Ruchir Sharma Analyses India's Centre-States Equation

Ruchir Sharma generally spends one week every month in a developing
country. As head of emerging market equities and global macro at
Morgan Stanley Investment Management, few people know the emerging
markets better. In 2012, his book Breakout Nations - In Pursuit of the
Next Economic Miracle, became a best-seller. Sharma says India’s
growth boom from 2003-11 was the result of global factors and the
flood of easy money. “The entire boom of the last decade, where growth
accelerated from 5-6 percent to 8-9 percent, was totally global in
nature. It had nothing to do with India-specific factors. And that
boom is now unwinding. Now can we undershoot 5-6 percent for a year or
two? Yeah, we can,” says Sharma. The following are excerpts from his
free-wheeling interview to Forbes India.

Q. Recently, you wrote an article in Foreign Policy magazine titled
“The Rise of the Rest of India”, in which you talk about Indian states
that have done well over the past few years. What are the factors that
make for a breakout state?
A very simple definition is that the state has been able to
consistently grow above the national average over a five- to 10-year
period. Often you can associate that growth to some change in policy
or leadership which has taken place. It is the same as the concept
that I have used in my book Breakout Nations.

Q. Which Indian states are potential breakout states or have already broken out?
The states where the most impressive results have been seen are
Gujarat, Bihar, Madhya Pradesh Odisha, Chhattisgarh, Delhi, etc. These
are the places where typically you have seen growth. The ones where
the most impressive delta, or change, has taken place have basically
been Bihar, Odisha, Madhya Pradesh and Chhattisgarh. That area has
done well.

Q. What about Gujarat?
Gujarat has done well. But Gujarat was already doing well in the
previous decade. It’s impressive [performance] is that it has done
better from a higher base. Similarly for Maharashtra, growth rates
have been okay, but in the last couple of years they have begun to
fall. And Maharashtra is so dependent on the legacy industrial base,
or the whole golden triangle of Mumbai, Pune and Nashik, that I don't
know how to call it a breakout state necessarily.

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Q. Does the Indian constitution need to be re-jigged to give Indian
states more economic power?
I'd say that maybe later, but to me that is not the big thing. India
has three lists—Central, state and the concurrent list. And the big
thing which has happened is that a lot of the items which were in the
state list and the concurrent list have been usurped by the Centre
over time. And this has got to do with environment, mining, labour and
even things like food. The whole culture needs to be a collaborative
culture rather than the Centre deciding, or one leader deciding, that
these are the five things that India is going to do. We have had
centralised leadership in the past. We have had the Indira Gandhi
days. Economic growth wasn't great during that period.

Q. So what needs to be done?
The first thing you can start doing is by giving power back to the
states. India's constitution envisaged a federal structure. It is just
that over time, particularly the 1970s and 1980s, a lot of the state
powers were usurped by the Centre in the name of centralisation and in
the name of the secessionists taking over. The whole point is that
when you have national schemes, you have to give much more flexibility
to the states. For example, the Planning Commission is now talking
about 10 percent discretion to states [on Central schemes for states].
That can be increased to 30 percent or 50 percent, rather than the
criteria and the mandates being set by the Centre.

Q. But can we have breakout states when the country is in a breakdown mode?
Of course not. The national average is ultimately a summation of the
states. The only reason for optimism is that at the state level things
are a bit better. State level leaders understand how to succeed in
various parts of India rather than having a one-size-fits-all national
policy. Having said that, there are issues at the state level as well.
Many states have their own crony capitalists. At times they are
autocratic and anti-democratic. But my entire point is that there is a
ray of optimism. Five years ago we were drawing straight lines stating
that India's GDP growth has been 8-9 percent and if it continues for
10 years where will we be? If it continues for 20 years where will we
be? And so on. Today it is hard to be optimistic on the country
because there is so much negativity going around. To me the breakdown
is a perception thing more than a reality.

Q. Are there things that can be done to set it right?
One flaw to me is this culture of lack of accountability. If you look
at India today the lack of accountability starts from this separation
of party and government. This has really been one of the fault lines
of India. To run a country with a division between party and
government is really very difficult. It fosters a culture of lack of
accountability. When you ask the people in the [Congress] party why
[some things] are not being done, they say it’s the government's
responsibility to do this. And you ask the government and they tell
you we don't have the political power to do it. That lack of
accountability just flows down. Also, if you look at the world,
technocrats have not been very good as heads of states.



