The reform blitz of September managed to reverse the reform-logjam that characterised the government. But land acquisition, GST and budget-balancing still need a push

The year 2012 was a year in two parts. A miserable first half when the economy came close to a freefall, followed by a promising second. Hope springs eternal. So despite the gloomy global outlook, fears of the US falling off the fiscal cliff, and lingering concerns over Europe?s problems, one is hopeful that 2013 will be a much better year.

2012, however, had begun on a hopeful note. Coming out of the Christmas break, global investors woke up to the liquidity rush that the ECB?s three-year repo program (LTRO) promised. With the likelihood of any extreme correction in European markets virtually ruled out by the ECB?s LTRO, global investors once again sought out returns and risk. Indian equities spiked from the surge in foreign inflows and the rupee gathered strength. For a moment, it looked as if the mayhem of the previous six months was just collateral damage of the vagaries of global risk that had hit all emerging market economies with current account deficits (Brazil, Mexico, South Africa, Turkey and Hungary) equally hard. With global risk normalising, there was hope that the worst was over.

And then came the FY13 budget. It wasn?t just the incredulous deficit target or the entirely unrealistic revenue and subsidy estimates that alarmed the market and corporates alike, but more damaging was what the budget said about the government?s frame of mind. For almost a year, the government had been shouting from every rooftop that India?s economy remained fundamentally strong, and the relentless slowing of the economy and languishing investment was just an unfortunate fallout of a bad global economy. After three years of persistent economic weakening and no reforms, it was no secret that India?s economy was unravelling and fundamentally corrective measures were needed to stem the rot. What the budget revealed was that the government had started to believe its own myth that all this was somehow Greece?s fault and nothing fundamentally needed to be changed. Added to that was the petulant threat to retroactively tax cross-border transactions and impose anti-avoidance tax rules flouting existing taxation treaties.

The reaction was painful. Equities tanked, investors pulled funds out of India, and the rupee tumbled breaking away from other high-yield emerging market economies. Amidst this gloom the one seemingly silver lining was a sharp drop in inflation. But much of this was due to base effects, i.e. high inflation in the previous year. However, RBI took this as a definitive signal that inflation was finally waning and saw the ambitious budget deficit target as the government?s resolve to reform. And so it cut policy rates after 18 months of relentless tightening. Alas, as many of us had suspected, both the hope of inflation falling and the promise of reforms were soon belied. Inflation returned with vengeance, RBI quickly backtracked, and the government continued to be a silent bystander amidst falling growth, plummeting industrial production, widening current account deficit, and the threat of rating downgrade.

It wasn?t until mid-June that things began to change. The move to make the finance minister the next President opened up the opportunity to form a new economic management team. Much has been written about the dramatic change in the government?s stance since then, but what is less talked about is the change in the economic thinking that the new team has brought along. While previously the space for policy action was seen as strictly circumscribed by the fragile dynamics of coalition politics, the new team felt that the eventual political damage from continued growth slowdown and possible credit downgrade outweighed the risks of upsetting coalition allies. More importantly, rather than collateral damage from the global economic slowdown, it also saw the falling growth, the languishing investment, and the worsening of current account deficit as consequences of the lack of domestic reforms and loose fiscal policy. It was this change in the government?s logic about what ailed India and how far it was willing to stretch the political limits of reforms that underpinned not only the reform blitz in September but also the hope that at least a few critical reforms will be pushed through in 2013 despite the fragile political dynamics, the 10-odd state elections, and the 2014 general elections.

The reform blitz in September is clearly the stand-out event of 2012. What is surprising is that even now the wheat is missed for the chaff. The first set of reforms in September?raising diesel prices, limiting the use of subsidised cooking gas, and FDI in multi-brand retail?was largely symbolic. All three reforms were political lighting rods, and it is quite likely that the government chose them precisely because they were politically sensitive to demonstrate that it had decisively broken away from the practices of the previous two years. It was meant to demonstrate a new-found political will and establish that the label ?policy paralysis? which been conjoined with the government over the past two years did not apply to the new economic team. Ironically, the harder the Opposition pushed back on these reforms, including as recently as the winter session of Parliament, the stronger it demonstrated the government?s resolve.

There were, however, some far-reaching reforms that the government slipped in during the reform-a-day blitz in September. Consider the launching of direct electronic cash transfers. Built on India?s ambitious biometric identity card programme, the programme envisages delivering all household subsidies in the form of bank transfers. This is game changing. Not only because it can markedly reduce the government?s subsidy bill and help avert a rating downgrade but also because it can change households? consumption behavior and alter local politics. Stories of widespread leakages in the existing subsidy delivery mechanisms are rampant. Even if half of these stories are true, significant sections of the population have gained from these leakages. With cash transfers, these beneficiaries stand to lose significant income. But we haven?t seen any real protest from them so far. Perhaps it is because of the scepticism about the government?s ability to implement the scheme. This scepticism, in some sense, is justified given the sheer enormity of the task. My guess is that this is one area where the government?s political and economic interests coincide and thus we just might just see the scheme implemented faster than we think.

There are two other such reforms hoping to see the light in 2013. One of them is the Land Acquisition Bill that was approved by the Cabinet last month. One of the biggest constraints on large project execution is undoubtedly land acquisition. CMIE estimates that investments worth R5 trillion were shelved in FY12, twice as much as after the Lehman crisis. Of these, the top 20 accounted for over 68% of the total value and half of them were shelved because of land acquisition bottlenecks. Today, land acquisition is governed by an 1894 Act with a compensation, resettlement and rehabilitation framework that has been long held to be neither fair nor equitable. While the new draft Bill has been criticised for being overly onerous on industry and is likely to raise the cost of acquiring land, at least the implementation risks will be reduced bringing much-needed certainty to projects.

The other is the national goods and services tax (GST). If implemented, for the first time India will have a single unified consumer market and a tax base capable of delivering significantly higher revenue, addressing the second key concern of the rating agencies. But this requires the Opposition?s help to be passed. There is really no technical impediment holding up the GST, just the fear in some quarters of doing so before 2014 elections. The big fight over GST has already been fought when states implemented VAT back in early 2000s. An easy compromise is to pass the needed constitutional amendment in the budget session, but hold back implementation till a new government comes into power in 2014. Hopefully, both the government and the Opposition will see past their self-interests and do the right thing.

If these Bills are passed, then, along with a sensible budget, 2013 may well see modestly higher growth. But these measures are unlikely to put the economy on a high growth path. In the heady days of 2003-08 when India grew at 9%, we did not pay much attention to the institutions that governed the economy. Unfortunately, a slew of sordid corruption stories have raised the spectre whether the surge in investment and growth in the mid-2000s was largely delivered through under-pricing resources and flouting regulations. This impression, rather than high interest costs or lack of approvals, has been the binding constraint to a turnaround in corporate investment. Reversing the perception requires difficult second-generation reforms. The cash transfer scheme, the Land Acquisition Bill and the national GST are few examples. But what is lacking is a national debate on the core elements of such a reform agenda. Rather than trading charges on what went wrong and who was responsible, the rising public indignation needs to be tapped to begin a national dialogue on the shape and form of India?s new institutions. One would place a permanent fiscal responsibility act that commits the government to hard-budget constraints; a framework to transparently price public resources (not just auctions); and a transparent set of election-finance rules very high on such an agenda.

The author is the senior Asia economist with JP Morgan Chase