Demonetization: recession at gate or GDP at 9%

Update 1: 12 Dec 2015 :

1. 34 days have passed since the announcement by PM Modi and as expected almost all of 14 lakh cr is going to be deposited in line with my prediction. India is a jugged country and people always figure out a way to beat system due to our long history of surviving in a hostile system.

2. I still stand by positive contribution to GDP but all assumptions were based on the idea that the situation will normalize in 10-15 days. As of now, it is not looking to normalize even in the next ½ months and hence impact is going to be negative now.

3. Big lesson – Indian middle class – bureaucracy, bank officials etc will boomerang any big reform and hence its high time output focus on reforming them.


Demonetisation has happened. 500 and 1000 rupee notes are banned. There are serpentine queues outside banks / ATMs and experts are busy. There are high pitched videos, columns, tweets and Facebook posts by every expert about how poor are hurt and how this will kill the trade. Roll back demands are being made from every armchair economist, citizens dining in five-star hotels but extremely concerned about poor, many chief ministers. Overall air of the nation is thick with not only smog but also with pro-poor and small business friendly experts and politicians.

There is a view propelled by a gang of astrologers masquerading as economists that demonetization is going to hit the hard economy as cash will be sucked out of system and trade will stop. This hypothesis does ring true if one notices the plugging sales at e-com ventures, lack of crowd in markets and drop in footfalls at malls. No wonder all Captain Obvious is at top of lungs on the incoming slowdown hitting Indian economy due to this demonetization.

History tells us that events rarely follow an obvious path and are shaped by unforeseen and unpredicted. Demonetization is such an event. It is not going to slow down the economy but going to put this economy in the high pedestal of growth. A jump by 2% to 3% in GDP if not more by demonetization is very much possible and for the first time in the world, we will see trickle up effect in the economy than usual trickle down.

The first foremost and obvious effect of demonetization is the elimination of the cash economy and shift towards banking system. Lot of people even without illegal money were not using banks and were saving in cash at home for a variety of reasons. Now all this money will go informal banking channels and will find its way to formal earning mediums like mutual funds, fixed deposits, savings accounts etc. This will create a push and boom as the cash lying idle at home will be at work and will create a contagion effect. Those dormant Jan dhan accounts will now be kicking with life and in a big way. Even if  10% cash lying idle at the household level, translates into 1.4 lakh crore ( $ 21 billion). Now this $21 billion will be available in the banking system and hence available to Govt/ Industry to kick-start new projects / build infrastructure. To get a relative perspective, FDI inflow in India in FY2015-16 was $40 bn while in FY 2014-15  it was $30 bn so the amount coming from dormant accounts to banking system alone is 53% of this year FDI and almost 70% of FY14-15 FDI.

The second kicker to the economy will come from fall in real estate prices. As per experts and general perception, real estate prices are going to fall by 20% to 30% in general (a black component of a deal). In India, in FY 2015-16, if one just takes top 8 cities, $14 bn worth (90,000 Cr) was invested in the real housing ( 3 lakh houses in 8 cities at a 30 lakh average price though in real numbers are much higher). As per experts, real estate prices are expected to crash by 20% to 25%. This drop in prices even if we take 50% drop in a number of transactions will leave more than 9000 Cr ($1.3 bn) money at the hand of these end users in just 8 cities and this amount will be 10x higher if one account for the whole country. This extra cash available with the consumer will go in other discretionary consumption and will either build the saving rates or drive consumption of services as well as consumable goods.

The third and not so obvious kicker will come from the attempt of all back money hoarders trying to convert it in white. As per data released by RBI, India has 14 lakh Cr ($ 210 bn) in circulation in 500/1000 bank note denominator. For a moment if we assume on a very aggressive basis that 50% of it is white and declared income ( fully tax paid), still there is INR 7 lakh Cr ($105 bn) in black money. Now, these cash hoarders will try to use people with low income to transfer 2.5 lakh into account. Now as per financial ministry data, India has opened 25 Cr (250 million) Jan dhan account for poor people as on today. Now if black money hoarder were able to use 50% of these accounts (12.5 Cr) to deposit cash in Jan dhan bank accounts, one just needs to deposit INR 70,000 in each account. So apparently all this cash will flow back in the system in next 50 days without any collateral damage to these money bags. However, the cost of organizing this deposit program will range anywhere from 20% to 40% ( as per the figures being circulated in media/social media). Even if we take a nominal cost of this transaction at 10% being paid to these Jan dhan accounts(against 30%), it will be a commission of INR 70,000 Cr ($11 bn) ( 10% of 8 lan crore) or 8,000 per Jan dhan account (12.5 Cr). This 8,000 will immediately find its way to consumption as this is massive cash for these account holders and even if just 50% is spent, Indian economy will see pumping of $6 bn (40,000 Cr) being spent in next 3/5 months. This class will binge on clothes, consumer goods and will create a massive multiplier effect. However for the first time multiplier will not trickle down but will trickle up as rural or low-cost goods will drive the industry. So in a way, PM Modi has imposed huge wealth tax on the rich people and accomplished direct cash transfer to poor people.

