The Maths of India’s Reforms: Where to Next?
It is undeniable that Narendra Modi has reshaped both India and international perceptions of it during his three years in office as Prime Minister. Having been overwhelmingly voted into power in 2014 on the promise of economic growth, Mr Modi set out to execute a wide-ranging reform agenda focused on domestic development, securing foreign investment and playing a more proactive role in regional and international affairs. Based on macro-economic data alone, it would appear that Mr Modi’s BJP party has been on track to deliver on his promises. GDP growth has averaged 7.5% over the past three years, with growth fuelled, to a large extent by an inflow of US$175bn capital from foreign investors, making India both the world’s fastest growing economy and the largest destination for foreign direct investment. Further, the government has also taken steps across a wide swathe of areas such as infrastructure development, financial inclusion, digitisation, foreign investment and graft, in its bid to secure the country’s long-term growth potential. A previous Sign of the Times had assessed the BJP’s performance in terms of reforms at the 24 month mark following the general election. With less than two years to go until the next general election, this month’s Sign of the Times takes a closer look at India’s progress both economically and in terms of its reforms in order to assess the Modi government’s performance. More importantly, it identifies the core priorities yet to be addressed to make advances towards its medium to long term potential, thereby providing the agenda for the next stage in the journey.
India’s Economy Beyond Headline Growth Numbers: Significant Improvements Across Key Indicators
Following three years of high growth, India’s most recent GDP numbers saw economic growth fall from an average of 7.4% over the past three years to 5.7%, its slowest rate during the Modi era. This recent slowdown has attracted a chorus of domestic criticism of Mr Modi. However, much of the slowdown can be attributed to the execution of two major policies, namely demonetisation and the nationwide rollout of the Goods and Services Tax (GST). Successive previous governments had failed to implement the GST, lacking the political clout and will to enforce one indirect tax schedule across the states of India, and thereby perpetuating the massive inefficiencies and corruptions in the supply chains of the nation. It was never going to be easy to execute these changes across a country as vast, poor, illiterate, bureaucratic, disorganised and disparate as India. Yet local expectations seemed set on smooth execution. With hindsight, the inevitable has happened and the execution of both of these reforms, while crucial to India’s continuing medium-long term development prospects, have resulted in adverse near-term impacts on manufacturing supply chains and consumer spending across the country, and created uncertainty among small and medium sized enterprises. However, the negative impact of both these events is expected to be short-term, with growth forecast to recover during the second half of the year, and stabilise at 7.4% in 2018 and accelerate to 8.2% over the coming five years. In addition, the consensus remains that the longer term impact of these changes is profound; GST is expected to add 1.5% to 2.0% to GDP and the inflow of cash savings into the banking system is expected to provide a boost to overall credit, private investment and consumer demand, and therefore positively impact corporate earnings. Stepping back, it makes sense to evaluate India’s economic progress through a broader set of short and long term indicators, including manufacturing and services sector output, inflation, consumption, and fiscal and trade positions. By these measures, India’s performance under Mr Modi’s BJP party has been robust.
Measured by the indicators above it is clear that the Indian economy today is in a significantly healthier position than it was when the Modi government came to power. The strong fiscal consolidation, a decrease in the current account deficit, low inflation, high discretionary consumption and favourable manufacturing and services sector output, has been created by the execution of an ambitious reform agenda, which has delivered a sound economic platform on which the government can implement new economic and political reforms, delivering further economic growth in the medium-to-long-term.
India’s Reforms: Government Making Significant Progress Across Key Areas
The breadth and ambition of the reform agenda laid out by the Modi government three years ago was unprecedented, and raised the hope that India could rise to compete with China, or at least follow in the footsteps the latter has left over the past decade of its rapid development, thereby refuting the long-held view that India’s democracy is a tax on in its development potential. Beyond targeted measures aimed at improving the key fundamental indicators above, the government also implemented broader economic reforms focusing on areas such as infrastructure development, foreign investment, financial inclusion, corruption, digitisation, the banking sector, and job creation. An evaluation of the government’s performance to date reveals that significant progress has been made across most of these areas over the last three years.
