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In many ways, India’s 2014 general election was nothing short of historic. Apart from a record turnout, it defied political and social scientists’ long-standing prediction: that India’s pluralism would translate into coalition governments till the eye could see. Instead, for the first time in a generation, a single party has secured a majority in the Lok Sabha.
Political stability—and the economic lessons implicit in the election —has created hope and expectation that India’s new government is well-positioned to pursue the second generation of reforms to liberalize India’s factor markets (land, labor, energy, infrastructure), which have become a binding constraint on growth. These reforms are politically sensitive, however, and will entail expending (potentially significant) political capital, to forge alliances in the Upper House (where the government does not have a majority) and with States, under whose jurisdiction most of these issues lie.
But political capital is not infinite. So the government will have to pick its early hits, especially given super-charged expectations. This essay discusses a potential policy agenda for the new government, identifying where we believe it will (and should) spend its political capital in the first year, and analyzing near-term trade-offs and risks.
The changed political-economy of food inflation
Guess what the most important voting issue was in the recent general elections (and, indeed, in the four state elections last year)? According to polls, it was not jobs or governance, but inflation!
It’s not surprising to see why. For starters, CPI inflation has averaged 9.5% over the last seven years underpinned by stubbornly high food inflation – averaging 11% over that period. The poor – whose incomes are least indexed – also vote in the largest proportions. So high inflation has often directly translated into reduced purchasing power and – in the absence of adequate savings – consumption. It’s no surprise, therefore, that despite a record harvest last year, rural consumption remained weak. Real rural wages had begun to moderate since 2012, in part because nominal wages began to moderate but surging rural inflation has been the real culprit in pulling down real wages.
Second, sustained food inflation in conjunction with the indexation of MGNREGA wages has contributed to a wage-price spiral in the rural economy that has also spilled over into urban wages.
Finally, its food and fuel inflation that is largely responsible for shaping household inflation expectations. Econometrically, we find that a 100 bps shock to food prices results in a 50 bps impact increase in inflation expectations that decays only over 8 quarters! In contrast, a 100 bps shock to core inflation affects expectations by only 30 bps and decays with two quarters So taming food inflation is critical to winning the battle on expectations.
The economics has been largely undisputed. What has changed in recent months is the clear message that high inflation is also bad politics. It’s hard to see how the current hope can sustain if a year from now food inflation is still stuck at current levels. To its credit, the new government has immediately recognized this and indicated that food inflation is its top priority. So what should the government start by doing?
In our view, start by taming cereals inflation. Despite the accumulation of record-buffer stocks over the last two years, cereal inflation has averaged 13%! So buffer-stocks have clearly lost their “threat value” in taming expectations. Instead, they’ve only served to take flow out of the open-market and pressure prices (see chart) For starters, therefore, stocks need to be used more effectively and preemptively to push down cereals inflation – both my procuring less and releasing more.
But accumulation of cereal stocks is, in turn, a function of the minimum support prices (MSPs) the government offers (see chart). Sharp increases in MSPs in recent years have overly-incentivized farmers to produce rice and wheat, and thereby impeded the supply response to other price signals. So MSPs have a both a direct impact on cereals inflation and an indirect impact by inhibiting substitution.
The good news is that, after an average increase of 11% over the last seven years, cereal MSP’s increased by only 5% in the last year of UPA-2. The new government would do well to limit MSP increases this year and eventually reform it. To its credit, the NDA government showed admirable restraint on the MSP front in its previous stint. The hope and expectation is that this would continue.
But food inflation is not limited to cereals. Non-cereal inflation is even higher at 12% over the last 5 years with fruits, vegetables and high-protein items becoming particular sources of pressure. A key contributor has been the Agricultural Produce and Marketing Committee (APMC) Act, which has acted as a monopsony at the farm gate, severely restricting agriculture trade, and thereby creating opportunities for hoarding and price manipulation. Removing fruits and vegetables from this mechanism would go a long way in moderating price pressures. But APMC is a state subject, and therefore the Central government will have to use significant political capital to lean on States to reform. The good news is that Prime Minister Modi is well aware of these bottlenecks, and articulated these reforms – and more – in a white paper back in 2011.
      
Jumpstarting capex : start with coal and land
There is no dispute over the fact that resolving implementation bottlenecks (land, coal, environmental clearances, raw materials) is critical to jumpstarting private capex. Quantitatively, we find that of the 695 bps slowdown that India suffered between 2010 and 2013 (ex agri and community services), almost 30% is because of bottlenecks on the ground and another 15% on account of the associated loss in investor confidence that is closely linked to the ease of doing business. The corollary is that half the slowdown could be reversed if these bottlenecks were completely alleviated and confidence returns. But where should the government start?
To analyze this, we looked at the top 50 projects (in value terms) that are currently stalled. These account for nearly 70% of the total stalled value, and so getting some traction on large projects is crucial. Our search revealed that 55% of stalled projects are because of land acquisition constraints, and another 25% because of issues in the power sector -- coal unavailability and state electricity board (SEB) pricing. Only 8% in this sample were stalled because of environmental clearances – which is understandable given the previous government made significant progress on that front.