Foreign investors pumped $10 bn in 20 months in Indian startup which put India on the world map as a top 3rd country for startups and changed the whole mood of the nation while creating many multi-billion enterprises. Payout of $6 bn in arrears to Govt employees in 2008 as per sixth pay commission, triggered a consumption boom in India and insulated it from the economic crisis which impacted every country. Hence this total amount of $40 bn hitting the banking sector/consumption in next 3/6 months is not just going to finish the black economy but going to put India on an autobahn of economic growth.

PM Modi in his usual total out of box thinking, has just put India on growth orbit of a different level where a minimum jump in GDP by 2% to 4% is not ruled out.

Gear up, the age of India has arrived.

Namo Namo

This article appeared at Times of India here.

GST and the end of hope

“Road to hell is paved with good intentions.”

GST – good and service tax, summed as India’s biggest tax reform in the last many years, is finally here. GST empowered committee in one of their last meeting, finalized rates on pending items with Gold getting taxed at a new rate of 3%. The empowered committee other than creating an additional layer of tax also proposed to impose levy/cess etc beyond specified 5 slabs of taxes.

Multiple tax rates, levy, cess, additional taxes!! It seems that somewhere the present Govt just lost the plot and caved into interested parties by enacting the same complicated rules as they were there before GST. Somebody summed up the situation correctly saying that it would have been better to rename the existing taxes as GST rather than going through this administrative nightmare.

If the multiple rates are not enough, Govt has gone ahead and created, even more, confusion by having multiple rates within a single service i.e. look at multiple tax rates at hotel rooms. Zero tax for rooms up to INR 1000, 28% on rooms above 5000 and few more slabs in between. These multiple rates are going to create litigation, an opportunity for corruption and money laundering. For example, a room priced at 999 for two people, get triple occupancy and now move to 10% tax bracket. The customer not willing to pay additional tax will force hotelier to adjust and hotelier, in order to not lose business, will accommodate and end up doing a crime which was not needed.

Adam Smith, the revered economist said that for taxation to be helpful in building nation-state, it needs to have three things in place. First, tax rates shall be reasonable. Second, it shall be easy to pay taxes and the third penalty shall be severe in the case of noncompliance.

If existing tax regime in India was the antithesis to all of three preambles of an efficient tax structure, GST has made it even worse. Multiple tax rates, the filing of tax report every month and on top of it almost draconian powers at the hand of tax officials.

It seems Indian govt is not working to create “ease of business” but is rather trying to ease out small businesses. For example, a trader has a turnover of 30 lakh will come under the ambit of GST and will have to do all compliance including having service of some CA firm which seems reasonable. However, a turnover of 30 lakh will hardly generate a net income of INR 30,000 to 40,000 even at 10% net margin. Can a person earning 30,000 per month, afford all IT infrastructure and have the mental capability of accounting for multiple rates, adjustments, input credits? Can he or she afford the services of a qualified CA to do all paperwork? While life becomes massively complicated for small vendors, it becomes a nightmare who is operating in multiple states. If a company was filing some 15-20 returns a year, it will be now filing 400 returns a year!!

Probably this explains as to why Business papers / Indian Inc, leading consulting firms and Share market are going gaga over such complicated GST regime. GST by virtue of complex compliance regime will wipe out small/informal business in one stroke and will shift all the market to big organized firms while at the same time simplify business/tax rates to a great extent for big businesses. This will boost the income of organized sector, will create more wealth for big players and boost GDP for sure but will also render all small businesses out of circulation. We might see a replay of the present scenario where SENSEX is creating new record every day and India is among the fastest GDP growth nation but there are no jobs!! This push by present complex GST system will create massive unemployment and will open India to global shocks as the informal business will not be there to absorb millions of youths looking for jobs every year.

