alliance (NDA) at 44.6 per cent is amongst the highest vote share ever for a pre-poll block since India became independent from British rule.

The BJP’s “Sankalp Patra” envisages the Indian economy reaching $5 trillion by 2025 from $2.8 trillion in 2018. This assumes the economy to compound at 9 per cent over the next decade. Since 2010, the Indian economy compounded at 7 per cent till 2018. A hostile beginning to this decade saw high inflation, high deficits, weakening currency and slowing economic growth, which eventually manifested into a crippling non-performing assets (NPAs) phase for the banking system in the second half of the decade.

Modi 1.0 was largely focused on repairing the stressed banking system and undertaking structural economic resets - Goods and Services Tax, Insolvency and Bankruptcy Code, and Real Estate Regulatory Act among others. Modi 1.0 has laid strong structural foundations which should put India back into strong growth mode over the next decade.

Accordingly, Modi 2.0 has its focus set up on ramping up infrastructure spend and turning around the investment cycle. To sustainably achieve this, there are some major immediate challenges which need to be overcome. We highlight six key issues in the realm of finance and economy, which the new government should look at on priority.

Shoring Liquidity and Credit Uptake - PSB Recapitalisation

Since FY16, the government has infused Rs 2.5 trillion in public sector banks (PSBs) (back loaded Rs 2 trillion over FY18-FY19) to capitalise and resolve the vulnerable PSB balance sheets. These banks have been reeling under unprecedented Non- Performing Assets from the 2004-12 credit cycle. Simultaneously, the game- changing Insolvency and Bankruptcy Code, 2016, has helped PSBs to recover Rs 1.95 trillion from their stressed assets over FY18 and FY19 with Rs 610 billion recoveries from two large steel NPAs round the corner.

While these capital and recovery initiatives have helped the banks heal and stabilise their balance sheets, they remain challenged for growth capital. PSBs being back in growth mode can help credit creation and economic growth, in addition to them playing a constructive role in alleviating pockets of new stress. Submission of the Dr. Jalan Committee report on excess capital of Reserve Bank of India (RBI), is expected by June 2019. Estimates suggest that more than Rs 1 trillion can be transferred to the exchequer, which in turn can be used to provide growth capital to the PSBs. Importantly, this transfer will be “fiscal deficit neutral”.

Tiding The Crisis of Confidence in Non-Banking Financial Companies (NBFCs)

While Modi 1.0 started with the “legacy inheritance” of stressed PSB balance sheets, Modi 2.0 is starting with the stressed condition of NBFCs. While the trigger for this crisis of confidence in NBFCs was the default by IL&FS, the ensuing pain for NBFCs is largely self-inflicted, brought upon by the pursuit of rapid growth over the last few years, especially by Housing Finance Companies (HFCs).

The pursuit of rapid growth by building a loan book of long duration assets financed by short-term liabilities, largely funded by mutual funds and money markets, is unsustainable. Over time, for some players, this has resulted in unsustainable Asset Liability Mismatches. So long as the music was on, and the markets were funding these mismatches, the dancing continued. With the default by IL&FS, the music stopped and the provision of liquidity to the sector has been impaired, except those who have a strong parentage or long vintage in the business. Nonetheless, the cost of capital has increased for everyone.

The impaired liquidity has two parts – Systemic and Entity Specific Solvency. RBI has been on the ball over the systemic part with liquidity infusion and forex swaps. However, it is the Entity Specific liquidity challenge that needs immediate attention. Another default by any large HFC or NBFC has the potential to balloon into a much larger crisis of confidence for the sector, where many entities now have balance sheets in excess of Rs 500 billon. While banks have RBI as the lender of last resort, NBFCs do not have recourse to such systemic arrangements. Hence, driven by fears of insolvency, wild rumours can begin to circulate and liquidity can dry up for many vulnerable players at the same time.

While RBI has ruled out any backstop funding arrangement for NBFCs, as an immediate near-term solution, PSBs can step in and buy out the good portion of the loan portfolios of the stressed entities. This will ensure liquidity for the struggling entities. Simultaneously, the RBI and the NHB should undertake an Asset Quality Review (AQR) of the Systemically Important (SI) NBFCs/HFCs. This will help allay fears over asset quality and solvency, thereby aiding the markets to provide liquidity.

Cost Of Capital

The manifesto of the BJP has eloquently pronounced the intent of the government to reduce the cost of capital to revive the investment cycle. Since November 2016, Consumer Inflation has averaged 3.5 per cent and remained comfortably below the 4 per cent anchor rate of RBI. Importantly, the Consumer Price Index (CPI) has remained consistently below the RBI’s target ceiling of 6 per cent since September 2014. As a result, the real interest rates in the economy have averaged around 300 bps (a basis point is one hundredth of a percentage) since September 2014 and stand at 425 bps currently.

This has kept monetary policy quite restrictive in India. Coupled with stressed PSBs, credit creation and money supply in the economy has remained far below the long-term averages of 18 per cent and 15 per cent respectively since 2012.

With important legislative changes such as the Insolvency and Bankruptcy Code and Inflation targeting mandate of RBI decisively in place, it is time the Cost of Capital is substantially lowered to kick-start the animal spirits in the economy and revive the investment cycle. With the slowing of the consumption cycle, in part driven by the stressed NBFCs, and lack of fiscal space to ramp up government expenditure, revival of the private investment cycle becomes all the more important.

