The Indian PM is planning the most audacious rethink of fiscal policy ever seen in India. Even if he is partially successful, Narendra Modi’s reconstruction of the Indian fiscal policy will have far-reaching implications for the incipient economic recovery underway in India.
In particular: (a) the PM’s focus on reducing “leakages” from the subsidy system looks likely to stymie the rural wealth effect that has been such a powerful driver of consumption over the past five years; (b) the big blast of government-funded capex that is likely to be announced in the Budget is likely to compensate for the private sector’s reluctance to embark upon capex; and (c) the PM’s willingness to use fiscal incentives to push states towards land, labour and subsidy reform creates the genuine possibility of structural reform in a country where the political class does not really want reform.
What is PM trying to do?
Based on my meetings with policymakers in Delhi, I reckon Mr Modi is pursuing four distinct goals as he and his team rethink and reconstruct Indian fiscal policy:
1) Higher tax/GDP ratio: India’s tax-to-GDP ratio has been between 8% and 12% over the past two decades. This makes India similar to most sub-Saharan African economies; as for most developed economies, this ratio is upwards of 25%. This unflattering comparison with more mature countries points highlights the sheer scale of tax evasion in India. Using GST (the Constitutional amendment for which has been tabled in Parliament) and clever IT infrastructure, Modi seems determined to lift India’s tax/GDP ratio.
2) Lower leakages: The PM’s advisors are convinced that by moving India’s subsidy mechanism from subsidies in kind (i.e. cheap food, fuel and fertiliser) to subsidies in cash (i.e. Direct Benefit Transfers into the recipients’ bank accounts), they can save at least 0.4% of GDP (which amounts to around $10 billion). In fact they say that if they go after the misspending by institutions like the Food Corporation of India, around 1% of GDP (i.e. $20 billion) can be saved every year.
3) More government capex: The savings outlined in the above bullet-point alongside savings arising from the drop in crude prices gives the PM a kitty equal to 1.5% of GDP ($30 billion). If you add to this the 1.5% of GDP that used to be allocated by the Planning Commission but now seems likely to be spent at the Finance Ministry’s discretion, you can see how the PM can command an annual kitty equal to 3% of GDP (around $60 billion).
I believe that this corpus will be spent in two ways, the first of which is big-ticket capex by the government. The PM’s advisors point out that over the past 10 years whilst government spending in general has grown at 13% CAGR, government spending on capex has grown at a pitiful 0.05% CAGR. Set alongside the very public failure of the PPP initiative to build India’s infrastructure, there appears to be a yawning need for the government to embark upon big-ticket capex. We therefore expect the Budget on 28 February to launch a blast of government spending on T&D, defence, railways, freight corridors and low cost housing.
4) “Competitive federalism”: The second area where the PM seems likely to direct funds is towards incentivising the states to follow his reform agenda i.e. states which launch Rajasthan-style land and labour reform, states which move their subsidy programmes on to the DBT platform, states which address their SEB losses and, perhaps most controversially, states which lend support to the NDA’s agenda in Parliament. This is where Modi’s reconstruction of the Indian fiscal policy is at its most inventive and the odds, we believe, are in favour of the PM using fiscal incentives to browbeat the states towards delivering his chosen agenda. As the Wall Street Journal noted in its editorial on 29 January, “The invitation to the states to get a headstart is part of the government’s policy of ‘competitive federalism,’ which in the best case will put pressure on upper house legislators not to stand in the way.” (Source: Modi’s Reform Push )
Will Modi succeed in pushing through this audacious rethink of fiscal policy?
Whilst the PM’s rethink of fiscal policy is audacious, I am circumspect about whether any more than half of this agenda can be delivered upon. There are at least three powerful groups that seem likely to oppose the PM’s agenda:
- Non-NDA state chief ministers are being emasculated in the construct that the PM has in mind. They will not take kindly to this and, at least in the short run, they will block whatever they can in Parliament in the hope that the PM will back down.
- The rural elites – many of them politicians at the state and local level - have benefited mightily from the expansion of subsidies (and the corresponding expansion of leakages) over the past 10 years. Given that India spends $70 billion per annum of subsidies, most estimates suggest that at least half of this ends up in the hands of the politicians and their henchmen. It is highly unlikely that these politicians will sit and watch the gravy train be de-commissioned by Narendra Modi.
- It is not clear to us how much of the RSS and indeed the BJP is on-side with the PM’s audacious agenda. Most of the BJP is made up of fairly conventional politicians and their interests are more aligned with other run-of-the-mill politicians (as per the previous bullet-point) than with the PM.
All of that being said, given the challenges that the PM is facing in the Rajya Sabha (one Opposition MP told me three weeks ago that “for the next two years we will shout down everything that is tabled in the Rajya Sabha”) unless Mr Modi uses a re-invented fiscal construct, he will find it hard to push legislation through Parliament.
Investment implication 1: The likely breakdown of the rural wealth effect
Whilst the exact sums are a matter of debate, it is safe to say that subsidy leakages have over the past decade resulted in the tens of billions of dollars per annum being pilfered by the rural elite (which is a combination of politicians, local thugs and local businesspeople – such as car dealers, cement distributors, FMCG distributors, and builders – working in cahoots with each other often in groups linked by close family or social ties). Since they could not “consume” such large sums of money without attracting the attention of the taxman, a lot of this pilfered wealth went into buying land and gold. Fifteen months ago I wrote in my column that:
“Regional experts highlight that each state in northern India has around a dozen highly cash-generative corporates who are central to the economic and political well-being of the politicians who run that state.
This construct is then replicated at the district level i.e. in each district, there will be, say, half a dozen families who control the key businesses in that area, account for the bulk of bank deposits arising from that area, control the majority of land in the district and hence control the bulk of jobs created in that area. These district-level business families usually have family members or associates embedded either in the village panchayat and/or at the district-level zilla parishad (just as their larger counterparts at the state level will have MLAs in the state legislature and their still larger cousins at the national level will have sitting MPs).”
As the PM seeks to reduce leakages, there is a real risk that he will break this rural wealth effect that has driven the consumption of cars, SUVs, jewellery and other big-ticket items. Furthermore, the post-May 2014 cooling off in rural land prices could also impact housing finance companies (many of which have recently seen a spectacular rally in their share prices).
At the other end of the consumption spectrum, it seems likely that the use of DBT to transfer money to low-income families could give them more disposable income. That in turn could boost the consumption of small-ticket items such as FMCG goods.
Investment implication 2: The government kicks off the still sluggish capex cycle
The government is likely to play an active role in building roads, freight corridors, affordable housing, T&D infrastructure and power plants. Once the cash inflows from these projects stabilise, the government might then sell down the asset to the private sector. As stated in its mid-year economic analysis, published on 19 December 2014, the government says that, “It seems imperative to consider the case for reviving public investment as one of the key engines of growth going forward, not to replace private investment but to revive and complement it.” (Source)
As a result of this dynamic, EPC companies – whether they be in the roads sector, in the T&D sector or in the affordable housing sector – seem likely to see an upsurge in their order books. Alongside this, with the balance sheets of the private sector infra asset owners in tatters, it seems more likely than not that the public sector asset owners (eg. PGCIL, Concor, BEL, Coal India, NTPC) are going to kings of the new wave of infrastructure building in India.
(Saurabh Mukherjea is CEO - Institutional Equities, at Ambit Capital and the author of “Gurus of Chaos: Modern India’s Money Masters”. He has no financial interest in the stocks mentioned in this column.)
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