Hence one wonders what is the intention of Govt behind GST? Off course one aim was always to plug the leakages, collect more taxes (8th Pay Commission is due) but why no attempt or thought to simplify life for small businesses.

Conspiracy theories among us will jump and say that it has been planned by big business to rob the informal sector etc. However, it seems that it is more a case of Hanlon Razor (Never attribute to malice that which is adequately explained by stupidity) than anything else.

Every year Govt leaders/bureaucrats tour developed nations showcasing India and pleading for investments while offering many sops to companies and one wonder why not same sops to SMEs in India? Free industrial land, no inspector raj, freedom from onerous compliance and one window scheme for starting the business?

Rather than simplifying life for small businesses, every move of the Govt is aimed at creating more litigation, collect more taxes while doubting every step of small businesses with zero trusts? Why a democratic govt chosen by popular vote, would like to make life more traumatic for the majority of its citizens (share of the small business / informal economy is far more bigger in India compared to OECD countries)?

The answer does not lie in NDA or UPA but is hidden in India’s history. India which was ruled for almost 1000 year by foreign rulers always had laws which were designed to rule and not to govern.  The rulers (foreigners with no empathy for local population) wanted to collect maximum taxes to fill their coffers ( look at growth in British GDP and decline in Indian GDP from 1800 to 1947 or wealth of Mughals who came on a bare horseback to India). Moreover, the rulers and their agents have a very low view of natives and minimal trust ( all are thieves).  This led to the creation of a governance model which was heavily rule-driven with an idea to plug any possible loophole with maximum power at the hand of the government servant.

Unfortunately post-independence, rather than building a nation for Indians, the new government just continued with the traditions/rules of Britishers (that was worst crime of Pandit Nehru) and maintained the same thought process of the rule rather than governance. This policy ensured that Indian businesses crawl only with the burden of compliance/bureaucracy/inspector raj sitting on its head.

In 2014, the election of Narendra Modi who had no baggage of Western training led to a faint hope that India will finally see freedom from the British rule in theory and practice. The shackles of bureaucracy will be broken and laws will be made with a focus on governance rather than the rule. Unfortunately, rolling out of GST in its present format has shattered all the hopes. If a Right-wing party led by a strong PM almost with Superman image, cannot tackle bureaucracy and can not usher Regan era in India, then no will.

Hence the hope that India will be able to cut its past of 1000 years of slavery, move forward and join the league of big nations has dashed against reality.

GST in a simpler form would have ended the tyranny of tax officials/bureaucracy, unlocked the real potential of Indian business crippled by inspectors raj and would have taken India to another level of prosperity/wealth while creating millions of jobs and boosting consumption.

Sadly, the hope has ended, God Save the King.

Raghuram Rajan Controversy: Why Subramanian Swamy HAS a Point

There is a sense of anger among Indian intellectual class, stunned by the demand made by Dr. Subramanian Swamy for the sacking of Dr. Raghuram Rajan – the most respected, ever charming, hottest RBI Governor India has ever had. From Shobha De to newspaper editors to the average Joe, Dr. Raghuram Rajan commands a following rivaling that of Salman Khan.

Not only analysts, commentators and financial daily editors have come out in support of Dr. Rajan, but the even common public also seems to be completely unanimous in their support of Dr. Rajan and all the good work he has been doing for the Indian economy. Going by the number of editorials/articles and public forum comments posted in support of Dr. Rajan, one can easily conclude that India is in safe hands, or at least perceived by the general public to be in safe hands.

There is no denying the fact that Dr. Raghuram Rajan is one of the finest brains when it comes to Economics. Applauded by some as one of the very few economists to warn about 2008 crisis much ahead of the time, he is widely respected and credited with a sound understanding of complex macroeconomics issues.

The last time a central banker got so much respect and public support was Alan Greenspan in the 2002 era. The other Economist, who got so much respect from Indian public/experts/intellectuals, was Dr. Manmohan Singh as India’s PM in 2004-09 era. Needless to say, public opinion is hardly the right barometer for gauging long-term impact if one goes by the disdain both these gentlemen now attract from academia and the general public alike – as public opinion, fickle at best, is always swayed by perception rather than hard facts.

