Missing the woods for the trees

When the crisis first broke out, the first ?new normal? was that emerging markets were de-coupled from the developed countries and they would remain unaffected from the events unravelling in the Western financial world.

The next new normal became a ?three-speed? global economic growth? with emerging markets still recording the fastest growth rates, the US beginning to show some signs of recovery and the EU continuing in a recessionary mode. Then came the big doomsday?May 22, 2013?when Fed Chairman Ben Bernanke hinted at the possibility of a tapering of QE3, which would reduce the pace of $85 billion worth of bond purchases each month. While he articulated this would not happen before the end of 2013, it nonetheless sent markets into a complete frenzy. Since then, most emerging markets have seen massive sell-offs and many of their currencies have had a free fall.

It is difficult to comprehend why there has been such widespread panic and why markets have been so irrational. No doubt, the US economy is showing signs of improvement. US GDP growth has strengthened, government debt levels are expected to stabilise and there has been a recovery in home prices. However, unemployment rates continue to be high at 7.6% and the Fed has reiterated its stance that it would not increase interest rates till unemployment levels fall to at least 6.5%. Unfortunately, markets have aggressively priced in the withdrawing of QE3. As a result, US 10-year bond yields have risen sharply within a month?s time from a low of 1.6% to over 2.6%. With the US dollar strengthening and bond yields hardening, carry trades are being unwound. The massive selling of bonds in emerging markets has in turned spilled over into the equity markets, causing more widespread panic. It is important to understand that the tide is changing in a number of emerging markets?but the reasons vary from country to country.

So the key question is how is India placed within this global chaos? There is a growing view that when the dust settles on global volatility, India will stand out amongst others. But this does not take away the fact that the present volatility has left India extremely vulnerable.

If I were to look at the past 12 months and assess the Indian economy, I would say that the reining in of the fiscal deficit was probably amongst the government?s best achievements. That the fiscal deficit last year finally came in lower than expected at 4.9% of GDP was a pleasant surprise. Bringing the fiscal deficit under control was extremely important otherwise India could have been downgraded by international rating agencies to junk status. This would have triggered a huge foreign investment outflow since many funds, mainly pension and endowment funds are only allowed to invest in countries that are investment grade and above. While much of the fiscal deficit target was achieved by severely curbing government spending, one must appreciate that the measures taken on the phased increases in diesel prices and curbing the number of subsidised LPG cylinders were bold measures to reduce subsidies.

Today there are once again visible green shoots in the Indian economy:

* India received a rating outlook upgrade from negative to stable from 2 international rating agencies;

* Inflation has steadily trended downwards to 4.7%, which is the lowest since October 2009. The consumer price index is still high, but there is generally a lag of 3 to 5 months before the CPI starts to trend in the same direction as the WPI;

* There is a pick-up in public sector capex and investments (though private sector capex plans are still to pick up);

* There is greater resolve to sort out issues pertaining to coal & gas pricing; and

l The Project Management Group constituted by the Prime Minister is now to meet on a weekly basis with the respective developers to clear projects. 30 projects have been taken up for immediate action and more should follow. This will get the investment cycle moving again.

For a long time, industry has been urging RBI to reduce interest rates. It is important to understand that a mere reduction in interest rates is not a panacea for the woes of the Indian economy. Monetary transmission in India has been slow for a variety of reasons. When RBI reduced repo rates, most banks were unable to reduce their rates by the same proportion. Part of the reason is that bank deposit growth has remained muted, having grown by only 13% in FY 2013 compared to over 15% in FY 2012. And if deposits do not grow, banks don?t have enough credit to give out as loans. Again when inflation was high, the real rates of return on fixed deposits were negative. As a result, one has seen a change in the savings pattern, with a rise in physical savings such as real estate and gold and consequently a fall in financial savings. With inflation slowing coming down, this saving pattern should gradually reverse.

Today, India?s key vulnerability lies with its CAD. India had a CAD of around $90 billion last year, of which just $23 billion was financed through FDI. This makes India more vulnerable to volatile FII flows. Further, India?s forex reserves at $290 billion now covers 7 months of imports compared to 15 months in the pre-crisis period when the economy, capital flows and the rupee was much stronger. The rupee has depreciated over 10% within a month?s time. While some solace may be taken by the fact that many emerging markets have also seen a free fall in their currencies, the sharp fall in the rupee leaves India in a precarious position.

