What holds us back

New government must identify the binding constraints on growth.

The BJP’s single-handed majority in the new Parliament ensures at least one thing: no more excuses of “fractured coalition politics” compromising policies and reforms. I must confess that having lived this refrain for 10 years, I am going to miss it! It was an easy explanation for almost everything anyone ever asked about India. Of course, there is still the “the government is in a minority in the Upper House” excuse but it doesn’t sound as convincing. This means that one can hopefully look forward to more decisive policymaking and less compromised legislative reforms. But that begs the question: what will be these policies and reforms?

The election has made the politics of policymaking easier but not the economic reality. The challenging growth-inflation dynamics, languishing investment cycle, need for continued fiscal consolidation and fears over the current account deficit flaring up again remain unchanged. A modest cyclical recovery is underway but it is just that. Nothing inspirational. To break through this ceiling and justify the collective faith of the electorate, much needs to be done and undone by the new government.

Almost by default, the government will need to identify and articulate what it considers are the binding constraints to growth as its first task. So far, we don’t have much to go by except its election manifesto. The only binding constraint highlighted in the manifesto is the dysfunctional decision-making by the previous government. Without getting embroiled in the justification of this statement, if this is what the new government truly believes, then by inference, we should expect much of the same as the last 10 years, except that the policies and reforms will be better executed. My guess is that this is unlikely to endear the new government to either investors or the citizenry.

To break from the past, the new government needs to articulate a more fundamental worldview than in its manifesto of where India went wrong in the last decade. More growth, more employment, more infrastructure, lower inflation is just motherhood and apple pie. Identifying and articulating the binding constraints holding these back is the heart of the problem. Policies and reforms to ease those constraints are much easier to design and implement, especially with the end of the political quagmire of the last 10 years.

We think that there are four binding constraints holding back growth. First, the altered state of the global economy. Back in the 1990s and 2000s, the key to high growth for an emerging market was to find a way to plug-in to rapidly expanding global trade and ride the globalisation wave. That’s what the reformist policies of 1992-93 and early 2000s in India were largely about: finding ways to better access global trade and financial markets. The dominant drivers of India’s growth in the 2000s were rapidly rising corporate investment producing goods and services that were overwhelmingly consumed by foreigners, that is, exported (sorry to disappoint those who still believe that India’s growth is driven by domestic consumption).

Take away the global crisis years (2008-09), and the biggest contributor to India’s growth even in the recent past has been exports. But the global economy isn’t as vibrant as before and is unlikely to achieve the expansion rate of the 2000s anytime soon. Not because of cyclical reasons but because of slow-moving structural changes, such as ageing populations in the developed markets, the economic rebalancing of China and a significant rise in the cost of capital globally because of regulatory changes.

That does not mean India should look inward. India still has far to go in expanding its export markets and share in global trade. Rightly, the government’s election manifesto identifies increasing productivity to be the key in boosting exports, and not subsidies or an undervalued exchange rate. Expanding India’s port facilities and connecting them to the hinterland through high-speed rail connections is a great way of reducing transaction costs and raising export productivity, as highlighted in the manifesto. But in a world of much slower global growth, the bang for the buck is that much less. As China learnt the hard way, connecting one part of the hinterland to another part is just as important if one wants to shift the drivers of growth to domestic demand and hedge the economy against external volatility.

The second key constraint is the hold-up in project implementation. An assessment of currently stalled projects suggests that most of these constraints lie in the hands of state governments. Unclogging them will require the Centre to work with state governments. The political outturn should help, but Narendra Modi’s experience as a long-running and successful chief minister could be key in treating state governments’ concerns and fears with a bit more sympathy. It often works much better than sanctions.

Third is the rise in leverage of many of India’s corporations in the infrastructure space. Infrastructure investment is critical in jumpstarting and sustaining growth. However, the high leverage could hold back funding, and resolving this requires recapitalising PSU banks when there is virtually no fiscal space. Privatisation is the natural solution, especially given current equity valuations. The new government in its previous avatar was clearly not averse to selling state assets. But this time around, it would mean reducing government’s shareholding to minority status in the banking space, which has been sacrosanct since the bank nationalisation of the 1970s. Not that there is anything wrong in doing so; on the contrary, it is the right policy as the RBI under Governor Raghuram Rajan has been advocating. However, it is a hard choice. The manifesto makes all the right noises about reducing non-performing loans and liberalising the banking sector. Hopefully we will know the details behind these intentions soon.

The fourth constraint is India’s doggedly high inflation over the last four years. At the risk of sounding like a broken record, here it is once more: there is no trade-off between growth and price rise at inflation rates above 4-5 per cent. There is a preponderance of cross-country evidence garnered over the last 30 years, and covering almost all economies, that shows once inflation breaches a threshold (around 4-5 per cent for India), higher inflation almost always reduces medium-term growth. That’s what happened in India over the last few years. Running loose monetary and fiscal policies to boost near-term growth has its costs. The current languishing growth is this cost. The RBI has finally moved towards adopting an informal inflation target. Pushing the RBI to boost growth via interest rate cuts will be just as costly a mistake as the “baby steps” in raising interest rates over 2010-11 were. The right choice for the government would be to unconditionally endorse the RBI’s inflation targeting framework and hold the institution responsible for delivering on it.
Supportive fiscal policy is obviously critical but that’s a policy choice, not a constraint. The full-year budget for this year will be the first formal presentation of the government’s policy direction. But well before that, the government needs to articulate its economic worldview: what ails India and what will reverse the growth slump. Markets and investors are perfectly willing to give it time provided the worldview and work plan are credible.

The writer is chief Asia economist, J.P. Morgan. Views are personal

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