The maths is clear. India has not seen this measure of change since the heady and idealistic years following independence and the public’s faith in rejecting the Gandhi family dynasty in favour of what appeared to be a dangerous revolutionary today seems well placed. The numbers point to the Modi government’s success in firmly re-establishing the credibility of the India Story, with meaningful progress made across most major reform fronts. However, the government must now balance the near-term needs of the economy with its medium-long term objectives, and this will prove to be an essential balance in the build up to the next election. In the short term, the dual impact of demonetisation and GST has hurt small enterprise (particularly in the informal sector) by cutting their sales, margins and cash flows and threatened their ability to sustain themselves. No matter what the longer term solution to this problem is , this pain cannot be ignored. Despite all the progress and development of the last few years, India still has a long road ahead of it, and the untapped potential is so significant it puts the current achievements into perspective as merely a small, but firm, step in a long journey. India’s GDP per capita in real terms is still just under a fifth of China’s, nearly half of its labour force is still in the agricultural sector, earning an average of just over US$4 per day, and industrial sectors represent less than 30% of total economic output. The asset of its young population, its mass entrepreneurialism and its investment potential need to be further unlocked in the next phase of change. These challenges and opportunities form the basis of the next set of bold moves that the Modi government will need to turn its attention to in the next two years and potentially its next term.
India’s Potential: A US$5 trillion Economy by 2024
Given the early victories in the transformation of India, the nation and investors worldwide expect the government will set its sights on even greater heights, stretching its growth targets from currently 7-8% to 10%+ for the next decade. The fundamental transformation that has taken place in India since the BJP assumed power in 2014 demonstrates that, given strong leadership, the country is capable of exceeding expectations and delivering results. This hopefully puts one myth to bed by showing that democracy has not been and is not a valid excuse for incompetence. Having begun to successfully tackle the key issues and reform areas laid out above, the government will need to build on the successes of the previous years and continue to execute further and deeper reforms to maintain and accelerate the pace of development. With the ‘easy wins’ picked off during Mr Modi’s first term, the BJP’s focus must now shift to the execution of more difficult reforms. This is clearly the case both in areas where reforms have gained initial traction as well as in key areas yet to be significantly tapped, such as banking sector reform, private investment, labour market reform, and agricultural and land reform. The resulting reform agenda will be on par with, if not greater than the one Mr Modi campaigned on in 2014. Pulling these various pieces together into a coherent strategy will require the creation of a development agenda for India spanning from the present to (at least) the general elections following the next ones, in 2024. The agenda would need to include ambitious targets for a number of development indicators which could include the following:
The February 2012 edition of Sign of the Times outlined a bold agenda for unlocking India’s potential under the banner of “India Wide Open”, with the key belief that India could only succeed, given its own challenges and the changing global context, if it invited the world into the country to invest and profit from developing the nation, and if the nation itself could be unburdened to realise its own potential. The relevance of that belief remains strong today. The agenda for this next phase will need to set comprehensive goals for a modern and industrialising nation that has fully leveraged its core assets and addressed they key issues that have inhibited its development, in some cases for decades.
Delivering on this vision is by no means an easy task and will require taking difficult decisions and making significant further reforms, which will provide the opposition and the government’s detractors with ammunition to strike. This next stage of more radical change will require the government to leverage the popular goodwill that it has won during its first three years in office and combine this with its increasingly growing political strength – the BJP and its allies hold 61% of all seats in the Lower House of Parliament, and are the largest political alliance in the Upper House of Parliament – in order to address some important issues.
