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The Second Wave of Economic Reforms

18 April, 2011

In a column six months ago I noted that inflation in India is structural in nature as aggregate demand is greater than the supply in this supply constrained economy. High inflation in turn impedes the translation of topline growth into earnings growth. This explains the historic phenomenon whereby equity returns are lower in a high inflation environment. Given that the impact of First Generation reforms (dating back to 1991) have run out of steam, only the administration of ‘Second Generation economic reforms can lead to continued GDP growth minus the inflation side effect. Let me explain further.

The Structural Nature of Inflation in India

India is a supply constrained economy where aggregate demand outstrips aggregate supply. This is responsible for the historical phenomenon whereby the high GDP growth rate pushes up capacity utilization levels which in turn translates into higher core inflation. My colleague Ritika Mankar’s analysis (performed on data from 2000-10) shows that whenever capacity utilization in the Indian economy rises 10% “above normal”, core inflation surges above 5%.

In a recent note, Ms.Mankar illustrated clearly that the Indian economy has now become incapable of growing at a fast pace without stoking inflation. In particular, what stands out is that since FY09, the supply side in India has persistently failed to expand despite consistently high levels of aggregate demand.

High Inflation Crunches Stock Market Returns

High inflation prevents profit growth from being stronger than sales growth by imposing input cost pressures. In particular, earnings growth in excess of topline growth becomes difficult as soon as WPI inflation rises above 7% and this dynamic is responsible for the historic phenomenon whereby equity returns across the broader market as well as across sectors are lower in a high inflation environment. In particular, in a high inflation environment (defined as months in which WPI inflation is above 5.5%), the Sensex’s monthly returns are a mere 0.4%. In contrast in a low inflation environment (i.e. months in which WPI inflation is below 5.5%), the Sensex’s monthly returns are a stellar 2.7%. (This analysis is based on FY01-11 data.)

This raises the critical question “What will it take to ease supply constraints and alter the structural nature of inflation in India?”.

‘Second Generation economic reforms’ needed

I believe that given that the impact of First Generation reforms have run out of steam (as is evident from the fact that supply constraints have become meaningful and high GDP growth stokes inflationary pressures), only the administration of ‘Second Generation economic reforms’ will lead to continued GDP growth sans the inflation side effect. My discussions with Indian companies suggests that for economic growth to result in investment gains, we need reforms in three areas in order to impart greater elasticity to aggregate supply in the economy:

Pillar #1: Reforms aimed at lowering the cost of capital in India

The cost of capital in India is one of the highest in the world and is the result of a repressed financial system, an under-developed corporate bond market and the presence of capital account controls. Given the criticality of the cost of capital in affecting project viability and given that the infrastructure sector in India has been a laggard on account of the absence of affordable long term capital, reforms aimed at strengthening this pillar, will to a large extent, determine whether we can break the growth-inflation trade-off.

Pillar #2: Reforms aimed at increasing the supply of skilled labour

The employer-unfriendly orientation of labour regulation in India as well as an inadequate education system has translated India’s comparative advantage in terms of the ample availability of labour into a disadvantage. Reform is needed both in the labour laws and in the education system so that vocational trading is emphasized upon.

Pillar #3: Reforms aimed at closing the infrastructure deficit in India

India’s infrastructure deficit is well known with financial as well as institutional impediments to infrastructure growth. Besides lack of access to long term affordable finance, institutional problems related to land acquisition, environmental clearances, engineering quality, deficiencies in the planning and control processes impede speedy infrastructure creation in India.

If our Government could focus on addressing these three pillars of reform rather than fighting scams and elections on a monthly basis, we would actually have grounds for a sustained bull market rather than the repeated false dawns that we have seen over the past year.

(Saurabh Mukherjea is the Head of Equities at Ambit Capital. The views expressed here are his own and not Ambit Capital’s.)


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The Second Wave of Economic Reforms

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