No early nirvana on GDP: 7% growth is at least two years away, even with reforms

Last week the GDP numbers for the second quarter of 2014-15 (July-September) showed a dip to 5.3 percent, down from the previous quarter’s 5.7 percent, which many in the NDA government prematurely claimed to be a sign of revival after Narendra Modi took over.

The truth is different: beyond sentiment and stock market valuations, there has been no revival of any kind that is showing up in the data. Even though the Modi government has started making incremental changes - more on the procedural and transparency fronts than on the reforms side - there is always a lag between positive action and a real turnaround. More so when the economic legacy left behind by the UPA is terrible.

Just as it takes a lot of time and effort to ruin an economy, it takes equally as long to improve it. The UPA did not run the economy into the ground in its last one or two years. It took consistent effort - like letting oil subsidies build for nine years to a massive Rs 8.3 lakh crore before trying to correct it all in the last year. But the biggest damage to future growth was done in the last year of UPA rule, when the Land Acquisition and Food Security laws were passed. These will be difficult to undo without legislation. Bad laws are always the toughest to remove, for they are populist in nature.

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Given this backdrop, sustainable revival is not going to happen in a year or two. This year (2014-15) will, of course, be better than last year’s 4.7 percent growth at around 5.5 percent, and next year (2015-16) we will see GDP head towards 6 percent (assuming the monsoon is not a disaster). But an eye-catching 7 percent is not going to happen till 2016-17. And all this is predicated on the assumption that next year’s budget will be good and incremental positive changes keep happening every month.

The main reason for my pessimism on growth is not the specific bad policies of the UPA, but the aftermath. A bad policy, especially one that requires no legislation, can be fixed pretty fast, but the downdraft resulting from it can linger for years.

For example, the centre’s decision to opt for retrospective legislation to claw back taxes on the Vodafone deal to buy Hutchison’s local telecom operations has set back investor confidence by years. To regain it, the centre has now to sacrifice even more of potential revenues. Recently, Vodafone and Shell won their transfer pricing cases in high courts. The finance ministry is unlikely to appeal against these judgments despite a potential loss of revenue running into several thousand crores each.

Finance Minister Arun Jaitley is paying prospectively for Pranab Mukherjee’s retrospective sins.

Then, there are the after-effects of various scams. While the 2G mess was cleaned up by the UPA itself by holding transparent spectrum auctions, the net result is high debt in the telecom sector. Fresh telecom investment will go largely into buying spectrum.

The coal block allocations that were overturned by the Supreme Court will take two more years to sort out. Not because the de-allocated blocks cannot be auctioned - that will happen early next year - but because large segments of industry and banks that lent money to them are stuck with losses.

The lasting damage left behind by the 2G and Coalgate scams is a huge accumulation of debt on corporate balance-sheets and humongous bad loans on banks’ books. The process of deleveraging and cleaning up balance-sheets means revival will be delayed. Revival has to be driven by fresh investment, and fresh investments need promoters to bring in more equity, and banks being willing to lend. Neither of that is yet beginning to happen.

Another roadblock to a quick economic turnaround is public expectations about transparency and clean money. This imposes its own costs on the economy. A less corrupt and transparent system is good for the economy in the long-run, but it also means growth will be slower in the short run.

If you sell spectrum and coal mines by auction, both telecom services and power costs will be costlier. If the increased costs are not passed on to consumers, they will lead us to the next fiscal mess - for power subsidies ultimately have to be borne by the stats and centre. Power and infrastructure companies are the biggest drags on the economy right now.

The Supreme Court has added to our fiscal problems by creating a SIT to ferret out black money. This not only cramps the ability of corporates to find flexible funding for fresh investment, but also prevents the government from offering an amnesty scheme for black money, both to collect more tax revenues and to get the money idling outside invested in India.

If black money is not going to come in, we will have to wait longer for the investment cycle to restart.

The only way to raise growth is by doing the following:

One is to increase government capital/plan spending immediately by either relaxing the fiscal deficit target to 4.5 percent (from 4.1 percent indicated in the budget) or by selling more public sector equity. This will help revive growth from sometime in the April quarter of next year.

To compensate for the higher fiscal deficit, the government should take an axe to revenue deficit by cutting subsidies. The focus of the next two years should be unproductive revenue deficit, which this year will be around 2.9 percent of GDP. Interesting fact: this figure has practically not budged from the 2004-05 figure of 2.7 percent - in fact, it is worse despite years of grappling with deficits.

The other low-hanging fruit available to the government is precisely the one it has refused to eat: privatising capital-hogging banks.

Minister of State for Finance Jayant Sinha told parliament the other day that bringing down the government stake in public sector banks could generate nearly Rs 90,000 crore, but this is neither here nor there. It will only kick the can down the road for another year or two. After which government will either have to put in more capital or privatise. So what is the need to keep so many banks in the public sector? Modi has to abandon his private hang-up about privatisation in the interests of economic revival.

The third way is to raise FDI in as many sectors as possible. This is, of course, happening, but a lot of the FDI will not come without two important legislative reforms: labour law and land law. Without more land at reasonable rates, no investment will come into manufacturing, which is the sector that is in the doldrums. Infrastructure, which is vital for growth, will also not happen. Infrastructure needs even more land than factories. If land and labour laws are not changed, FDI will flow only to areas that are not dependent on them - like IT, e-commerce or services. This is already happening. Whether it is Flipkart or Snapdeal or taxi services like Olacabs or Uber, foreign investment is flowing into services. Growth will be lopsided in services - but even this cannot be sustained as logistics (the key to services and ecommerce) needs physical infrastructure for delivery.

To revive growth, the Modi government must thus be prepared to do deal with the devil. It has to get Congress and regional party cooperation on key legislation and pay the political price for it - whether it is by offering Congress Leader of Opposition status in the Lok Sabha or allowing sweetheart political deals to the regional parties.

Even if all the legislation is passed, growth will still be several quarters away.

Modi and Jaitley have no time to lose. And here’s a counter-intuitive reason they should chew on: if India Inc is waiting for reform, it is possible that many of them are holding back planned investment waiting for something better. At some point, they need to know for sure what is coming by way of reform. Mere hints of something better round the corner may itself be resulting in a delay in investments.