In­dia’s bud­get is not the real story

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

Fol­low­ing In­dia’s dra­matic na­tional ac­counts re­vi­sion, images of a turbo-charged ele­phant over­tak­ing an ex­hausted dragon are be­com­ing tire­some. We are up­beat on In­dia’s secular growth out­look, but strug­gle to rec­on­cile last year’s pur­ported 6.9% ex­pan­sion with other in­di­ca­tors. Our con­cern is that for all Naren­dra Modi’s re­form­ing zeal, cap­i­tal spend­ing re­mains near its post-2009 cri­sis low. With the an­nual bud­get un­veiled over the week­end, the key fac­tor for In­dia to gen­uinely kick-start a new growth cy­cle must be the adop­tion of poli­cies to boost cap­i­tal for­ma­tion.

With the rul­ing Bharatiya Janata Party hav­ing

re­cently suf­fered a bruis­ing po­lit­i­cal loss in Delhi state elec­tions, the gov­ern­ment must re­gain the ini­tia­tive. The prob­lem for fi­nance min­is­ter Arun Jait­ley is that nei­ther the public nor pri­vate sec­tor is es­pe­cially well placed to do his bid­ding. Cor­po­rate In­dia has high lever­age, while banks are un­der­cap­i­talised and con­tinue to strug­gle with bad debts which have not been prop­erly ac­knowl­edged. The gov­ern­ment re­mains in a fis­cal con­sol­i­da­tion phase, with a plan to re­duce its deficit from a likely 4.1% of GDP this fis­cal year (end­ing March) to 3.6% next year and then 3% of GDP by March 2017.

In re­cent months, fis­cal doves have ar­gued that the gov­ern­ment should ease up on its fis­cal tar­gets so long as money goes into in­vest­ment rather than re­cur­rent spend­ing. Af­ter all, state cof­fers have ben­e­fit­ted from lower oil prices as sub­si­dies for most fu­els have been stopped. What has com­pli­cated the pic­ture is a re­cent set­tle­ment be­tween the fed­eral and state gov­ern­ments in how public money gets dis­persed. Un­der the plan state gov­ern­ments will get to spend 42% of all centrally raised taxes, up from 32%. As a re­sult, Delhi sud­denly has much less scope to en­gage in large scale dis­cre­tionary spend­ing, but must rely on states to do the job.

To un­der­stand the sig­nif­i­cance of this shift in gov­er­nance, it is worth re­cap­ping the cause of In­dia’s eco­nomic scle­ro­sis over the last five years or so. Gov­ern­ment is set up in In­dia such that Delhi sets pol­icy and dic­tates the terms of big projects, while state gov­ern­ments do the im­ple­men­ta­tion. The prob­lem is that state gov­ern­ments have lacked the re­sources to ac­tu­ally de­liver the planned roads, bridges, power sta­tions and industrial parks. Per­verse as it may seem, the po­lit­i­cal in­cen­tive for such lo­cal gov­ern­ments has been to cre­ate bu­reau­cratic hin­drances that en­sure such “un­af­ford­able” projects never get built. A key plank of Modi’s cam­paign in last year’s na­tional elec­tion was to rem­edy this dys­func­tion. He com­mit­ted to trans­fer more pow­ers to state gov­ern­ments in a broad plat­form dubbed “com­pet­i­tive and co­op­er­a­tive fed­er­al­ism.” The idea was for states to have the ca­pac­ity to de­liver on projects rather than be in­cen­tivised to look for ex­cuses. And hav­ing been given the power, and funds, to do the job, a process of com­pe­ti­tion would hope­fully en­sure that states en­gage in a race to the top, rather than the bot­tom. This de­volved ap­proach to pol­icy im­ple­men­ta­tion is in­deed one of the key rea­sons we be­came so bullish on the In­dian secular out­look in the mid­dle of last year.

The fis­cal re­bal­anc­ing be­tween Delhi and the states is also part of a car­rot and stick ex­er­cise that it is hoped will pave the way for a sim­pli­fi­ca­tion of the tax code and adop­tion of a sin­gle na­tional goods and ser­vices tax in place of mul­ti­ple fed­eral and lo­cal levies. This should im­prove the busi­ness cli­mate and hope­fully spur pri­vate sec­tor in­vest­ment. The prob­lem with such re­forms is the time hori­zons over which they work. Un­like a centrally-ad­min­is­tered de­mand stim­u­lus (of the type that has typ­i­cally been adopted in In­dian bud­gets) the new fund­ing struc­tures are not suited to quick-fix so­lu­tions.

The new fund­ing set­tle­ment be­tween the fed­eral and state gov­ern­ments en­vis­ages a way around this prob­lem. Not only will state gov­ern­ments get more money, but the pro­posal is to in­crease their bor­row­ing ca­pac­ity by 0.5pp of a state’s GDP on the qual­i­fy­ing pro­viso, among other fac­tors, that debt lev­els are less than 25% of a state’s GDP. State’s are legally man­dated to keep their fis­cal deficits be­low 3% of GDP and presently the av­er­age level stands at 2.4%.

The point is that very few of th­ese new fund­ing struc­tures are yet in place so Satur­day’s bud­get was not ex­pected to pro­duce glow­ing head­lines and cure-all so­lu­tions. Rather, the In­dian gov­ern­ment has ini­ti­ated po­ten­tially pow­er­ful re­forms which-if im­ple­mented-should have the cu­mu­la­tive ef­fect of sig­nal­ing to busi­ness that a sub­stan­tially changed busi­ness en­vi­ron­ment is right around the cor­ner. We re­main ex­tremely hope­ful that In­dia is headed in the right di­rec­tion, but are cog­nisant that a num­ber of pieces still need to fall in place for the ef­fect to feed through to a sub­stan­tially im­proved cycli­cal out­look.

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