India: policy reforms back on the anvil but execution remains the key -- ::JPMorgan

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India: policy reforms back on the anvil but execution remains the key

Conspicuous by their absence over the last two years, policy reforms seem back on the anvil as a slew of pronouncements are made over the last few days In a long-awaited move, a committee of secretaries approves the entry of 51 percent FDI into multi-brand retail; only a Cabinet nod now stands in the way of this much-anticipated reform Separately, a Cabinet Committee approves the RIL-BP oil and gas deal, which would constitute the largest-ever FDI transaction and provide a much-needed fillip to declining FDI inflows Authorities to table a land acquisition bill in the coming monsoon session of Parliament; though expected to be contentious, the bill is expected to provide much-needed clarity on the issue of acquisition and rehabilitation If carried out to their logical conclusion, the recent pronouncements are expected to be positive for the INR and the equity market by boosting FDI and improving domestic and FII sentiment While these policy initiatives could potentially result in an investment up-tick in select sectors, they are still unlikely to induce a sharp or broad-based pick-up in corporate investment until the current macro-stability concerns are resolved   A policy vacuum since 2009   Since it was re-elected in May 2009, a key criticism of the United Progressive Alliance (UPA) government has been that big-ticket economic policy reforms have been conspicuous by their absence. The goods and services tax (GST) has been repeatedly postponed and seems stuck in a political quagmire, the Direct Tax Code (DTC) has been watered down to the point of ceasing to be a significant reform, key financial sector reforms (pension, reform) are still languishing, land acquisition issues continue to fester and impede large projects, and regulatory uncertainty (exemplified by environmental clearances) has increased sharply over the last year.   The implications of this policy inertia are being felt both cyclically and structurally. Cyclically, private investment (outside of infrastructure) has been anemic since the global financial crisis of 2008 and ground to a near halt by the first quarter of 2011. Even infrastructure investment, which was propping up gross capital formation over the last 2 years, has slowed considerably in the wake of mounting implementation challenges. As a consequence, gross FDI flows actually contracted by about 25% in FY11, even as many of India’s Asian neighbours experienced healthy increases in FDI flows. While macro-stability concerns have served as a significant deterrent to corporate investment in recent quarters, the policy inertia over the last 2 years, accompanied by heightened regulatory uncertainty, has also been a key contributor to depressing corporate investment. This has helped sustain a vicious cycle wherein the lack of investment, in the wake of strong domestic demand in 2010, exacerbated output gaps and caused core and headline inflation to accelerate which, in turn, have served to further depress the desire to invest       The structural implications could be even more profound. Policy inertia is likely to have contributed to significantly increasing the cost of doing business in India and thereby hastened the desire of corporates to increasingly invest abroad (as manifested by rising outbound FDI) as well as reduce the attractiveness of India as an FDI destination, thereby threatening India’s medium term growth potential.     UPA finds its second wind   All that said, things seem to be changing over the last month. The policy sluggishness that characterized the last two years seems to be increasingly replaced by a new-found desire on the part of policymakers to clear the mounting backlog across a variety of issues, from oil price reform, to FDI in multiple sectors, to land acquisition issues and the goods and services tax (GST).   It began almost exactly a month ago. After vacillating for months, authorities finally acted boldly by increasing the retail price of petroleum products (more than the market had expected) to align them slightly closer to international crude prices and thereby reduce oil-company losses. Additionally, in a reformist move, authorities explicitly fiscalized the government’s share of remaining losses (see, “India: government bites the bullet - increases prices and slashes duties on oil products,” MorganMarkets, June 25, 2011) so as to reduce the continual uncertainty that plagued burden sharing between the different stakeholders (upstream oil companies, downstream companies and government).   FDI into multi-brand retail a step closer   Then, last week, the economy came one step closer to a potentially significant reform: allowing FDI into multi-brand retail. Specifically, a committee of secretaries approved 51 percent foreign direct investment into multi-brand retail, subject to the fact that the minimum FDI is $100 million, and half the total investment is in back-end infrastructure such as cold-storage facilities, soil testing labs and seed farming. The committee also proposed that this would be restricted to the 36 Tier 1 cities with population over a million. To come into effect, the proposal needs only to be cleared by the Cabinet and does not require parliamentary approval, thereby increasing the likelihood of passage.   If approved, the introduction of FDI into multi-brand retail has the potential to deliver significant benefits to the economy in the medium-term. For starters, it could potentially result in significant foreign investment into the retail sector, half of which would then be forced into back-end infrastructure. This, in turn, is likely to help rationalize the supply chain from farm-to-fork. Recall, the current supply chain is riddled with inefficiencies resulting in significant delays, waste, and capture by middleman, which has likely contributed to keeping food inflation high over the last several years as well as impeded the transmission of price signals from consumers to producers, thereby limiting the needed supply response.     