Green Shoots or False Dawn?

Amidst a barrage of bad economic news, the IHS Markit India Services Purchasing Managers’ Index offers a glimmer of light at the end of the slowdown tunnel. The index rose to 52.7 in November 2019, the highest in four months.

Is the worst over? Or does more economic pain lie ahead? Pollyanna de Lima, principal economist at IHS Markit was equivocal: “Although the services economy shrugged off some of the weakness seen in September and October, the latest PMI results continue to sound a note of caution regarding demand and the underlying state of the sector.”

Others were more hopeful. Bloomberg said: “The improved PMI data for November strengthens our view that the worst might be over for the economy and a shallow recovery lies ahead. Recent efforts by the RBI and the government are beginning to now show results and economic activity should pick up momentum over the next few months.”

In a further boost to the government, Standard & Poor’s maintained India’s sovereign credit rating at BBB- with a stable outlook. Weeks earlier Moody’s had downgraded India’s rating to BBB- with a negative outlook.

None of this camouflage the fact that the economy is caught in a cyclical and structural pincer. To break out of a vicious cycle of declining GDP growth, stagnating exports and weak consumer spending, structural reforms are imperative. Finance Minister Nirmala Sitharaman has her work cut out. The 2020-21 Union Budget is less than two months away. The Indian economy is going through the stress that has roots in both a global slowdown and domestic demand paralysis. Long-ignored structural reforms have caused the economy to seize up. Without bold reforms, the economy will not quickly return to an annual real GDP growth rate of 7.5 per cent.

To spur domestic demand and boost exports, six structural fixes are necessary. If these are implemented with robust intent, they will dovetail nicely with a cyclical upturn in the global and local economy, both of which should occur in 2020-21. For Prime Minister Narendra Modi, a strong economy will be the third prong in his election strategy, along with national security and welfare benefits. Without this third prong, the other two will not stand up to electoral scrutiny.  

The first structural reform is tax rationalisation. Personal tax rates must fall in line with the progressive recommendations of the Direct Tax Code (DTC). This will put money into the pockets of the urban middle class. The Goods and Services Tax (GST) regime should meanwhile move to three rates with a mean rate of 15 per cent. The 28 per cent “sin” rate must go. The lower the tax rate, the greater the compliance is a well-worn axiom. Counter-intuitively, GST revenue could rise significantly if GST rates are simplified and lowered. This will boost rural demand since GST affects everyone, not just the middle class. 

Input credit requirements and slow refunds have cut small vendors out of the GST supply chain. Large companies prefer to source their requirements from more established vendors, dealing a death blow to the MSME sector. GST reform is therefore as critical as personal tax reform. A more robust but simplified GST could take monthly inflows past Rs. one lakh crore on a sustainable basis, easing fears of a ballooning fiscal deficit. 

The second category of structural reforms relates to agriculture. India has more arable land than China but produces just over half of China’s foodgrain output. Innovation is the key to reforming Indian agriculture: GM crops that the rest of the world safely uses; corporatised and leased farm holdings; and elimination of the several layers of middlemen between farm and fork that shortchange farmers. The politically sensitive decision to tax large farmers – many of them politicians themselves – will also need to be taken sooner or later to widen India’s tax base. 

A key third structural reform is the privatisation of public sector units (PSUs) on a sustainable basis. The recent decision to divest five PSUs is a start – but it is only a start. The market value of 85 listed PSUs is Rs. 20 lakh crore. Divesting just 10 per cent from this bloated universe every year will help moderate the fisc, provide funds for government spending in infrastructure, and make privatised PSUs more productive, creating a virtuous cycle of new jobs and greater stakeholder value. If the value of privatised PSUs rises on average by a modest annualised 10 per cent, the government’s holdings of Rs. 20 lakh crore will stand replenished every year, allowing it to make privatisation a self-sustaining reform. 

Three other vital structural economic reforms are politically volatile but the government must now bite the bullet on each: land, labour and laws. Land acquisition remains an obstacle in the completion of infrastructure projects. Labour reform is equally critical to enhancing India’s ease of doing business. Here too, after initial reforms, the government has been stymied by powerful sympathisers of trade unions, many affiliated to the RSS. In a positive development, the Union Cabinet last month approved the Industrial Relations Code Bill 2019 which provides the legal framework for “fixed-term employment” and fairer rules for retrenchment.  

The high cost of land and capital makes Indian products uncompetitive. Exports have stagnated while imports have risen for over three years, forcing the Modi government to opt-out, for the moment, of the Regional Comprehensive Economic Partnership (RCEP). The absence of flexible – but fair – labour laws diminishes India’s attractiveness as a destination for both foreign and domestic investment.

The most vital structural reform that transcends the economy but impacts it significantly is India’s smorgasbord of laws, many dating back to the colonial 1800s. Former President Pranab Mukherjee epitomised the affliction when he introduced in 2012, as finance minister in the UPA2 government, retrospective tax legislation. The ill-effects of the retrospective law are still playing out in various courts seven years later with global companies like Cairn and Vodafone trapped in endless litigation. 

Unless all six of these structural reforms are implemented, the Indian economy will not live up to its full potential. India’s population is the youngest among all major world economies – its median age is 28 against 37 for China and 38 for the United States. This demographic advantage won’t last forever.