In For A Fall

The run-up to elections has seen a major rally in India’s financial markets. Share prices are scaling record highs every day and the rupee has appreciated considerably. This optimism is being driven by evidence from opinion and exit polls, which suggest that the BJP— viewed by investors as more business friendly— will form the next government. But a number of factors, particularly the fact that the new government will be operating in the same unfavourable conditions such as rising corporate debt, fiscal inflexibility and the possible shackles of a loose coalition, suggest that investors’ surging optimism is unfounded.

Investors are optimistic

The possibility of a BJP-led government has filled investors’ hearts with the hope of a turnaround in India’s economic fortunes. The stock market is scaling record highs every day and the rupee has gained considerably against the US dollar. Evidence from exit and opinion polls suggests that the BJP will head the new government and investors’ escalating optimism has its roots in the belief that the BJP’s prime ministerial candidate, Narendra Modi, is more pro-business than the incumbent Congress party. In their view, this pro-business stance will help to lift India out of its current economic mire— GDP has grown by less than 5% year-on-year for the past seven quarters, well below the near 8% average of the previous ten years. 

But reviving growth will be difficult

The chances of the BJP heading the next government are high. But given the deep roots of India’s current predicament and the type of reforms that are required suggest that investors’ optimism about an economic bounce-back is unfounded. 

India’s growth slowdown over the past couple of years can be traced back to a sharp drop-off in investment, which having risen by more than 10% a year in 2007-11, slowed to growth of just 1.3% a year in 2012-13. Therefore in order to revive growth, it is crucial for the government to kick-start the investment cycle. This is easier said than done.

New government, same old conditions

The exit polls point to a very favourable outcome for the BJP. But taking a conservative view of these results— which have proved inaccurate in the past— the BJP will most likely have to align itself with other regional parties and form a coalition government. As such, they will be plagued by the same indecision that the Congress was facing, with regional parties determined to protect their states’ electorate and stand in the way of pro-growth reforms like liberalising FDI. 

India has, so far, narrowly avoided a downgrade of its sovereign credit rating to junk status, so the fiscal position will continue to be precarious. The government’s hands, with regards to increasing capital expenditure to boost infrastructure and therefore potential growth, will remain tied down. 

The health of the private sector has also deteriorated considerably. Companies are highly leveraged, with the debt-to-equity ratio elevated at 83%, highest among all emerging markets, and below only Greece and Italy. The levels of bad debt in the financial system are also rapidly on the rise. So regardless of the party in power, both banks’ ability to lend money to businesses and companies’ propensity to invest is limited. 

Many believe that a stronger government with more capable leadership will be able to restart stalled infrastructure projects, which have been held back so far due to regulatory hurdles. However according to a recent report by Credit Suisse, only a quarter of the stalled investment projects are stuck with the central government, of which two-thirds are in power and steel; sectors that are already swamped with overcapacity. The others need clearance from state governments.

According to an IMF working paper (Disentangling India’s Investment Slowdown, Rahul Anand and Volodymyr Tulin) , a lot of India’s investment slowdown is because of deteriorating business confidence and heightened policy uncertainty. While investor confidence is surging in the run-up to elections, businesses are more cautious. According to a survey of 73 CEOs in the manufacturing sector conducted by the Federation of Indian Chambers of Commerce and Industry (FICCI), there is no clear sign of optimism among businesses regarding their profit levels or growth and employment in the near future, despite being of the view that Mr Modi will come to power. In their view, high interest rates, which are expected to remain at their current levels for a prolonged period, are a major hurdle to increasing investment. 

Institutional change will take time to come through

In order to achieve the government’s target growth rate of around 8% a year, India requires a major institutional overhaul aimed at reducing crony capitalism and improving the business environment. According to the World Bank’s Ease of Doing Business Survey for 2014, out of 185 economies India ranked 134— well below its emerging market counterparts. And India scores just 36 on the World Bank’s Corruption Perceptions Index for 2013 (100 is very clean, and 0 is highly corrupt). This is even below the emerging economies’ average score of 37.5 and nearly half the average score of developed economies. 

Such problems, as highlighted by Ila Patnaik, Professor at the National Institute of Public Finance and Policy, stem from factors like the lack of a transparent and nondiscretionary policy framework, as a result of which many government decisions are based on individual discretion. For instance, the state issues licenses and permits to firms for their operation on a case-by-case basis, a practice that encourages government officials to choose which companies receive clearance and which don’t. In a country fraught with widespread corruption; favouritism and bribery often tend to influence the government’s decisions. This is very detrimental for the investment environment. Although these factors failed to obstruct growth over the previous decade, looking ahead, they need to be addressed, given that the economy is much larger and depends at least in part on better institutions and a stronger rule of law. 

There is scant evidence to suggest that the BJP is much better than the Congress in this regard. In fact, Mr Modi, as the Gujarat Chief Minister has shown clear favouritism towards big businesses like the Tata and Reliance groups, while being silent on the subject of crony capitalism in his election manifesto. Furthermore even if the next government works towards addressing these issues, it will be a while before its positive impact is felt on the economy. So it appears that financial markets and investors risk disappointment. 

Nida Ali is a London-based economist with a consulting firm Oxford Economics