That said, it is important to recognize that supply chain rationalization is unlikely to be a panacea for food inflation. As we have repeatedly pointed out, high primary food inflation also reflects rising incomes and changing consumption habits. It is also not clear what safeguards the bill will introduce to prevent monopsonistic behavior at the back end by large retailers, for example, For all these reasons, a more thorough assessment would warrant studying details of the proposal that is finally approved, but suffice to say the advent of FDI into multi-brand retail will be construed as a significant reform.   RIL-BP deal is approved   On the same day last week, the Cabinet Committee on Economic Affairs (CCEA) also gave unconditional approval to the Reliance-British Petroleum FDI deal, under which Reliance would sell 30 percent of its stake in 21 oil and gas blocks for $7.2 billion – the largest FDI deal ever conducted in India. In addition, BP is also expected to make investments to the tune of $13 billion in the blocks, and the deal is expected to result in potentially significant technology transfer into India.   Land acquisition bill likely to be tabled in Monsoon session of Parliament   Meanwhile, the government appears to have finalized the draft of a land acquisition bill which also integrates provisions for rehabilitation (as proposed by the National Advisory Council) and is likely to be tabled in the Monsoon session of Parliament starting next week. While the provisions of the bill (the current draft mandates consent of 80% of the land owners before purchase) are likely to be contentious and come under much debate, the fact that a land acquisition bill will likely be in place sooner rather than later, is expected to reduce the controversies that have dogged individual projects over the last 2 years and reduce the heightened uncertainty that land acquisition has come to represent. Land acquisition problems have been at the heart of why some large FDI projects into India have been stalled, and clarity and transparency on the issue of acquisition and rehabilitation are critical pre-requisites to ensuring that this does not serve as a bottleneck to future large projects both in the infrastructure space and outside.   A new lease of life for the GST?   Finally, first signs that the political impasse over the goods and services tax (GST) could eventually be resolved were visible when the Deputy Chief Minister of Bihar and a member of the principle opposition party (BJP) was elected to head the empowered committee on the GST. Recall, progress on implementation of the GST has been stymied by opposition-governed states fearing a loss of their fiscal autonomy. While there is still no dramatic breakthrough on this issue and the GST is almost certain to miss its April 2012 deadline, the appointment of a key opposition member to head this panel could eventually facilitate a political compromise on this issue. It is important to underscore that the GST is a potentially game-changing reform whose implementation is expected to result in significant revenue buoyancy in the medium term, as well as potentially-large efficiency gains through the creation of a common market across States.   Reforms positive for the rupee and the equity market but implementation is the key   To the extent that the flurry of policy pronouncements made over the last few days are seen to be carried through to their logical conclusion, the INR and the equity market are expected to be impacted positively.   As indicated above, the BP-RIL deal is India’s largest FDI deal and will provide a much-needed fillip to FDI inflows in this fiscal. Similarly, the introduction of FDI into multi-brand retail could result in significant FDI flows into that sector over the course of this year. Both of these are policy-pronouncements are therefore expected to have a direct, positive effect on the INR by boosting FDI inflows (though the impact of the BP-RIL is likely to have largely been priced in already given that it was first announced several months ago).     More generally, however, to the extent that all of the above-mentioned policy reforms are construed as increasing India’s medium-term investment potential, productivity and therefore growth potential, they are likely to boost domestic and FII investor sentiment and thereby be positive for the equity markets and the INR.   To reap these benefits and sustain this momentum, however, it is critical that the recent policy pronouncements are carried through to their logical conclusion and do not lapse into a false dawn, as has been the case with the GST several times over the last year.   …. but investment still likely to be deterred by macro-stability concerns in the near term   As pointed out above, the investment slowdown in India has its genesis in policy inertia over the last few years, heightened global uncertainty in 2010 and, increasingly, on account of macro-stability concerns. Specifically, with every month that inflation stays elevated and volatile, concerns rise that the growth slowdown will have to be significant to reverse increasingly entrenched inflationary pressures and expectations. It is unlikely that an environment such as this will witness a sharp or broad-based pick-up corporate investment, even if some of the policy inertia is reversed.   That said, sustained policy reforms in key sectors are likely to induce an up-tick in private investment in those sectors. And so the introduction of FDI into multi-brand retail may well see some investment momentum in that sector. Similarly, a balanced land-acquisition bill could well serve to jump-start some of the larger projects that feared being held up for that reason.   However, a broader and deeper pick-up in the investment cycle across corporate India is likely to require both a resolution of the current macro-stability concerns and a sustained policy reform impetus that takes the recent policy pronouncements to their logical conclusion.