It’s a chilly mid-December day in New Delhi, and the fog is so thick you can stare straight at the midafternoon sun for several seconds without straining your eyes. Outside the Ministry of Coal, dozens of functionaries and supplicants gather around a snack bar while nearby a monkey scampers along the ground next to a vendor selling nuts. Inside the aging eight-story building, an air of mild chaos reigns as groups of people stream through the dingy hallways, their shuffling feet and conversation echoing off the bare walls and dusty marble floors.
From his spacious third-floor office, Anil Swarup is bringing order and purpose to this sprawling bureaucracy. A former telecommunications bureaucrat, Swarup was tapped in October by Prime Minister Narendra Modi to become secretary of the Coal Ministry. His mission: Unblock a logjam in coal mining caused by the Indian Supreme Court, which in September overturned more than 200 mining licenses awarded years ago to Indian companies, saying the process was arbitrary and not transparent. Coal generates some two thirds of the nation’s power, and supply shortages have crippled electricity production — and growth — in recent years. With lightning speed, Swarup and his team drafted an ordinance that will put 101 mining properties up for auction by the end of March and for the first time open the sector, long dominated by state-controlled Coal India, to commercial mining for purposes other than industrial companies’ power needs. Swarup is optimistic that the mines can produce 350 million tons of coal a year within a couple of years’ time, increasing the country’s total output by 75 percent.
Welcome to the new India. Since Modi led his Bharatiya Janata Party (BJP) to a sweeping election victory last May, the prime minister’s strong political mandate and determination to pursue reforms and get the economy moving have replaced years of political paralysis and stifling bureaucracy. Modi has vowed to revive stalled infrastructure projects, boost the manufacturing sector, cut red tape and encourage greater foreign investment, raising hopes that India and its economy are on the rebound. “There is a desire to take decisions. There is a clarity of intent and a clarity of direction,” Swarup tells Institutional Investor. “The message is clear that India means business. There is a sincere effort to facilitate business.”
The government made an even bigger declaration of intent in December by introducing legislation in Parliament to create a new goods and services tax. The GST, as it’s called, promises to transform India’s fiscal and business environment by replacing a welter of state levies, including entry taxes at state borders, with a single national levy. First proposed nearly a decade ago by the Indian National Congress–led government of former prime minister Manmohan Singh, the tax can be compared to the introduction of the income tax in the U.S. a century ago or the launch of the European Union’s single market in the 1990s. The GST would eliminate border barriers among India’s 29 states and provide a steady flow of resources to a government starved of revenue.
“That’s going to be one of the most monumental tax reforms in India since independence,” Finance Minister Arun Jaitley told an audience at the World Economic Forum in Davos, Switzerland, last week.
“It will definitely be a big fillip for growth and investment,” says Paul Cashin, assistant director of the International Monetary Fund’s Asia and Pacific Department, who is leading the Fund’s annual review of the Indian economy. “It’s as if you are doing away with trade barriers for 29 individual countries.”
For Indian business executives and investors frustrated by the flagging reform efforts and political weakness of the Singh government over the past decade, the arrival of a powerful, decisive government committed to economic reform is more than welcome. “After almost 30 years, India has a clear-cut government that can take decisions,” says Nimesh Shah, chief executive of Mumbai-based ICICI Prudential Asset Management Co. Trade partners are also cheering on Modi, hoping that the world’s second-most-populous country will become a badly needed growth engine for the global economy. The development of closer trade and investment ties topped the agenda when President Barack Obama visited New Delhi to attend India’s Republic Day ceremonies earlier this week.
The World Bank last month predicted that India’s growth rate, which hit a six-year low of 4.7 percent in the fiscal year ended March 31, 2014, will recover to 5.6 percent in the current fiscal year, 6.4 percent next year and 7 percent the year after. Economists at Goldman Sachs Group forecast in December that India will overtake China as the fastest-growing major emerging-markets economy by 2018.
“We project that India will be a bright spot in an otherwise mediocre global economic outlook,” World Bank president Jim Yong Kim said at a gathering of business and political leaders headed by Modi in the western Indian state of Gujarat earlier this month. Anticipation of stronger growth made the Bombay Stock Exchange one of the best performers in the world last year, with the S&P BSE Sensex index climbing 28.8 percent.