Q. So that brings me to the logical question. Is that leader Narendra Modi?
I am not sure of that. I don't want to get into this thing about who
it should be or who it shouldn't be. My entire point is that you have
mass-based leaders at the state level. The states are not run by
technocrats. The breakout states that I speak about are run by
politically smart people, who understand what needs to be done for
development, and who get the connection of what is good economics and
what is good politics. They see the bridge between the two. To me it’s
about mass-based leaders. Whether India can have this at the national
level, I am doubtful about [that].

Q. But do successful state-level leaders transform into national leaders?
It has never happened. Never. That's the staggering point. Many
leaders have tried to go out. The list is a long one. From Sharad
Pawar to Mulayam Singh Yadav and even someone like Mayawati, they have
all tried to build a national footprint but they have never been able
to succeed. Often having strong regional roots is a liability at the
centre, because then they begin to associate you only with one
particular state. Even in the Congress, I find it fascinating that
there is so much talk as to who could be the next candidate for Prime
Minister. I would think that logically it should be a chief minister
rather than any of the national leaders.

Q. But no one comes to my mind when I think of the Congress chief ministers...
Exactly. Logically, we should argue that if, by any chance, Sheila
Dikshit wins the next election, then she should be the automatic
choice for being the next PM candidate assuming that Rahul doesn't
want the top job. Someone like her should be the top person for that
job. You need someone with a mass base, who understands politics.

Q. What has suddenly gone wrong with the rupee? Between January and
May it yo-yoed between 53.5 to 55.5 to the dollar.  But after that it
has fallen dramatically...
All countries with high current account deficits [CADs] have really
taken a big hit as far as their currencies are concerned. The whole
game began to change, as is well documented by now, after the Federal
Reserve decided that it wants to think about tapering off its
quantitative easing. After that, US interest rates have risen a lot.
The 10-year interest rate has gone up by 100 basis (1 percent) points
since May. This has obviously led to people evaluating how much money
they want to put up internationally.

Q. Economic theory suggests that as the currency depreciates exports
go up and imports fall. But in the last two years, our trade deficit
has gone up dramatically. How’s that?
The recent fall of the rupee has been very sharp but before this the
rupee was adjusting for the high inflation we have had for such a long
period of time. Exports are dependent on multiple factors, exchange
rates being only one of them. Global demand has been weak. If just
changing the nominal exchange rate was the game, then it would be such
an easy recipe for every country to follow. But in the real world you
need other supporting factors to come through. You need a
manufacturing sector which can respond to a cheap currency. Our
manufacturing sector, as has been well documented, has been throttled
by all sorts of local problems.

Q. What are the other impacts of a falling rupee?
One of the factors that has been under-appreciated is that there is a
negative effect from the huge foreign exchange loans taken by
corporates. So even though there is not much that can be done to stop
the rupee's fall you can't at the same time wish that you will devalue
your way to prosperity.
There is a negative feedback loop because the corporate sector is
heavily indebted in foreign currency. So that is the problem.

Q. So there is a corporate debt crisis brewing. You have pointed out
in the past that one in four Indian companies does not have enough
cash flow to repay debt. How is that playing out?
Those companies are just going to be shunned for a long period of
time. People are now just investing in the 15-20 big companies and
keeping away from the rest. India has lost a major competitive
advantage. India's advantage, which used to be quoted to foreign
equity investors, was how we have a huge number of companies to invest
in. That has shrunk incredibly now. Some of these companies are not
going to be able to survive. That's the harsh reality.

Q. Oil prices are at an all-time high in rupee terms. What sort of
impact will that have on the fiscal deficit? Can we buy the finance
minister’s target of 4.8 percent?
We achieved the [fiscal deficit] target last year, but you have to
understand how that was done. The government will have to really
freeze spending, and that in turn will compress consumer demand. The
issue is whether they have the political appetite to do that. Or the
government will have to raise diesel prices. Currently, they are Rs
9-10 behind on under-recoveries. They need to raise diesel prices by
such a massive amount to stick to the fiscal deficit target. So can
the government meet its fiscal deficit target? Of course it can. But
the price in this case will be economic growth.

Q. If they don't increase diesel prices they have a problem. If they
do increase diesel prices they have a problem.
Exactly. That's the negative feedback loop I talked about. Moving the
exchange rate from X to Y and hoping that exports will pick up is a
very simplistic solution. It does not take into account the negative
feedback loops that can arise in terms of corporate debt denominated
in foreign currencies and also the fact that the oil import bill gets
considerably worse.