The government under pressure to control fiscal deficit, coupled with a tight monetary policy means India is running both and fiscal and monetary policies counter-cyclically in an economy under duress. The Finance Ministry and the RBI have to work together to address this issue.

Agriculture, SME/MSME and Real Estate Support

Two key economic planks of the Opposition over the last couple of years have been agrarian distress and employment opportunities. The competitive populism and politics of loan waivers over the last few years has found traction in state elections largely due to the stress in the farm economy.

In the Lok Sabha elections, the farming community has backed the BJP strongly on the back of its income support scheme. With the income support scheme in addition to hikes in Minimum Support Prices (MSPs), the BJP government seems to have found a right policy plug to balance the near-term income support with longer term initiatives like crop insurance and a National Agricultural Market. However, it will be pertinent to ensure the flow of credit and investments into the farm economy and hence, resolution of the NBFC stress on a war footing is essential since they play an important role in the last-mile delivery of credit in the rural economy.

Likewise, small traders and businesses too have evidently stood firmly behind the BJP government in the Lok Sabha elections. Despite the MUDRA scheme, the flow of credit to this segment of economy could get impaired if NBFC stress lingers. With the Real Estate Regulation Act (RERA) and GST, the real estate sector is undergoing a structural transformation and given its large multiplier effect on the economy, it is necessary to help the sector by meaningfully reducing interest rates. While larger questions remain on the initiative of the developers to undertake pricing adjustments to clear the historic inventory in key geographies, from the policy angle, it is pertinent to reduce the systemic cost of capital to aid demand propensity.

Labour Reforms

Due to various reasons, there wasn’t much of a movement on labour reforms during Modi 1.0. Various states like Madhya Pradesh, Maharashtra, and Rajasthan changed their own laws to ease some of the archaic labour laws which India inherited from the British and never amended. However, a systemic action in the early days of Modi 2.0 can really benefit the industry. The government has the requisite political capital and the Opposition does not have steam left for quick galvanising against any government proposals.

The dilemma in labour law reform is that the government will likely get stick from both ends. Any small change will be made to sound draconian by labour bodies and unions. All change will be derided by the business commentators as not ambitious enough. Stuck between rock and a hard place, successive governments have made absolutely no progress on this subject. Modi 2.0 should approach this issue in byte-size increments.

Consolidation of labour laws across various codes, even with minimal changes to actual rules and regulations, can itself help the industry. Today, there is a lot of confusion on basic definitions itself which concern management of human capital. A consolidated set of laws, which shrink the current 44 central laws into four Acts will be a great start. Each Act can deal with codes in specific areas – industrial relations, social security, wages, and workplace safety and wellbeing.

This consolidation – a lot of the work on this has already been done in Modi 1.0, but the codes are yet to reach the Parliament – will help significantly reduce the cost of compliance and cost of judicial action. This itself will be a big gain for the industry.

The more contentious provisions around hiring and firing, creating competition for the costly Employees State Insurance Corporation (ESIC) and simplifying employee contracts can be phased over the Modi 2.0 term.

Make-in-India Opportunity

During Modi 1.0, India launched an ambitious Make-in-India programme, which sought to localise parts of the manufacturing process and reduce India’s import dependence, at the same time boost export earnings. The progress has been mixed. Some interesting projects have taken off in the defence and auto sectors, and parts of the mobile manufacturing value chains have been Indianised, but there is a lot more to do.

Additionally, the opportunity is bigger now, with the United States of America (USA) and China being in the middle of a trade war. Neither side has shown any intent of backing down from their respective positions. India can make use of this wedge to boost exports to both the USA and China.

India can target specific Chinese manufacturing companies with offers of easier land buys and other facilities to set up shop. The companies, which are facing tariff sanctions by the USA, may want to hedge their bets using India as a secondary base, which may grow over time. Simpler labour laws will play a key part in making this transition a viable proposition. Other structural interventions like providing necessary infrastructure support, tax simplification, and quicker time to production may make the Indian value proposition more attractive.

The government should look at promoting the two defence corridors in Tamil Nadu and in Uttar Pradesh. All offset production and fulfillment can be moved to the two corridors, where the respective states have promised to simplify processes and procedures to attract fresh investment.

The Commerce Ministry should focus on designing export incentives which stay compliant with the World Trade Organization (WTO) tariff norms. In the years to come, USA and other countries will keep challenging India’s export incentive programme, which is based on a combination of export value and their destination. Instead, the ministry should design incentives at the production stage, which then doesn’t fall askew at the point of export.

Prime Minister Narendra Modi ran his first term in a pragmatic fashion, focusing on fixing the plumbing. His non-doctrinaire, do-what-is-needed approach was disliked by his capitalist backers and communist haters alike for different reasons. In the end, common people saw value in his approach to run the economy and voted overwhelmingly for his state as a “catalyst and aggregator worldview”.

The second term can be about reducing friction in factor markets which he can influence – labour and capital. This, backed by specific incentivisation of industry can put India firmly on the path of achieving $5 trillion in GDP in quick time.