The government’s ambitions — and the market’s hopes — for growth go much higher in the medium term. With per capita GDP of just $1,500, by far the lowest among the BRICS nations and on a par with Côte d’Ivoire, India needs years of supercharged growth to raise living standards and create the tens of millions of jobs its young population needs. As Jaitley told the Davos crowd, “Our real potential is 9 percent plus, and therefore we would like to take India in that direction.”
Growth got an unexpected boost last month from a surprise cut in interest rates. The Reserve Bank of India, which raised rates in 2013 to defend the rupee amid speculative pressure on the currency, cut its policy rate by a quarter point, to 7.75 percent. With tumbling world oil prices causing India’s inflation rate to fall much faster than anticipated, to 5 percent in December, many analysts are looking to RBI governor Raghuram Rajan for more cuts.
In an interview at his office in Mumbai in December, before the latest move, Rajan declined to comment specifically on rates but said progress in containing inflation and India’s budget deficit would give the central bank more room to maneuver. “We have said that if we see the path of disinflation continue, and also we get more confidence that fiscal targets will be met, we will be in a better position to increase monetary accommodation,” he said.
Yet for all the dynamism and promise that Modi has brought to New Delhi, there are plenty of signs that the old India hasn’t gone away completely. Opposition parties may have been routed in the May election, but they have used their continued dominance of the upper house of Parliament to stall many of Modi’s initiatives, including a measure to raise the ceiling for foreign investment in Indian insurance companies to 49 percent from 26 percent and a bill to make it easier for companies to appropriate land for infrastructure projects. Coal unions staged a five-day strike earlier this month to protest the government’s plans to open up their industry to private investment. The government skirted some of the obstructions by implementing some reforms with short-term executive ordinances, but it will need to win parliamentary votes for its key reforms, including the GST and higher limits on foreign investment, in the three-month session that opens in mid-February.
Skeptics say the government’s actions in other areas have fallen far short of its rhetoric. In August, Modi launched a campaign he calls Make in India to promote manufacturing as a key growth driver. He is fond of setting targets, including one of lifting India into the top 50 countries for the ease of doing business, according to the World Bank; it currently ranks 142nd out of 189 countries. It’s far too early to tell whether the government can achieve those goals, though.
The government, meanwhile, has been cutting spending, including capital investments, in a bid to adhere to the tight deficit target set by the Singh government. Analysts at Morgan Stanley estimate that infrastructure spending will slow to 6 percent of GDP in the fiscal year ending March 31 from a peak of 8.4 percent four years earlier. Such cutbacks are at cross-purposes with the government’s stated desire to ramp up infrastructure development, says Indranil Pan, chief economist at Kotak Mahindra Bank in Mumbai.
Arvind Subramanian, a senior fellow at the Washington-based Peter G. Peterson Institute for International Economics, who was tapped by Modi in November to serve as the government’s chief economic adviser, promptly urged the government to consider boosting infrastructure spending to jump-start the economy. “It seems imperative to consider the case for reviving public investment as one of the key engines of growth going forward,” he wrote in the Ministry of Finance’s midyear economic analysis, published in December. But many analysts expect Jaitley to target a further reduction in the budget deficit, to 3.6 percent, when he delivers his 2015–’16 budget at the end of February.
“Expectations have been set too high,” Pan says. He notes that when India had its spurt of 8 percent-plus growth rates in the mid-2000s, the U.S. economy was humming along and China was growing at a double-digit pace, lifting India and other emerging-markets economies in their wakes. “With the global growth situation being so poor, India can’t grow more than 6 percent a year for the next two years,” Pan contends.
Government officials say the skepticism is overdone. At Davos, Jaitley rattled off a list of significant reforms already adopted: abolishing subsidies on diesel fuel and cutting them on natural gas, opening the defense and railway industries to foreign investment, and getting more than two thirds of states to support the GST (necessary because the measure requires a change in the Indian constitution). “This government had a mandate to act very fast, and we are moving very fast,” the Finance minister said.
Even many of those disappointed by the pace of change to date believe Modi is putting India firmly on a path to higher growth in the medium to long term.
“The hype that was built during the campaign was so high that people thought Modi was coming very fast; now people have begun to find the change slow,” says A.M. Naik, executive chairman of Larsen & Toubro, a leading Indian engineering and construction concern. The company operates two coal-fired power plants and struggles to obtain enough coal to keep the lights on. “We are hand-to-mouth,” Naik says. “We have two days’ stock, three days’ stock. If the train doesn’t come, we are stuck.”