The arguments made in support of Dr. Rajan are multifold and cover almost every possible ground to demonstrate how Rajan is the best man for the job and how wrong is Subramanian Swamy. The main arguments given by supporters of Dr. Rajan are as follows:

1. Dr. Rajan has been able to keep inflation under control by keeping interest rates high initially and didn’t succumb to political pressure (greatest virtue in the country of Singham). This hard stance towards inflation kept cheap money out and didn’t allow the buildup of another sub-prime scenario in India.

2. He has cracked open the NPA issue of banks and brought out the muck in open. This cleansing of bank balance-sheets will usher in a new era of transparency and will fix the nexus of politician-banker-bureaucrat forever, as the public sector banks are the primary source of crony capitalism and high real estate prices in India.

3. He has published far more papers than Dr. Swamy and is cited / peer-reviewed many times more compared to Dr. Swamy.

4. He is very well respected by International media and considered to be one of the best brains in Economics

5. He is a far better economist than Dr. Subramanian Swamy who is more of a lone ranger/fringe politician.

All the above arguments seem quite valid on the face of it, but then keep in mind that the criticism of Raghuram Rajan is not made by some usual analyst but none other than Dr. Subramanian Swamy – one of the sharpest brains around with an enviable track record of proving his points. So rather than jumping in defense of Raghuram Rajan, it is much better to have a deeper look at the critique, since Dr. Swamy has a reputation of not making false claims without support from necessary data. So rather than debating on issues like nos of papers published, who is the better economist, etc., let us focus on the major issue of interest rates and inflation, which seems to be the bone of contention among fan-boys and Dr. Swamy.

There is no debate that inflation has remained within limits since Dr. Rajan took over RBI in 2013; however, the low inflation has been more of a function of the massive drop in oil prices and commodity prices. Since 2013, oil prices have dropped from the heights of US$ 90 a barrel to US$ 40 a barrel (55% drop). Further, by choosing not to pass this price drop benefit to consumers, Indian govt has been able to manage its high fiscal deficit, which in turn calmed down its currency. Further, Modi Govt has been quite proactive in controlling food inflation by taking quick actions, be it the import of food items or action against hoarders. Hence, to say that inflation in India is down due to strong monetary policy and high-interest rates is nothing but a big myth. In fact, a little bit of movement in oil prices in last quarter has already perked up the inflation.

Hence, it is obvious that the high-interest rate regime has nothing to do with inflation and in fact everything to do with low growth faced by India. Interestingly, everyone has jumped on Subramanian Swamy, harping on the fact of rate cuts not passed by banks to consumers and talking of headline interest rate, while totally forgetting that Swamy is not talking of main interest rate but interest rate available to SME sector.  Interestingly, while interest rates for large corporate hover around 9%, interest rates for SME sector hover in the range of 16% to 22% and no attempt has been made to bring down this rate.

Worldwide, and especially in the Western world, monetary policies are effective tools to manage inflation; however, the economists trained in Western view need to understand that India is not West and does not have the luxury of enormous resources or well-oiled supply chain. Inflation in India is not a function of more demand but supply-side constraints, which become worse with higher interest rates and crony capitalism. So far, not only has RBI failed in bringing down overall lending rates in the general economy, but it has also not worked on main inflation which is plaguing middle class and poor in India.

Unfortunately, all discussions related to inflation in India revolve around food prices, while in actual the bigger share is consumed by the housing sector. On an average, almost 34% of a household income goes towards meeting the housing cost (Rent/EMI), and thanks to liberal policies/crony capitalism indulged by banks (primarily PSU Banks), the prices of housing have remained strong in India and in fact are much higher than even the prices in Dr Rajan’s adopted country. In 2008, when the whole world was reeling under severe liquidity crunch and asset prices collapsed like anything, Indian real estate and Indian economy remained insular and that was not due to sheer brain of Dr. Manmohan Singh but sheer luck in the form of 6th Pay Commission and crony capitalism of PSU banks (banks pumped capital in real estate firms and thus allowed them to keep prices high) that saved the day for Indian economy and builders.