So, to the extent that the government can make progress on the land and coal front, they could make a significant dent into implementation bottlenecks. But land acquisition is on the con-current list and so not under the direct jurisdiction of the central government. Therefore, what the government will likely need to do is both (i) reform the new land acquisition bill to make it more business-friendly; and (ii) use political-capital with individual states to ensure that land acquisition issues related to large projects are resolved.
Constraints in the power sector are at both ends of the spectrum – the unavailability of domestic coal (forcing the import of coal which is currently 20-25% more expensive) and the inability to sell to SEBs that are cash strapped. The latter is a more complex problem that requires meaningful tariff hikes, is under the domain of the states, and is politically very sensitive. For starters, therefore, we recommend the government prioritize coal production in India. India has among the largest coal reserves in the world and yet it is the fourth largest importer of coal (!) because CoaI India’s production has literally ground to a halt.
So what could the government do? For starters, building 3 new rail-lines covering about 200kms (though logistically not trivial given the terrain) potentially opens up another 200 million tones of coal per annum that can be mined and transported from Chhatisgarh, Orissa and Jharkhand. This needs to be complemented by injecting private efficiencies into Coal India. One option is reform by stealth. Future coal licenses should be allocated to the private sector, who would be able to extract coal more efficiently and sell it to Coal India who, in turn, could on-sell it to power producers.
Bottom line: if the government can begin to tackle coal and land in the first year, the capex cycle could finally get going.
  
The dark horse: labour market reforms
The economic reforms heretofore that have powered growth have largely focused on product-market reforms. But it’s clear that factor markets have become a binding constraint, and for potential growth to go back anywhere near the mid-2000 levels, factor markets need to be reformed. Within this, reforming labour laws are key.
The motivation is obvious. There are concerns that India has recently experienced jobless growth. One explanation for this is that despite having an abundance of unskilled labour – India’s comparative advantage – Indian firms have expanded largely in capital-intensive sectors (engineering goods, pharmaceuticals) or used excessively capital-intensive technologies in other sectors, resulting in a sub-optimally low utilization of labour. Labour laws are deemed a key culprit. By making firing, and therefore hiring, difficult and introducing other rigidities they have essentially bid-up the relative cost of labour, and induced firms into operating at sub-optimally high (from a societal perspective) capital-intensive technologies.
Professors Jagdish Bhagwati and Arvind Panagriya effectively demonstrate how the textile industry, for example, is littered with small firms in India because labour laws have constricted expansion, and therefore from realizing economies of scale. As the accompanying chart below demonstrates, almost 93% of workers in the labour-intensive textile industry are employed in firms employing 49 workers or less – in large part die to labour laws -- a far cry from China’s size distribution (Page 134, “India’s Tryst With Destiny,” by Jagdish Bhagwati and Arvind Panagriya).
But a glimmer of hope is finally emerging. Less than a week ago, the Rajasthan government amended three important laws – Industrial Disputes Act, Factories Act and Contract Labour Act – to make hiring and firing of employees more flexible. However, the laws fall on the concurrent list and need Presidential (not legislative) approval. If they do secure it, this could serve as a powerful demonstration effect to other states, who may also be induced into liberalizing laws for fear of losing investment to states that reform.
The First Budget: Opportunities and Trade-offs
Next month’s budget will be the new government' first major policy statement, providing an opportunity to lay out its vision. But it also involves trade-offs, and therefore will reveal what the government’s near term priorities are.
On the face of it, the budget involves two, potentially conflicting objectives. First, it will be important to persevere with fiscal consolidation. To its credit, the previous government reined in the deficit the last two years – achieving a 1.2% of GDP cyclically-adjusted consolidation – in a period of low growth and populated with elections. This, in turn, was a critical prerequisite to restoring macroeconomic stability. It’s important that this signal be sustained.
But simultaneously, it’s equally important to jumpstart the capex cycle by boosting public investment and recapitalizing public sector banks. Civilian capex off the budget has fallen to worrying levels. With balance sheets in infrastructure still stretched and banks still handicapped by elevated NPAs and restructured loans, creating some capex momentum through public investment is critical.
So how does the Budget simultaneously achieve a 0.5% of GDP boost to public investment and simultaneously consolidate by 0.4% of GDP? There is some space to rationalize urban subsidies but an aggressive rationalization of rural subsidies or welfare programs is unlikely given fears of a sub-par monsoon.
The key therefore is disinvestment. The sharp rally in recent weeks – with PSU equity prices rallying 55% in the last 6 weeks – provides an ideal opportunity for the government to accelerate its disinvestment program and use those proceeds for infrastructure investment. As Chief Minister of Gujarat, the PM has indicated a preference for making PSU’s more autonomous an professional. But market discipline is another equally-effective mechanism of reaching those objectives.
