• Arindam Som

Weakening Institutions Can Cause a Slowdown in India

Men, women and children line up for a roller-coaster ride primarily to indulge themselves in the thrill associated with the rapid ascends and descends through the peaks & troughs. While the thrill is what drives both the intrinsic and economic value of a roller-coaster ride, yet no such utility would exist if the ride were to be sans the safety equipment. The safety protocol essentially allows a rider to enjoy the drop from the peak to the trough without actually falling off and injuring himself or herself. The same applies to the economic structure of any well-managed country. In times as turbulent as the previous year, it is the structure, depth and integrity of the economic institutions – regulators and market participants alike – that makes the roller-coaster ride ‘enjoyable’, with reduced if not zero risks.

2018 was a year which saw the comeback of volatility. As inflation and global economic growth seem to have finally pickup, the divergences in the global economic landscape have only increased. For instance, while inflation in the United States has more than covered the ground it lost in 2009, the price level and inflation in Europe remains stubbornly low. With the end of Quantitative Easing (QE) by the US Federal Reserve last year, the initiation of Quantitative Tightening (QT) the next year by the European Central Bank (ECB) - likely to be accompanied by QT measures by the Bank of England as well – global monetary policy at large is expected to remain relatively less conducive for emerging economies like India. In particular, liquidity is likely to remain modest at best which the aggregate interest rate levels are expected to continue to harden. The impact on the interest rates is likely to be even more pronounced given that global inflation rate is expected to aggregate well above 3% between 2019 and 2021 – levels not seen in the last 5 years. Consequently, foreign portfolio investors (FPIs) liquidated their holdings – especially in the debt markets – across emerging markets like India and Indonesia. This prompted central banks to raise benchmark rates and the RBI has resorted to an unprecedented level of Open Market Operations (OMO). All in all, as the world economy copes with a long run of tighter liquidity and higher interest rates the shift, from over a decade of easy liquidity, is bound to push up uncertainty and volatility in the capital markets and in the currency markets.

It is, however, encouraging that notwithstanding the dramatic movement in rates and currencies we have continued to maintain our growth. But the real question is – for how long and is this enough? It has always been more than evident that it is not the level of prices, rates and exchange rate that ends up hurting consumption and investment demand. Rather, it is the uncertainty associated with these macro variables that is a source of concern.

It has been nearly a decade since India saw a meaningful pickup in capital expenditure (capex) by the private sector. With rates picking up and liquidity stretched, it is unlikely that the corporate sector will be too excited to expand their balance sheets anytime soon. In such a scenario, the onus to boost investment consumption falls back on the government – which in turn affects the fiscal arithmetic and makes foreign suppliers of capital jittery at the least and paranoid at best. As foreign investors keep themselves at bay, both rates and liquidity would move unfavorably and the cycle would start all over again. Therefore, to answer whether growth would continue at the current pace or not, we need to assess whether in the current times our economy has the ability to move out of this vicious cycle.

Before moving onto this assessment, let us address other the other question above – whether the current growth is something to rejoice or not. My sense is that no, it isn’t. While we may be the fastest growing major economy, our base continues to be way smaller than that of our peers – especially China. To put this into perspective, if China grows by 5%, it would add ~$0.6 trillion annually while on the other hand even if India grows by 10%, it would add ~$0.24 trillion annually. While the current growth rate is commendable, yet, at this pace, closing the gap between us and the likes of China seems distant, at best.

While there is a gamut of policy prescriptions, social policy changes that the likes Dr. Abhijit Bannerji have time again vociferously advocated, there seems to be a couple of structural changes in the previous year that have invariably taken the environment farther away from what is ideal. The last year saw a gradual erosion of institutional independence, loosening of the fiscal belt and a fair bit of fiscal jugglery to cover it up. Institutional integrity, fiscal prudence and reliable reporting (material over form) are three of the most important ‘safety equipment’ that the economy must wear while on its own roller-coaster ride.