However, this benevolence of Indian banks created other victims – that is overall economic growth in general and middle class in particular. The continued high real estate cost (EMI/Rent) left hardly any surplus cash in the hands of an average consumer and in turn led to continued slowdown in the Indian industry (a fact clearly visible if one goes by almost flat growth of white goods, commercial vehicles, etc.), which was already reeling under high interest costs.

Now one may argue as to what is the relation between housing prices with inflation and interest rates. By keeping interest rates for housing at 11% while the lending rate for SME at 14%, RBI has crowded out money from all sectors and diverted it to housing. Given the power of leverage and faulty income tax laws, investors are earning 30% to 36% returns from real estate and thus creating capital scarcity and higher interest rates. Today, an SME or a hospital or an educational institute pay interest rates in the order of 14%+ while housing loans are disbursed at 11% or lower, and on top of it get significant income tax rebate.

Dr. Rajan, in his 2005 address, had observed that ongoing financial developments had made the world a riskier place (no, he didn’t predict the 2008 crisis as believed popularly) and raised concerns regarding banks’ inability to handle risks beyond a limit due to flawed reward structure. Interestingly, despite deep insight into the workings of the banking system, the RBI Governor in India never restrained banks from providing additional liquidity to real estate or stopped fancy derivative schemes like interest subvention, etc. This continued liquidity given to the housing sector in the form of lower interest rates and subvention schemes has created a massive build-up of risk in the Indian banking system in the form of housing. Strangely, Dr. Rajan didn’t take any action in terms of normalizing exposure to the housing sector.

Hence, Dr. Subramanian Swamy is correct when he says that Dr. Raghuram Rajan has wrecked the economy by wrong policies since continuous 22% interest rate has wrecked SME sector due to high costs and low demand as an average household has hardly any cash surplus left after paying for real estate costs (Rent/EMI).

So rather than saving and steering Indian economy, the policies of present Governor have pushed India in a unique crisis with almost no industrial growth coupled with high-interest rates where there is massive unemployment or no job growth except some small slivers of hope on account of massive funding to startups.

Now with oil slowly limping back to US$ 50 per barrel and above, and 7thPay Commission on the horizon, Indian economy is going to face double whammy for which neither Indian Finance Ministry nor RBI is well prepared.

So why is there such wide support for Dr. Raghuram Rajan and so much disdain for Dr. Swamy? Interestingly, the reasons don’t lie in economics data or hard facts but in human behavior.

We all love Dr. Rajan because he is so much like us and represents our aspirations – be it his education (IIT, IIMA, MIT), his career path (Chicago Professor, IMF, RBI Governor), which we all aspire for us or for our kids to have. Not in the distant past, we all went gaga over a certain another economist who ruled this country for 10 years and despite all hard data/evidence about lack of moral compass and corruption, we kept him revered and on the altar of perfection. So this is basically about us and not at all about Dr. Rajan or Dr. Manmohan Singh.

Now on Dr Swamy – the reason for the disdain and smirks thrown at him by the great middle class is obvious as Dr. Swamy is that super-intelligent lone warrior in the class whom we all secretly admire but have none of the intellect, guts or courage, and hence mock him, because however hard we try, we can’t be him.

But then when was economics about data and not about human behavior!!!

Union Budget 2015: Ordinary Ahoy!

First, let me give a disclaimer before I get into the nitty-gritty of budget analysis. Overall, this has been quite a good budget, and in normal routine times, it might have got 8.5/10 or so. But then these are extraordinary times with extraordinary ambitions, and so, we all need an extraordinary budget and not routine, as routine brilliance is nothing but mediocre in such times!!!

There seems to be quite a euphoria related to the formation of MUDRA Bank as well as the allocation of INR 1,000 Cr to start-ups. But before we all start celebrating, we need to pause and ask about what happened to the INR 10,000 Cr which was allocated last year to start-ups! Last year, the Railways Minister in Modi Government’s maiden railway budget said that every budget makes lots of promises but only a few get implemented and the rest remain on paper. Hence, it is high time the Govt provided implementation records and performance reviews of all the announcements made in previous years’ budgets.

In order to put the nation on a high growth trajectory and to create happiness all around, the Govt needs to foster an environment which enables entrepreneurship, the creation of jobs, a fair level playing field, and a sense of fairness & stability in the legal system. Unfortunately, the budget this year falls short in all parameters.