Between January to May 21, 2013, FIIs had invested close to $5.6 billion into the Indian debt market. The FII debt sell off within the last four weeks has virtually wiped off the entire inflow in the year so far. My gut feel is that this volatility will settle down. The equity markets have not seen as furious a sell off as the debt markets have. The moot point, however, is that the Indian markets need to be deeper with a wider investor base and needs stronger support from domestic institutional investors and retail investors. A diversified investor base prevents dependence on one investor class and thereby helps insulate markets in volatile times.

Nonetheless, India has to get its house in order to encourage more FDI. This is not something new or radical, but the timing cannot be more imperative. The point that has to be driven home is that India is vulnerable on its external sector. No one disputes that FDI needs to encouraged. The recent recommendations of the government to review and open up various sectoral caps on FDI is laudable. Finally, some sense seems to prevail that sectoral caps (barring a few sensitive sectors) have little reason to exist the way they do. For instance, a 26% shareholding allows an investor to veto special resolutions, while a 51% shareholding allows majority control. Given that a foreign shareholder?s rights do not change between 26% to 49%, the government should be indifferent to shifting a 26% FDI cap to 49%. The advantage here is that a foreign shareholder will be allowed to bring in more capital into the company and this would help in expansion and growth. The same logic can be extended for FDI caps of 51% to be increased to 74%. The recommendations of the committee are good, but this is a classic example of missing the woods for the trees.

The bigger and more critical problem at hand is the manner in which the government is handling foreign investment proposals. On one hand, ministers go all out to woo foreign investors, on the other hand almost every large investment that has required FIPB approval has either got stuck or has been delayed for want of a clear policy framework. And this is in almost every sector whether it is aviation, telecom, multi brand retail, pharma or financial services. Each ministry appears to be pulling in different directions and there are far too many vested interests. Especially at this juncture, India cannot afford to dilly dally on FDI. It has to be a top priority and the manner in which FIPB functions needs a complete revamp. India can no longer afford the attitude that ?foreign capital needs India more than India needs foreign capital?.

Recently, many of us have become perennial pessimists. Yes, the Indian economy is struggling on many grounds whether it is getting its infrastructure in place, policy uncertainties, corruption scandals, coalition politics and of course, growing uncertainties with the impending general elections in 2014.

Yet we need to keep reminding ourselves that the fundamentals of the Indian economy are very much intact?a young population; growing middle class; rising aspirations; better job opportunities; and rising disposable incomes.

I do believe that India has a lot going for it, but certain structural changes are needed. I think our biggest failure today is that we have allowed ourselves to become immune to corruption. I have always been a strong advocate that India must have an act similar to the UK Bribery Act, 2010 wherein it is a criminal offence for both, the giver and taker of a bribe and it is also a corporate offence if a business is found to have failed to prevent bribery. Such an act is increasingly important to have, especially since the manner in which bribes are being given and taken in India have changed dramatically. Today, a number of bribes are being channelled through sophisticated corporate deals, which prima facie look like normal investments, but are in companies that are backed by those in power. These funds are in actuality pay-offs in return for various favours. Such transactions are harder to detect, but what is worrisome is that the amounts involved are stupendous.

As citizens, we have to keep championing for better governance. India is expected to have about 800 million people on its electoral rolls, of which 110 million comprise youth born post 1990, who have become eligible to vote in 2014 elections. The desires and ambitions of the electorate are shifting. They would rather prefer jobs, opportunities, income and growth over vote buying sops which in any case rarely get to them. The faster political parties recognise this, the better is the future of India. If one looks at the outcome of various state assembly elections, governments that have delivered on growth have been voted back and those that haven?t have been given the boot.

The leaders of this country have to accept that economic reforms in isolation cannot bring about long-term growth. Without a strong emphasis on judicial, electoral, police and labour reforms, India?s true potential may not be attained.

To conclude, India as the world?s largest democracy is both, a boon and a bane. Encouraging debate and dissent is the good aspect of our Parliament, but continuous disruption which prevents Parliament from functioning will keep bringing us down. There are 116 legislations pending in Parliament. The passing of at least some of crucial bills will enable India to get back to an 8 to 9% growth trajectory. We cannot afford to continue in this manner any longer.

Excerpted from Deepak S Parekh, chairman, HDFC Ltd?s speech at Gujarat Chamber of Commerce & Industry, Ahmedabad, June 29, 2013