On the high priority list of the government will need to be:
- Privatisation and Deregulation – Beginning with Energy. China was highly effective at galvanizing global support through privatization. India can learn from this experience. India’s coal and power distribution sectors are struggling due to a lack of private sector presence, with a shortfall of 140m tonnes of coal leaving power producers reliant on imports, and 300m people lacking adequate access to electricity due to distribution being controlled by operationally inefficient state electricity boards (SEBs). Private participation in the energy value chain will be required to quickly unblock these bottlenecks. The government will need to incentivise states to tender power distribution to the private sector, by acquiring up to 51% in SEBs, as well as allowing private sector companies to develop new resources that help unlock energy reserves. However, with power distribution currently in the hands of individual states, deregulation will likely require the central government to broker individual agreements with state governments, a number of which are formed by regional and opposition political parties.
- Fixing India’s Banking Sector. The quality of banking assets in India has deteriorated significantly over the last three years, with the overall gross NPA ratio increasing from 4.65% in June 2014 to 10.21% in June 2017. While the government and the Reserve Bank of India have worked together to try and resolve this problem through the creation of a new Insolvency and Bankruptcy Code (IBC), and more stringent provisioning standards, further measures are required in order help revive credit growth including, among others, the re-capitalisation of public sector banks through a combination of capital injections and privatization (a process that has kicked off with the government’s recently announced US$32 recapitalisation plan), and the swift implementation of the IBC to ensure that the stressed industrial and infrastructure assets are rapidly either liquidated or sold to buyers who can see them through completion.
- Reviving Domestic Investment. India appears to be in the middle of an investment slowdown, with the investment rate (as a percentage of GDP) having fallen from 38% in 2007 to c.30% today, and current investment levels are not adequate to support growth in excess of c.8%. While the longer-term solution to this slowdown will need to involve reforming India’s banking sector (including the measures described above), in the short-term, the gap will most likely need to be bridged by government investment. While the government has to date demonstrated admirable fiscal discipline, bringing the country’s deficit down by c.25% over the last three years, it will now need to loosen its purse strings for a brief period. A short-term increase in government investment, particularly across key sectors like infrastructure, manufacturing, defence, healthcare and agriculture, will likely have a “crowding in” effect on private investment in the medium-to long run.
- Job Creation. With over 1m new people joining India’s workforce every month, creating employment opportunities is a critical requirement. Mr Modi recognised this in 2014, and an important element of his party’s election manifesto was centred around job creation. Three years later, however, it would appear that the government has fallen short of its employment targets. While investing in infrastructure over the last three years has created c.2m new jobs, employment generation in other important sectors, particularly manufacturing, has been inadequate. This can be explained by a combination of reduced private sector investment and stagnation in informal sector jobs (which includes casual and contractual employment) due to the combination of demonetisation and the GST rollout. India’s large unorganised labour force is an outcome of employers looking to circumvent current inflexible labour laws, which do not allow for the easy hiring and retrenchment of full-time employees. While the government has implemented a few labour reforms (including amending the Apprentices Act), it will need to significantly overhaul current labour laws at both central and state levels, particularly those related to retrenchment, if it hopes to create an environment that is conducive for the creation of meaningful employment opportunities for the nearly 12m annual labour force entrants over the next decade.
- Agricultural Productivity and Land Reform. Despite having the second largest arable land area in the world, India’s agricultural productivity is c.40% lower than the United States’, driven by a lack of access to new farming technologies, minimum support prices (MSPs) that incentivise farmers to only grow certain crops, and an inefficient government-controlled distribution system. A wide range of reforms will be needed to address these deficiencies, including introducing land consolidation initiatives that permit large-scale farming without changes in ownership, promoting the availability of institutional capital (e.g. public listings to scaled land projects), and providing tax incentives for agricultural co-operatives. All of these measures will require spending significant political capital: India’s current agricultural distribution system is deeply entrenched politically and its major beneficiaries are well connected, creating stiff opposition to change from well organised interest groups.