The Indian tax regime has remained as complicated as ever, and by postponing GAAR, the Finance Minister has just chosen to ignore the elephant in the room. Furthermore, a lot of provisions against black money have been brought in, but how the legal part of it will be solved remains unclear. Given the backlogs in nation’s courts and overall sad state of legal affairs, it’s high time the Govt takes another look at the budgets allocated to the judiciary and work on creating capacities in the system. Unfortunately, the Budget 2015 has chosen to remain silent in this area.

Besides the unstable legal environment, another major issue affecting entrepreneurship and creation of new business is red tape and the amount of paper-work involved, and in this budget, there is now a proposal to appoint an expert committee to oversee all that!!! So now yet another expert committee to view and analyze, which most probably means things will remain as they are. This budget has really fallen short on the expectations regarding making things simple, done no more than offer some words, and it seems words are all we have.

It’s high time we see some real action on cutting of the red tape rather than going back and forth on the same issues. In 2010, the then Govt made a bold move of bringing Direct Taxes Code (DTC) and to do away with all exemptions and thus plug all leakages as well as corruptions. DTC faced stiff resistance from existing power centers then also, and in this budget, got a quick burial.

The announcement related to MUDRA Bank is quite welcome, but again, rather than being a provider of capital, the Govt needs to create an environment where private capital shall flow in an efficient manner and create opportunities for all stakeholders. If Govt provides capital, it will lead to crony capitalism, and in long-term, will distort the system instead of reforming it, as we all have seen in the case of PSU banks in terms of high NPA/high real estate prices. Given the fact that SMEs in India suffer very high-interest costs (18% or above) and have continued to face challenges in terms of slowing demand and high-interest costs as well as real estate costs, it will be better if the interest rate for SMEs are lowered in the way it is done for the housing sector. Here again, this budget missed the chance to kick-start the economy in a major way and has chosen a rather timid option of creating another institution.

The Indian economy, notwithstanding the performance of SENSEX, is witnessing one of the toughest period post-2008/09 with falling corporate earnings as well as a reduction in overall capital formation. Large corporate, as well as small business, are facing serious challenges since overall consumption is falling due to drop in available discretionary income at the individual level on account of the very high cost of housing (EMI/Rentals), inflation and almost flat growth in income. Given the fact that 40% to 50% of individual income in young families, which are the basic blocks of the economy, goes towards housing in the form of rental/EMI, it is high time Govt increases affordability of the first house, and at the same time needs to discourage crowding out by investors. Unfortunately, this budget has remained totally silent on this aspect.

Overall, I agree that though the main aim of a national budget is to present checks & balances of annual revenue along with expenditure and provide an outlook of the overall economic health of the country, the annual budget for all practical purposes needs to go a little beyond that. It needs to shape-up the long-term behavior of the public at large by way of taxation, policies, etc., and therefore, by continuing to focus on exemptions, allocations, and tax limits, it seems that this year the Finance Minister has chosen to grant/allocate more medical leaves right when the economy needed lifestyle changes to jump-start to the next level.

However, it is still a great peace-time budget and would have done well for the economy. But as I said, we are in the middle of extraordinary times and this war-like situation, to which this budget fails to give direction, hope & vision and settles for ordinary. Hence, it shall be rated as 4/10. 

In the time of Euphoria

We are all at a wonderful ball where the champagne sparkles in every glass and soft laughter fall upon the summer air. We know, by the rules, that at some moment the Black Horsemen will come shattering through the great terrace doors, wreaking vengeance and scattering the survivors. Those who leave early are saved, but the ball is so splendid no one wants to leave while there is still time, so that everyone keeps asking, “What time is it? What time is it?” but none of the clocks have hands.

                                                                               ~ Adam Smith, SuperMoney

2014 : Economic Crisis at the Gate

The year 2014 onwards, one is bound to see India facing its worst economic crisis, irrespective of the fact whether Mr. Modi becomes PM or not. Since it is the first time India will face an economic crisis without any luck or local stimulant as Manmohan Singh’s actions (or rather lack of them) have exhausted India of any option, and India is staring at serious crisis without any arrow in its quiver. With 6th Pay Commission stimulus tapering off and with the almost negligible capital formation for last few years, attempts of bringing back growth by having same old & tired textbook measures – like interest rate cuts – are not going to yield any positives. The author argues that the only way India can escape this crisis is by building consumption in short-term and capital formation in long-term, which means taking extraordinary counter-intuitive measures like deflating real estate sector and boosting SME/manufacturing/infrastructure by simplifying rules/reducing the interest rate. 