At the same time, Larsen & Toubro is looking to take advantage of the government’s opening of defense procurement to the private sector and foreign direct investors, aiming to boost its tiny defense business. Larsen & Toubro is bidding for a $2 billion multiyear contract to refurbish submarines and expects to grow its defense revenue tenfold over the next decade, to $2 billion a year. “One policy change can lead to consequential results,” Naik tells II. “And this is what we will see in the next ten years.”
Even in the face of government paralysis, India managed to grow at a nearly 5 percent pace in recent years thanks to strong underlying demand from the country’s 1.2 billion people, notes the RBI’s Rajan. He asserts that authorities can lift growth without radical reforms, just by getting some of the basics right: clamping down on inflation, getting deficit spending under control, reviving stalled power projects and facilitating land acquisition for infrastructure projects.
“There’s lots of low-hanging fruit in this economy, both for us and for the government,” Rajan says. “And I think that over time you will see more of this fruit being picked up. People are impatient; people want to see results. But I think we need to focus on the medium to long term to create a sustainable path for growth.” He believes it’s “eminently doable” to increase growth to a rate of 7 to 7.5 percent within two years.
Rajan has done as much as anyone to improve the economic climate in India. The Singh government appointed him central bank governor in September 2013, when India, then a charter member of the so-called Fragile Five of distressed emerging-markets countries, was reeling, with a yawning current-account deficit, a plunging rupee and an inflation rate exceeding 10 percent. As a University of Chicago economist and former IMF chief economist who famously warned of the risk of financial crisis at the Fed’s 2005 Jackson Hole, Wyoming, conclave, Rajan brought market credibility to the job and wasted no time in putting it to use.
On the day he took office, he announced the creation of a swap facility to attract long-term deposits from overseas Indians and bolster the country’s reserves; it pulled in some $40 billion in less than three months. Barely two weeks into the job, Rajan raised the central bank’s policy rate by a quarter point, to 7.50 percent; two more hikes would follow over the next four months, bringing the rate to 8 percent. The central bank introduced restrictions on bank lending for gold imports, which had helped drive the current-account deficit to a record $87.8 billion in the fiscal year ended March 31, 2013.
“The question was, how do we restore a sense of confidence?” Rajan recalls. “We had to bring the current-account deficit under control, show we could raise money and indicate that investors should have confidence about the path of inflation, because one of the reasons the rupee was weakening was because of high inflation. So we did all three.”
Beyond these immediate measures, Rajan moved to put monetary policy on a sounder footing. He created a committee, chaired by deputy governor Urjit Patel, to study ways to improve the central bank’s policy framework. The panel’s report, issued in January 2014, called for the RBI to adopt a formal inflation-targeting strategy akin to the practice of the Federal Reserve, the European Central Bank and dozens of leading emerging-markets central banks. It called for using the consumer price index rather than wholesale prices as the inflation target — a sign of rigor given that the CPI has outpaced the wholesale price index by an average of 2.6 percentage points a year in recent years. The panel recommended that the RBI seek to reduce CPI inflation, then running at a 10 percent rate, to 8 percent by this January and 6 percent by 2016 before adopting a permanent target of 4 percent plus or minus 2 points.
Although elements of the framework, including the creation of a monetary policy committee to set rates, must be enacted by legislation, Rajan has embraced inflation targeting in practice, bolstering the central bank’s credibility. The governor has also enjoyed a fair bit of luck, as a good harvest last year — food makes up nearly 50 percent of the CPI basket — and the plunge in global oil prices have helped inflation fall faster than anyone expected, touching 4.4 percent in November before rebounding to 5 percent in December.
Analysts believe Rajan will be cautious about rate cuts until inflation is firmly and durably under control. “For a country like India to get down to 4 percent will be a major challenge,” says the IMF’s Cashin. “You probably will not be able to do that with monetary policy alone. Monetary policymakers are going to need some help from Delhi in terms of alleviating supply-side bottlenecks in the economy.”
Foreign investors are counting on the RBI to maintain a hard line. “The Reserve Bank has rightly focused on the need to bring inflation firmly under control before reducing rates,” says Shankar Narayanan, co-head of Asian private equity and manager of Indian growth investments at Carlyle Group, which has invested $1.1 billion in 30 Indian companies since 2004. “Coupled with the oil price decline, it provides a foundation for long-term, sustained and spectacular growth.”
