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Modi has his hands full, still time for him to deliver results?

By Saurabh Mukherjea
April 16, 2015 10:15 IST

The PM's resets - by attacking subsidies and black money - could help tame inflation on a structural basis, says Saurabh Mukherjea.  

Image: India expects sea change in terms of reforms and policy measures from the Modi government. Photograph: PTI

Until the early 1980s, the Indian economy did not exhibit what economists call the "business cycle" and gross domestic product (GDP) growth hovered around 3.5 per cent from Independence through to the 1980s.

Then in 1981, Indira Gandhi launched the first wave of liberalisation, consisting largely of relaxing industrial controls.

As a result, since 1984 the Indian economy has displayed an 8-10 year economic cycle in which, typically, after a decisive general election result (for example, 1984 or 2004), demand picks up and so does GDP growth.  

However, because of rigidities in India's factor market (land is difficult to buy, skilled labour is difficult to hire or fire and the cost of capital is among the highest for a non-African economy), supply in India rarely responds adequately to growing demand.

As a result, in an economic recovery, inflation and corruption fill the yawning gap between rising demand and static supply.

Therefore, typically, within four years of the decisive election result, growth starts tapering off and with it dies the stock market boom.  

While these problems are well known, what Prime Minister Narendra Modi seems to be trying to do is mount a novel attack on these supply-side rigidities by seeking to: (1) shift India's savings landscape away from gold and land, and towards the formal financial system by enacting new legislation later this month, which specifically cracks down on black money hidden overseas and by amending the Income Tax Act to make it harder to conduct black money transactions in real estate;

(2) disrupt the Indian model of crony capitalism by visibly tightening law enforcement in the seedy borderland, where commerce and politics intersects in India; and

(3) redefine India's subsidy system through the direct benefits transfer mechanism while arresting the growth in subsidies (between FY05-14 subsidies compounded at 19 per cent per annum).  

Inflation in India was low and stable until the United Progressive Alliance (UPA)'s 10-year rule.

Then, under UPA-II, inflation roared away towards double digits. Modi's resets - by attacking subsidies, by attacking black money and by pushing labour and capital towards the organised economy - could help tame inflation on a structural basis.  

However, the new structure will take some time to become fully operational; hence the three resets look likely to adversely impact GDP growth in FY16.

My colleagues' macroeconomic modelling suggests that FY16 GDP growth will be around 7.5 per cent, similar to FY15 economic growth.

The short-term pain in GDP growth will be driven by: (1) alterations in the subsidy regime, which will adversely affect rural/semi-urban consumption and construction activity;

(2) crony capitalists' refusal to begin capex activity, as they see reduced scope for supernormal profits under Modi; and (3) Modi's attack on black money, leading to a crack in land and real estate prices, which will adversely impact lenders' balance sheets.  

History suggests that the initiation of powerful resets renders redundant the traditional constructs used by investors.

This, in turn, spawns a new generation of winners and losers in the Indian stock market. For instance, 1992-2002 saw the era of the 'licence raj' coming to an end and as a result, 18 of the 30 companies in the Sensex in 1992 were out of the Sensex by 2002.  

While in the short term Modi's resets will adversely impact crony capitalists and rural-demand reliant companies in the cement, auto, electricals, paints, banking and NBFC sectors, the more interesting development will be the emergence of a new generation of winners. My belief is that these winners will emerge from the:

Financial services sector: Currently, two-thirds of India's annual household savings of around $450 billion goes into gold and real estate. As a result, banks and the stock market struggle to attract funding. If the PM's attack on black money is even marginally successful, the cost of funding will fall for banks.  

Agrochemicals sector: As the PM throttles back on the rapid hikes in minimum support prices of food grain seen under UPA-II, we are likely to see more farmers shift towards fruit and vegetables, items that are in short supply. This, in turn, should increase the demand for agrochemicals.  

Export-centric manufacturing sector: Manufacturing's share of Indian GDP has been stagnant for three decades now.

The 80 per cent depreciation of the rupee to the renminbi over the past seven years has given the Indian light industrial manufacturing sector a silent competitiveness boost vis-à-vis its Chinese counterpart.

Now, if the cost of land, labour and capital stabilises, Indian manufacturers will have a better chance of building larger global franchises.  

Tempting as it is to yearn for full-throttle change in India, economies as big as India are hard to change quickly.

Hence, one has to focus on change at the margin because on issues such as black money and manufacturing exports the underlying economic institutions that encourage black money and retard exports will take a long time to change.

What the National Democratic Alliance seems to be kicking-off is such a process of marginal change which, if sustained (and that is a big "if"), could have a meaningful economic impact.

Saurabh Mukherjea is CEO, Institutional Equities, at Ambit Capital

Saurabh Mukherjea
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