2014 is here and somehow things look a lot better than what they were six months ago. Political change is in the air. AAP party, in a historical mandate, has been sworn in Delhi, and Raghuram Rajan, the new RBI Governor is making all the right noises. Suddenly from the despair of 2013, we seem to usher in a new year with a lot of positive vibes and hopes. No longer are talks of Indian rupee hitting a new low or Sensex collapse ruling news channels but newspapers are filled with reports of growth in hiring, salary increments and SENSEX hitting 25,000 by May 2014.

In fact, there is a wide-spread hope and belief that Indian economy will go in further overdrive if Narendra Modi / BJP gets the decisive victory which is, at best, a wishful thinking, and at worst, simply a mirage. This thinking stems from the fact or view that India was able to manage earlier economic disturbances on account of smart leadership maneuvers, and hence, coming crisis can also be taken care of by the sheer leadership of Narendra Damodar Modi. Before jumping to such conclusions, probably one needs to understand the Indian context and earlier brushes with economic crisis faced by the nation in a post-liberalized world.

India, despite being one of the ancient civilizations, has a very short history of being an independent state and even shorter history of being a liberalized economic market. This means that as a nation we have hardly any experience of boom/bust cycles as pre-1991, average household budget used to follow Hindu rate of growth governed by a monthly quota of ration and benevolence of state, while post-1991 India has just seen a phenomenal increase in overall wealth and conspicuous consumption.

Though post-1991, India did face an economic crisis in 2001 and 2008, but due to a variety of unintended situations, all these crises failed to make any impact as details below.

Dotcom Bubble and 2001 Economic Downturn

Post-liberalization (1991), the World and India stared at its first recession at the beginning of 21st century, when the dot-com bubble collapsed and 9/11 attacks happened, bringing global economic engines to almost a halt. However, other than some offer withdrawals at Indian management institutes, 2001/02 recession didn’t impact India at all for a variety of reasons. A lot of levers got in play to push the Indian economy on a growth trajectory despite the overall slowdown. Of all reasons, the foremost engine driver was BPO/KPO sector which not only created huge job opportunities in major cities but also absorbed the pain caused by the slowdown of IT industry. While BPO/KPO sector was keeping job growth fast and driving export income, on the domestic front, Infrastructure (road/port, etc.) and telecom sectors were taking shape.

The NDA Government, led by Prime Minister Atal Bihari Vajpayee, focused on building world-class roads all across India and rolled out the golden triangle. On the other hand, the entry of MTNL in mobile services with incoming calls becoming free led to price-drops and super explosion in growth of subscribers.

These two factors, i.e., improved road infrastructure and growth in telecom subscriber numbers, unlocked constraints in the economy and in fact paved way for one of the biggest GDP expansion India had ever seen, and year after year India clocked 7%+ GDP growth. This super rocket growth helped SENSEX break every record every quarter and India joined China in being the darling of fund managers on Wall Street. Billions of dollars were raised by funds to participate in India story. In a way, India had arrived on the world economic stage.

2008/09: Subprime Mortgage Crisis and Lehman Brothers’ Bankruptcy

While India was marching ahead to glory, far far away, USA was busy rediscovering nirvana in housing/mortgage driven by cheap Greenspan dollars whose solution for every problem was a little more liquidity. However, the party soon ran out of fuel and the world was hit by one of the biggest financial crisis with stalwarts like Lehman Brothers going bankrupt and 100s of banks in the US collapsing under subprime load. The whole world went into crisis except one country – India. While the majority of people were led to believe that India survived on account of the leadership of then economist PM; however, the truth is India survived the aftermath of Global Recession more by luck than any other thing, and least by Govt actions.

In 2006, Indian Govt without any idea of the upcoming 2008 financial crisis, set up 6th Pay Commission to review and revise the salary of Govt employees. The Commission came with its report in 2008 and released arrears in 2009-2010. This commission impacted almost 20 million Govt employees (Central and State Govts) and resulted in an annual increase of INR 12,561 Cr per annum (USD 2.5 Billion per year) and one time arrear of INR 30,000 Cr (around USD 6 Billion). As expected, this worked as mini-stimulus, as almost all of it went into auto and housing sector. The table below is almost self-explanatory where one can see growth in sales of passenger cars which witnessed the largest increase of 27% in the year 2009/10 and 2010/11, while the commercial sector was hardly growing. 