- Industrial Hubs. Despite the launch of campaigns such as Mr Modi’s ‘Make in India’ initiative, the country’s manufacturing potential remains hampered by poor infrastructure, inflexible labour laws and a regulatory system that is not conducive to domestic production, a situation that is compounded by lengthy approval processes. China’s experience, which created special industrial zones that gave birth to manufacturing hubs throughout the country, is relevant to India in this regard. By systematically and simultaneously creating different types of hubs or industrial clusters across the country depending on the demographic and income profile of the respective state or region through targeted incentives (i.e. low-value-added manufacturing for poorer and younger regions, high-value-added manufacturing for more prosperous ones), the government can ensure rapid and broad-based development across the country by customising the policy initiatives to each region’s unique requirements, rather than trying in vain to implement a ‘one-size-fits-all’ policy framework. In subsequent waves, these policies can be expanded to corridors and zones throughout the country to drive manufacturing on a national level, leading to the eventual endgame of creating a policy framework for the entire country.
- Open Urban Infrastructure. India’s urban infrastructure is grossly ill-equipped to cope with the 10m migrants moving to cities annually due to a severe shortage of quality housing, water supply and sewerage, poor planning laws and inefficient urban infrastructure financing, with over 100m Indians, representing as much as 40% of the total population in certain large cities, living in makeshift housing with inadequate access to sanitation, security and basic public services. . Unlocking the potential from India’s cities and its urban workforce will require not only a comprehensive plan to build-out necessary infrastructure, but also innovative solutions for how to re-design slum areas and create urban governance frameworks which allow for cities to develop and scale organically This would need to include tripling urban infrastructure investment (to c.2% of GDP), leveraging public private partnerships to raise the necessary capital, eliminating rules required to convert agricultural land into residential land in urban areas, and devolving much more power (including revenue collection and spending) to the municipal level, among other things. Most importantly, the issue of urban design and development cannot be solved entirely through top-down policies or even financing; it requires a holistic approach that recognises India’s cities as its primary engines of growth, and the creation and empowerment of ‘CEO-like’ mayors who can focus on and implement the transformative changes in their respective cities.
If India can achieve the 2024 targets laid out above, the transformation of the country over the next seven years will be staggering and dwarf the accomplishments of the first three years of the BJP’s reign. The table below shows the comparative shift the country would make across the key indicators, and demonstrates the order of magnitude of the transformation.
By 2024, India has the potential to be an industrialised nation well on the way to becoming a ‘moderately prosperous society’, to borrow a development goal from China. Consensus estimates see India growing at 7-8% annually over the next few years. While this would be commendable growth anywhere else in the world, particularly for its neighbour, China, it would be a squandered opportunity in India, which is at an earlier stage in its journey and has the potential to deliver more. Breaking through consensus level growth requires extending and deepening the initial reform efforts of the BJP, which in turn will incur short to medium term costs that previous governments have deemed unaffordable in pre-general election periods. A bigger
alignment of the people across the various diverse populations of India will help Mr Modi in this difficult next phase. Mr Modi’s successes to date have certainly strengthened the BJP’s position at the ballot box so far and placed him in a position to call for a greater alignment and unity behind an even bigger agenda. However, in the build up to the last election and at various points in the last three years, the media have seen evidence of their fears being realized in the workings of a nationalist party. It can now afford to use some of its credibility to build a broad consensus in Indian society on the future shape of the country and the path being embarked on. This will require a rethink of the more polarising events and actions that have played well to the BJP’s base but alienated other sections of society, such as the beef ban, or the ineffective government response to a series of Muslim lynchings and attacks on critical journalists, which risk dividing society on sectarian lines. An India as economically productive as Japan, as digitally connected and as innovative as the EU and with the industrial output of Germany can only be created with the buy-in and support of the whole country. Mr Modi is now in a position to play out the broad inclusion theme that he spoke of during the election: “Sabka Saath, Sabka Vikas” (translated as ‘Collective efforts for inclusive growth for everyone’).
The past three years have clearly demonstrated the BJP’s ability to push through and execute significant reforms, despite the issues of doing this perfectly. They have also demonstrated the country’s ability to mobilise resources and deliver rapid economic growth, the recent slowdown notwithstanding. If Mr Modi is to fulfil his vision of creating a strong and economically powerful India, he will need to go much, much further. The government will need to deliver not just on the remaining promises from his last election campaign, but present a new vision that secures a second term to lock in the gains from the first, continue deepening the reforms currently underway, address the remaining core challenges facing the country and build an India that has the ability to shoot for its full potential.