In other areas Rajan has been more willing to use the RBI’s considerable discretionary powers over markets than his University of Chicago background might suggest. Portfolio investors returned to India last year, encouraged by the tighter policy stance and a rupee that has stabilized at about 62 to the dollar. Most of the money went into short-term government bonds rather than equities, reaching the RBI’s total limit of $20 billion in July. Rajan increased the limit modestly, to $25 billion, and told foreign investors looking to roll over maturing securities to move out on the curve, to maturities of three years or longer. The governor has been vocal in warning about the potential for volatile capital flows if the Federal Reserve begins hiking interest rates later this year, and he’s determined to try to limit the fallout in India.
“There are times when any Tom, Dick and Harry looking for funds will get funds and you have a surge of capital inflows,” he explains. “And there are times when even your best companies can’t raise any money. Given that, how do we reduce the procyclicality of fund flows? A little bit of sand in the wheels through prudential measures is not a bad idea.” The RBI has also intervened in the foreign exchange market, but Rajan insists the bank’s aims are limited: “We are not trying to have an undervalued exchange rate. We’re just trying to reduce volatility.”
MODI GENERATED HIGH EXPECTAttions because of his record as a business-friendly pragmatist who oversaw strong growth in Gujarat during his 13 years as chief minister of the state. Vowing to promote development with a strategy of “maximum governance, minimum government,” his campaign appealed to the aspirations of Indians across the income spectrum by promising opportunity rather than subsidies. That message allowed the BJP to defeat the paternalistic and statist Congress Party and its United Progressive Alliance coalition even in their rural strongholds.
Aditya Puri, head of HDFC Bank, says the BJP represents generational change: “Modi came in and said, ‘We are a young India.’ People aren’t ordinarily interested in the old dogma. They want development. They want a good life. They like what they see on TV, and they think they deserve it.” (See “Consumer Banking Comes to Rural India.”) Mary Callahan Erdoes, head of J.P. Morgan Asset Management, also sees broader forces at work that should sustain momentum behind the government’s reform efforts. “Modi’s a movement, not a person, and Modi’s for real,” she says.
The BJP now holds an absolute majority in the Lok Sabha, or lower house of Parliament — the first time any party has enjoyed such control since Rajiv Gandhi led Congress to a landslide victory in 1984 after the assassination of his mother, Indira. Congress’s drubbing damaged the reputation of party leader Rahul Gandhi, casting doubt on the future of a family and party that have dominated Indian politics since independence in 1948.
“The election was a real watershed for India,” says David Mulford, vice chairman international at Credit Suisse, who served as U.S. ambassador to India from 2004 to 2009. “It would appear to mark an end to dynastic politics.”
Modi, a staunch nationalist, is using his mandate to claim a more assertive role for India in regional affairs and to subtly alter the country’s foreign relations. He struck a quick alliance with Prime Minister Shinzo Abe of Japan, visiting the country in late August and early September — his first trip outside South Asia since taking power. He regards Japan as both a useful ally against Chinese dominance in Asia and a source of much-needed investment. He left Tokyo with a promise of $35 billion in Japanese infrastructure investment, notably in the Delhi-Mumbai Industrial Corridor, a $90 billion project to develop new road and rail links and a network of industrial hubs between the two cities. Abe shares Modi’s wariness about China and regards India as a potentially rich export market. Modi is “a geopolitical godsend for the Japanese,” says Ian Bremmer, founder and president of political risk consulting firm Eurasia Group.
The prime minister also has moved to deepen India’s historically chilly relationship with the U.S. — all the more notable considering that Washington denied him an entry visa in 2005 because of allegations that Modi had either encouraged or failed to prevent anti-Muslim riots in Gujarat that claimed more than 1,000 lives in 2002. Modi received a rock star–like reception when he finally visited the U.S. in October; Obama became the first U.S. president to visit India twice and to attend the highly symbolic Republic Day ceremonies.
Visting India earlier this month to prepare for the presidential visit, Secretary of State John Kerry said the U.S. wanted to increase two-way trade with India to $500 billion a year from $97 billion in 2013. “We can do more together, and we must do more together, and we have to do it faster,” he said.
All hopes of expanding India’s influence ultimately rest on Modi’s ability to turn the economy around. The prime minister and his team “know that 8, 9, 10 percent growth is vital for lifting the mass of Indians out of poverty,” says Carlyle Group’s Narayanan.