However, lack of any new initiative and slowing down of the economy due to policy paralysis resulted in almost zero job growth scenario and impacted car sales. Automobile sector faced slower growth in 2011-12, which turned into negative growth as automobile sale decreased every month in 2013.

2013 Onwards: Of NREGA / Fiscal Deficit and Real Estate

The year 2009 saw the re-election of Dr. Manmohan Singh led Congress Govt, which made analysts believe the beginning of another golden era since the government was no longer at the mercy of mercurial left parties and a prison to their economic agenda. It was expected that government emboldened by its electoral win, will unleash economic reforms, which coupled with GST and DST will catapult India much ahead of China.

However, in a karmic turn of events, all deeds of UPA I came to haunt UPA II. Bad moral hazard expenditure, like NREGA, increased labor cost for marginal farmers, thus created supply-side challenges while 6th Pay Commission returned to haunt Govt in the form of the high fiscal deficit which ballooned to 6% from earlier range of 2.5% to 3.0% in 2006.

Hence, despite all the talk of big revival and growth, India, in fact, is in the middle of a crisis as is evident by the following:

  • The automobile sector is seeing negative growth: 9-month consecutive drop in sales. Leading companies like Ashok Leyland, Tata Motors, etc., are cutting production schedule and realigning workforce.
  • Telecom sector after posting consecutive growth is now slowing down and is no longer front end driver of the economy.
  • Infrastructure remains in the middle of nowhere as no large projects are being announced while earlier projects which had absorbed billions of dollars are yet to see the light of the day, thus creating a real crisis for investors as all invested capital remains locked as an unproductive asset.
  • PE funds who had invested big time in Power / Infrastructure and roads in 2007-09 are yet to see any return of capital and majority of investment remains under water.
  • PSU banks, which helped real estate sector weather the storm in year 2009 by restructuring loans and saved it from big crash, is again staring at next level of restructuring, since the real estate players got greedy post-2009 and led to a price growth of 3x in the last 5 years and focused on EBITDA protection rather than cash flow management.

Real Estate – The Double Whammy

Real estate in India remains an interesting asset class, which has given best returns among all asset classes since 2000 and continues to rise despite the call of bubble burst now and then. In a way, the real estate sector in India, while showcases success and growth, also symbolizes as whatever is wrong with the Indian economy. Today, the real estate sector poses the following challenges:

  • Very high housing prices in comparison to median earning. Housing in India is expensive or at par with housing cost in the developed world.
  • Debt level at real estate companies is at an astronomically high level where some of the companies, like Jaypee Infratech, have a very high level of debt posing a systemic risk to Indian banking sector, as noted by RBI Governor in a recent statement.
  • Real Estate sector growth has to lead to jumping in housing prices by 5x to 10x in last 10 years while rentals have also jumped by the same level, though salaries have not kept pace at the same level. Today, the majority of free cash flow at the household level is going either in EMI payment or rent, which is restricting discretionary spend and thus creating a slowdown in consumption.

Road Ahead

As one can see the Indian economy is facing a unique crisis of having high inflation and very low growth. This unique scenario has made limited options available to RBI, which anyway never moves beyond Keynesian models. High inflation will eliminate the possibility of a rate cut as there is this naïve belief in India that low-interest rate will fuel inflation and will further impact growth. The powers in finance ministry need to understand that India is not west and does not have the luxury of enormous resources as well as well-oiled supply chain. Inflation in India is not a function of more demand but supply-side constraints, which becomes worse with higher interest rate and crony capitalism.

The only way Indian economy will find wings again is if real estate sector collapses (price reduction of 30% to 50%) and help to unlock all productive capital locked there and manufacturing becomes friction-free, which is the elimination of red-tapism and paperwork for small and medium enterprises.

So in a nutshell, RBI and finance ministry need to reduce interest rates for SME sector and agriculture while doing away with housing loan interest tax breaks, increase interest rates for housing by at-least 300 basis points for the additional house. Till this is done, the local economy will remain sluggish and will not witness any fundamental shift at grass-root level and 2010-2020 will be more of a lost decade than an Indian decade.