Eventually, of course, the government has to find a way to achieve closure on the goods and services (GST), the most important fiscal reform of our time. By truly making India a common market, it will drive allocative efficiency and boost productivity growth. However, GST will be a harder legislative slog, because it entails a constitutional amendment and requires a two-thirds majority in each house of Parliament – which the NDA lacks -- apart from 50% of State Assemblies. So the government will need to build a national consensus to push through the GST.
  
The First Test: a deficient monsoon
The first real risk for the new government is a deficient monsoon. Earlier this week, the MET indicated there is a 71% chance of a sub-normal or deficient monsoon. Simultaneously the likelihood of an El Nino, though a mild for now, is pegged at 70%. The last time India suffered from an El Nino in 2009, the similarities were eery. The Met’s first two forecast of the monsoon were 95% and 93% of its long term average – exactly what they have predicted this year. As it turned out actual rainfall was only 79%.
A deficient monsoon would impart a stagflationary shock to the economy. Agricultural production would suffer and drag down rural incomes and consumption. Simultaneously, food prices would be pressured – depending on the severity of the shock and the nimbleness of the policy response. In 2009, for example, food inflation which was already at 10% in the year leading to the deficient monsoon, surged to 17% the year after. Moreover, given the wage-price spiral in the rural economy, this pushed up wages and resulted in a more generalize inflation spiral. And there will be fiscal implications, too. Automatic stabilizers like MNREGA will kick-in, growth – and therefore tax collections – will suffer, and it will be harder to rationalize rural subsidies.
Therefore, under our base case of a deficient monsoon, and the consequent implications on inflation, wages, and the fisc, we have penciled in a 25 bps hike by the RBI in 4Q14. If it turns out the monsoon is not as deficient as feared or the policy response is nimble, we will take off our rate hike call.
Putting it all together
The outturn of the elections offers India’s new government a unique opportunity to push through the next generation of reforms. But political capital is not infinite, and it is hoped and expected that the government will put its weight in the first year behind one or two key areas (food inflation, land, coal) rather than trying to be all things to all people. The early signs are very encouraging.
The government has sounded all the right noises and appears ready to tackle the big problems. But July will present the first real tests for the new government – a Budget with trade-offs and a potentially-deficient monsoon. That said, we could be at the cusp of a structural-break in policymaking. Stay tuned.
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| Indian Equities The Hurry and the Hurray for Cyclicals | ||
(%)
|
Mar-10
|
Mar-14
|
Change
|
Consumer Staples
|
5
|
10
|
5
|
Information Technology
|
9
|
14
|
5
|
Consumer Discretionary
|
7
|
9
|
3
|
Health Care
|
4
|
6
|
2
|
Financials
|
18
|
19
|
1
|
Telecommunication Services
|
3
|
4
|
0
|
Energy
|
15
|
14
|
(1)
|
Materials
|
14
|
10
|
(4)
|
Utilities
|
9
|
5
|
(4)
|
Industrials
|
15
|
8
|
(6)
|
| Indian Equities Beta Breakout: Too Far, Too Fast ? | ||
| India Equity Strategy NDA sweeps the National Election. What next? | ||
Current
|
Portfolio Stance
|
Top Picks
|
Avoids
|
CONSUMER DISCRETIONARY
|
Underweight
|
Zee, Tata Motors
|
Hero Moto, Maruti
|
CONSUMER STAPLES
|
Neutral
|
ITC,GSK Consumer
|
Hindustan Unilever, Asian Paints
|
ENERGY
|
Neutral
|
RIL
| |
FINANCIALS
|
Underweight
|
ICICI Bank, HDFC Bank
|
Second tier banks, NBFCs
|
HEALTH CARE
|
Overweight
|
Dr. Reddy's Lab
|
Apollo Hospital
|
INDUSTRIALS
|
Underweight
|
BHEL
| |
INFORMATION TECHNOLOGY
|
Overweight
|
Infosys, Tech Mahindra
| |
MATERIALS
|
Overweight
|
Grasim, Tata Steel, Sesa Sterlite
| |
TELECOM
|
Underweight
| ||
UTILITIES
|
Neutral
|
Power Grid, Tata Power
|
Private Sector Infra/ IPPs
|
NDA
|
UPA
|
Other Key Parties
| |||||
BJP
|
284
|
INC
|
45
|
ADMK
|
37
| ||
TDP
|
16
|
RJD
|
3
|
TMC
|
34
| ||
SS
|
18
|
NCP
|
6
|
BJD
|
19
| ||
LJP
|
6
|
JKNC
|
3
|
TRS
|
11
| ||
SAD
|
4
|
JMM
|
1
|
CPI (M)
|
9
| ||
Others
|
7
|
Others
|
3
|
SP
|
5
| ||
AAP
|
4
| ||||||
Total
|
335
|
Total
|
61
|
JD(U)
|
2
| ||
JD(S)
|
2
| ||||||