Before taking things further, let me clarify that the lack of institutional independence does not necessarily cast a shadow over the integrity of the institution. Having said that, it does, however, lead an outsider (say a foreign investor) to reevaluate their perception of the institution, say the central bank - and rightfully so. With the exit of Urijit Patel as Government of the RBI, the tone of the monetary policy has completely revamped. The Option Indexed Swap (OIS) curve is pricing in a rate cut by April, 2019 while rating agencies like Fitch has sounded the alarm bells.

In the coming year, the RBI’s approach towards fiscal policy would be key and we are entering into uncharted territory. For instance, in the current environment, a rate cut could actually be counterproductive. A Repo Rate cut, could actually push out foreign investors further – who have just started coming back in November – December, 2018 – and therefore raise market yields further. While in normal circumstances, this would be offset by a rise in credit growth as banks would find it cheaper to borrower, but currently nearly 30% of the Indian banks (by share in total advances in FY18) are not in a position to lend. Therefore, a repo cut would do little to boost credit offtake. Rather, with the SEBI requiring large corporates to mandatorily raise funds from the capital markets (and not from banks), the FPI outflows could raise borrowing costs further for corporates.

On the fiscal front, everything from farm loan waiver to the minimum basic income stink of populism and are expensive pre-poll candies. For instance, in case of farm loan waivers, delinquencies for other lenders such as non-bank finance companies has also risen primarily because the waiver creates a moral hazard – wherein borrowers are inherently disincentivized to service their debt regularly. The long term implications of rising agrarian delinquency is that credit flows from the private financial institutions could be severely constrained as the credit culture in the rural pockets would have been altered for the worse. This in turn would have adverse implications for rural development and consumption growth and thereby have a bearing on the overall growth numbers over the long run.

In honesty, minimum basic income is a noble idea and is a paradigm shift in this country’s social policy. Yet, from a fiscal standpoint it does not augur well with the existing policy landscape. The World Bank estimates that there exist over 400 schemes aimed at targeted towards poverty alleviation. The challenge with such a policy structure is that the state is neither able to push through any single policy agenda with full force, nor is it able to evaluate the performance of each scheme independently. So, if all these 400 schemes are subsumed within the idea of a minimum basic income, India could not only address the poverty related challenges more effectively but also make the fiscal room for such a massive social welfare scheme.

On the fiscal policy front, with disinvestment lagging behind, fiscal deficit could well cross the budgeted estimates in reality. But, there exists a large mismatch between the optical and real fiscal deficit. This gap is catered to by fiscal ‘adjustments’ from time to time. These adjustments have two implications. First, they understate the problem and restrict our ability to assess the health/ill-health of the economy. Second, and more importantly, it creates a ‘trust-deficit’. Look at the acquisition of the Rural Electrification Corporation (REC) by the Power Financing Corporation (PFC). This transaction is not disinvestment in the truest form as the cash inflows for the government would simply be attributable to the capital to be raised by PFC (including PFC’s own internal accruals) – which is another Government of India holding. Therefore if the total debt held by PFC, REC and the Government of India is added, this transaction is unlikely to meaningfully reduce the net borrowings, aka, the fiscal deficit.

These issues pose an important concern – as we embark on a mega roller-coaster ride – are we seriously undermining the safety net that is available with us? If the answer is yes, then the 7% plus growth is not only unsustainable but also risky. There is no crystal ball or econometric model that could reliably account for both volatility and the rate of change of volatility this coming year. Therefore, 2019 will be a year to watch out for. Everyone from farmers to fortune tellers must pray to their Gods and Satan alike.

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About the Author

Arindam Som is an Analyst working with India Ratings & Research - the Indian arm of Fitch Ratings. He has completed his Financial Risk Manager Certification from the Global Association of Risk Professionals and currently provides coverage to various Indian Corporates across sectors including construction, agro-commodities and logistics. He has also extensively worked on credit risk assessment of Indian Non-Banking Finance companies, Public Sector Enterprises and structured finance instruments. In his free time, he enjoys travelling, music and writing.

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