With the benefit of hindsight, one can see that India has struggled for its 70 years of independence to achieve its potential. The crowning glory of the post independence period has not been economic development, but the establishment of a robust and lasting democracy, an achievement that is not to be taken lightly. However, in terms of political effectiveness at delivering prosperity, it stands totally outpaced by China, whose development has been guided by a succession of highly competent leaders. India’s leaders on the other hand failed to deliver real growth and relieve their people from poverty, and blamed their failure on the pluralism and dissent that the country’s democracy enabled. India’s recent performance under the BJP however has rekindled and galvanised the belief that democracy can deliver growth, inclusion and development.
As recent events have demonstrated, the pent up demand for radical change and reforms has left many in the business community dissatisfied with the pace of change achieved to date, allowing the political opposition and its supporters to dismiss programmes such as demonetisation and the GST for their execution shortcomings. However, populations in the EU will attest to the difficulties of enforcing the common market, as the US will to agreeing healthcare and tax reforms and the Japanese to defence reforms. None of Europe, the US and Japan face the challenges of poverty, illiteracy and broken infrastructure that India does and yet still struggle to make fundamental change. In this context, three years seems a short time to judge Mr Modi too harshly, although the pain to ordinary people caused by the implementation of demonetisation and GST has been real and should not to be under-estimated.
In order to succeed, Mr Modi and the BJP need to look forward and focus India’s on digesting change and striving towards their bright future, rather than becoming too obsessed with things not being solved overnight. In any country, a sustained improvement in the lot of people’s lives creates an expectation that these improvements will continue to accrue in the future. In authoritarian countries such as China, it is well understood that governments derive legitimacy from their ability to deliver continuing economic development (and maintain social stability in the process). However, in a democracy such as India’s, if the rate of improvements in people’s lives stagnates or fails to increase further, voters will make their displeasure felt at the ballot box. If Mr Modi is unable to continue to deliver reforms and growth, his next electoral victory may not to provide him with the political freedom of action that the majority he enjoys today does. Democracy is indeed a hard task master in our times.
 Source: Ministry of Commerce and Industry, Government of India, indicates cumulative FDI inflows into India from April 2014 until June 2017
 Source: Reserve Bank of India National Accounts, indicates year-on-year change in quarterly GDP at market prices; in the Modi era, quarterly GDP growth reached 9.1% in the quarter ending March 2016 and declined to 5.7% in the quarter ending June 2017
 Based on the latest (October 2017) forecast from the International Monetary Fund. In spite of the forecast that growth will recover in the second half of 2017 and continue to accelerate to 8% or higher, a number of economists, most notably former ministers from Mr Modi’s own party, have argued that the slowdown is due to reasons beyond just the negative impact of demonetisation and GST and could potentially last longer than expected
 Source: Forbes India, GST: A Critical Reform That Will Drive Economic Growth, July 2017
 As stated in the BJP’s 2014 Election Manifesto
 Department of Agriculture, India
 See the February 2016 Sign of the Times: Realising India’s Demographic Dividend: The People Determine Success
 See the October 2016 Sign of the Times:
The Enrichment of India’s Farming Community is the key to Adding US$4.3 trillion to Indian GDP
 Please refer to the Sign of the Times leaders from August 2014, Unleashing India’s Industrial Potential: Building a Globally Competitive Manufacturing Base and from April 2015, India Has to Create Big Waves to Succeed for a more detailed overview of the policies required to unleash India’s industrial potential through industrial hubs
 See the October 2013 Sign of the Times: Transforming India’s Slums: A Critical Step in Creating the New India
 Data listed reflects recent India statistics as of October 2017; country comparables based on latest available actuals (2016-2017)
 Data reflects achievement of 2024 targets listed above; country comparables based on latest available actuals (2016-2017)
Risk | India | Risk-Adjusted Returns | Structural Reforms | Rebalancing | Investment Allocation | Capital Flows