This May, unlike the normal lackluster Mays (“sell in May and go away”), proved to be very exciting as expected. The NDA got a resounding mandate to rule for another 5-year term. On 20th May the Nifty responded to exit polls by zooming 3.7 percent or 421 points to record the best performance in 10 years followed by profit booking on actual results on 23rd. Both Nifty and Sensex touched record highs. Further trend of the market will depend on corporate earnings, which in turn, hinges on the performance of the economy. If the economy is to accelerate, the new government will have to manage some major challenges that the economy faces and implement the much-needed reforms.
Managing the macro headwinds
During the last five years India has been in a macro sweet spot. The favorable global environment, soft commodity prices, fiscal consolidation and declining inflation strengthened India’s macros. Sustained FPI flows helped finance the CAD. This benign environment is unlikely to continue and there are signs of trouble looming on the horizon. The shortfall in tax collections in FY2019 means that the fisc is more expansionary than what the budget figures suggest. The NBFC crisis and the liquidity squeeze in the economy have severely impacted some segments like autos. This has started impacting economic growth.
Addressing the growth slowdown
The biggest challenge facing the government is the growth slowdown. We might clock a GDP growth rate of around 7 percent in FY 20. This might be one of the best among the large economies in the world, perhaps the best, but would be well below our potential and woefully inadequate to realize our goals. The global economic environment is not favorable with global growth slowing down to 3.3 percent in 2019 from 3.6 percent in 2018 (IMF projections).
When there is a growth slowdown, the standard response is to stimulate growth: through monetary stimulus by the central bank and fiscal stimulus by the government. But monetary stimulus (the RBI reduced rates twice so far in 2019) is not producing the desired effects since monetary transmission is constrained by the liquidity squeeze in the economy. On the fiscal front, high fiscal deficit leaves little elbowroom for the government to provide the stimulus. This calls for structural reforms like land and labor market reforms even while addressing the liquidity squeeze and fiscal concerns.
The slowdown is sharp in segments like autos. But this is cyclical rather than structural and therefore can be managed by addressing the main cause of the problem. A major cause of the slowdown is the NBFC crisis.
The NBFC crisis
During the last several years, the NBFCs have been playing an important role by providing credit to retail and SMEs apart from their traditional strength in the hire purchase market. During the last few years, NBFCs accounted for almost 70 percent of the borrowings in the corporate bond market. The surge in credit growth by NBFCs was helped by the capital constraints experienced by the PSU banks. The NBFCs, in turn, were mainly funded by the mutual funds, which benefited from huge inflows following the financialization of savings triggered by demonetization. The IL&FS crisis and crisis triggered by defaults by some corporate groups have snowballed into a major liquidity squeeze impacting lending in sectors like autos. The RBI has to initiate measures to address the NBFC crisis and ease liquidity. This is absolutely necessary for revival of demand in crucial segments like autos.
The RBI did play a pro-active role by cutting rates twice in succession, liquidity infusion through OMOs and dollar swaps. But more needs to be done to repair the jammed liquidity situation in the system.
Reforms in land and labor markets
As mentioned earlier, it is time the government focused on some important structural issues. Some major constraints in accelerating India’s growth rate relate to the land and labor markets. Infrastructure development needs large tracts of land. Fast acquisition of land helped China develop world-class infrastructure in a short period of time. We cannot be like China since Indian laws relating to land and property are different from China’s. But the process needs to be speeded up. The prohibitive cost of land also is a constraint.
Similarly labor market needs urgent reforms. With the right kind of labor market reforms India can create large number of jobs in manufacturing. China is now a middle-income country with a per capita income of more than $9000. With rising wages China will be forced to move away from many labor-intensive segments. Vietnam and Bangladesh are exploiting the opportunity created by the exit of China by setting up huge manufacturing capacity. India stands the risk of missing the bus because of her restrictive labor laws. Therefore, reform of the land and labor markets has to be a top priority of the government.
The data transparency challenge
Compilation of data, like the GDP estimates, in a huge and complex developing country like India has always been a challenge. Even though there were academic debates relating to methodology etc in the past, never before has the authenticity of the data been questioned, like presently. Policy decision-making requires authentic data and therefore it is important that the integrity of our statistical institutions is established beyond doubt and crucial economic data becomes transparent and is of high quality. An independent statistical body comprising of highly respected professionals should be entrusted with this task and this should be a top priority for the new government.
Addressing the rural distress
Around 50 percent of India’s workforce is employed in the agriculture sector; but produce only 16 percent of our GDP. This is the root cause of the rural distress. Farm incomes have to be raised and this is possible only through government intervention. But interventions have to be of the right kind. DBTs like PM Kisan are the right steps. Loan waivers are the worst form of competitive populism cutting at the root of healthy credit culture. Along with short-term measures to address the rural distress we have to initiate long-term measures for shifting the surplus labor in agriculture to non-agricultural activities.
Banking sector reforms
There are other areas that call for reforms, like the banking sector reforms. No country in the world, except China, has 70 percent of banking under government ownership. PSU banks (Rs 82000 crores losses in FY2018) with their huge NPAs have imposed a great burden on the economy and have become a major strain on government’s resources. The huge resources spent on recapitalization of PSU banks could have been spent much better and more productively on infrastructure, education and health. Even though the political acceptability of banking sector reforms is doubtful a strong government with political will can pull off a major brave structural reform in this area.
The hope factor
The market in the short-term will be driven by sentiments and in the medium term can be substantially influenced by hope; but in the long run earnings would dictate the market trend. If the government initiates the much-needed reforms, that would lead to turn around corporate earnings and pave the way for sustained earnings growth for an extended period of time. This hope can sustain the bullishness in the market even at high valuations. But at high valuations, the risk of a sharp correction triggered by a domestic or external factors, also is very high. So investors should be guarded. There is room for optimism; but unbridled euphoria is not warranted.