Q. Our current account deficit did not appear overnight.
This is the irony, that the crisis has been badly managed. These fault
lines have existed for a while. The CAD has been going up continuously
over the last two to three years, above levels which most economists
consider to be sustainable. And we ignored that. In our desire to keep
growth artificially high in 2009 and 2010, we engaged in a lot of
stimulus spending. We let our fiscal deficit blow out. We violated the
FRBM [Fiscal Responsibility and Budget Management Act] and have never
ever gone back to that. The Prime Minister has ignored so many fault
lines.

Q. Could you elaborate on that?
He dismissed crony capitalism as being something which possibly is the
rite of passage that any country going through an early stage of
development will have to go through. Every such country will have its
own robber barons. So what is the big deal that India does? He
dismissed inflation by saying that the rise in food prices is a sign
of prosperity. He went on about how savings and investment ratios are
so high that growth is unlikely to ever dip below 8-9 percent. And on
each one of them any sort of serious economic analysis would suggest
that these arguments were flawed.

Q. And this has had a huge impact?
We know that if you have crony capitalism, it can lead to a backlash
against wealth creation. Look at issues like the ban on iron ore
exports, the mining of coal, etc. Some of this is because we have had
crony capitalism and that has led to a backlash against wealth
creation.

Q. What about the inflation argument offered by Manmohan Singh?
The whole business about inflation rising because of a rise in
prosperity is a real myth. Why has China not seen this massive
inflation problem despite 30 years of great growth? Why did Korea and
Taiwan not see any sustained inflation pressure? Or even Japan during
their very high growth phases? Why? This is a total myth. India's
inflation rankings have deteriorated considerably. Our inflation used
to be always below the emerging market average for the last 20-30
years. It's only in the last three to four years that we have been way
higher than the emerging market average. Not just a bit higher, but
way higher.

Q. You recently wrote that “A not so funny thing happened; while the
world was watching for an emerging market crisis to erupt in China,
the crisis erupted in India instead.” Explain…
For the first half of the year a lot of focus was on China. China has
had a massive credit binge over the last five years. In recent times
we have seen that in the US, Spain, etc. Typically, countries which
have had a massive credit binge are vulnerable. When you increase your
debt over a short span of time of three to five years, you accumulate
a lot of bad assets. And that leads to trouble for the entire banking
system. So people have been very worried about the high debt to GDP
ratio in China. Even I have been concerned about it and written about
it. There were people sending out alerts on a China crisis. I think
very few people were sending out alerts about the India crisis.

Q. Nobody did.
Exactly. That's the irony to me. Everyone was looking for a crisis in
China and it ends up erupting in India first.

Q. Indian economic growth has fallen to around 5 percent. Do you see
us going back to the good old Hindu rate of growth of 3.5 percent?
No, that's not been my case. Hopefully, things have changed. There is
a lot of natural buoyancy. What I do find more impressive compared to
30-40 years ago is the quality of state chief ministers. They have
improved a lot in comparison to the 1970s and 1980s. In fact, even the
1990s. The moment we think of the third front we all get a bit scared
because we think of a motley crew which ran the government in the
mid-1990s. If you look at state chief ministers today, they are
generally better. My entire case, which I have even made in the book,
was that the entire boom of the last decade, where growth accelerated
from 5-6 percent to 8-9 percent, was totally global in nature. That
had nothing to do with India-specific factors. And that boom is now
unwinding. Now, can we undershoot 5-6 percent for a year or two? Yeah,
we can. We overshot for a while, we can undershoot for a while. That
is still my base case scenario. I am not willing to give up on India
and say that India is going to go down the route of 3 percent growth
which existed till 1980. Also it is important to remember that the
aspiration levels of people here are too high now to tolerate that
kind of an outcome. They will force something to happen to change that
outcome.

Q. Any view on the Food Security Bill which was recently passed by the
Lok Sabha?
I have no strong views on that. My concern is about the fact that you
can't keep writing cheques which the country can't cash. We need to
understand that we can only spend that much. And if we have to spend
extra then we have to show stuff that we can cut elsewhere. The big
damage of the Food Security Bill is not the bill itself but why the
Prime Minister did not use this as an excuse to, say, okay, if you
want to pass this, you have to raise diesel prices by x amount, so
that we offset some of the cost.

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