Modi signaled a fresh departure in policy in August by announcing the abolition of the Planning Commission, the powerful policy-setting agency that for decades has been a symbol of state control of the economy. But the prime minister is no Indian Margaret Thatcher, as some outsiders have rushed to proclaim him.
Consider the banking sector. State-owned banks dominate the industry but have been hobbled by nonperforming loans, particularly for stalled infrastructure projects. Nonperforming and restructured loans average more than 10 percent of all loans at public sector banks. IMF analysts have estimated it could cost the government as much as 5 percent of GDP, or more than $90 billion, to recapitalize those banks.
At a meeting with senior bankers and officials in Pune earlier this month, Modi said the government would sell shares in the banks to raise capital from the private sector but made clear that the state would retain majority stakes of at least 51 percent. Similarly, the government’s supposedly big opening to foreign insurers stopped at 49 percent. “He doesn’t favor large-scale privatization,” says Ridham Desai, head of Indian equity research at Morgan Stanley in Mumbai. “He believes in the role of the state to keep the economy balanced.”
The government has also moved gingerly on a key issue that’s deterring foreign direct investment (FDI): retroactive tax judgments. Indian tax authorities stunned Vodafone Group in 2007 by slapping the U.K. mobile operator with a $2 billion tax bill on its purchase of a controlling stake in an Indian phone company from Hutchison Whampoa, effectively taxing Vodafone for Hutchison’s capital gain on the deal. Vodafone sued to overturn the judgment, and in 2012 the Supreme Court ruled in its favor. Parliament responded by passing a law allowing the authorities to reimpose the tax on a retroactive basis.
In November, Royal Dutch Shell found itself in a similar position when it won a court case over a $2.5 billion transfer of shares from its Indian subsidiary to the Anglo-Dutch parent company. The authorities contended that the transfer was designed to avoid taxes and should be considered as income. The government has indicated it won’t appeal the court ruling, allowing Shell to prevail, but officials are making no effort to repeal the retroactive tax law. That stance is likely to leave many potential FDI players sitting on the fence.
“Retroactive tax problems have been a detriment to FDI,” says Credit Suisse’s Mulford. “It’s a real damper on people’s thinking.”
The government faces checks on its ambitions. The BJP holds only 24 percent of the seats in the Rajya Sabha, or upper house of Parliament, and because those seats are determined on a rolling basis in state elections, it’s unlikely that Modi’s party could gain a majority before 2019, when its current term in the lower house expires, according to an electoral analysis by Morgan Stanley. The government is far from powerless, though. Modi and Finance Minister Jaitley showed as much late last year in persuading state governments to back the goods and services tax by promising to make up most of the shortfall in their revenue for the next five years. “It’s been nine years in the previous government, and they couldn’t move the needle forward” on the tax, notes Morgan Stanley’s Desai. “These guys did it in seven months.”
Still, India is very much a federal government that gives the states wide powers over many key economic issues, such as labor regulations, land use and planning permissions. In this context Modi’s background in state-level politics offers grounds for optimism on the reform front.
The northwestern state of Rajasthan is taking the lead in pursuing labor market reforms, for example. In July the state’s BJP-controlled government approved changes to several laws that make it easier for small and medium-size companies to hire and fire workers, make it harder to organize unions and provide state funding for apprenticeships, among other things. Since then the state of Madhya Pradesh has approved similar reforms; leaders in neighboring Haryana and in Maharashtra, the populous western state whose capital is Mumbai, have signaled a willingness to follow suit.
Modi may not be able to turn all of India into a dynamo like Gujarat, but “if he can create ten Gujarats in India, that’s going to move the needle,” says Eurasia Group’s Bremmer.
For Modi and India, the honeymoon is ending and the testing time is about to begin. The government needs to show it can enact major economic reforms in the parliamentary session that opens in February, says Dennis Nally, chairman of PricewaterhouseCoopers International. The potential prize is huge: A PwC study in November projected that India could grow its economy more than fivefold over the next 20 years, to some $10 trillion, if it embraced both reform and a step change in technology, such as the development of distributed rather than centralized power generation.
Says Nally, “This country, with its demographics, has about the best potential in the world — if they can get their act together.” • •
Follow Tom Buerkle on Twitter at @tombuerkle.
