Modi's Business Agenda

By Knowledge@Wharton | June 28, 2014

In the months of campaigning since his first rally last September, Narendra Modi covered more than 200,000 miles in the process of holding 5,827 public meetings to convince voters to throw their support behind him as India’s next leader.

It was a strenuous schedule that has brought its due reward — Modi will be India’s next prime minister. His Bharatiya Janata Party (BJP) won 282 of the 543 seats in the Lok Sabha (as the lower house of Parliament is called). This is the first one-party majority in the country in 30 years. In addition, along with his pre-poll allies, the National Democratic Alliance (NDA), Modi can count on a whopping 336 seats.

It may be a cliché, but is nevertheless true: The tough part for India’s new government starts now. The challenge has very little to do with religion or caste equations, though these were used to criticize Modi during the electioneering process. (Rival politicians labeled him the “butcher of Gujarat” and the “merchant of death” in reference to his lack of action to stop massive anti-Muslim violence that broke out in the state in 2002, when Modi was chief minister. Some of his close aides were found guilty of taking part in the violence, but Modi has denied any responsibility.)

The economy will be at the top of the prime minister’s new agenda. Modi inherits a nation where GDP growth has slowed to 4.5% (2012-2013). The International Monetary Fund has projected a marginally improved 4.6% for 2013-2014, 5.4% in 2014-2015 and 6.4% the next year. India’s wholesale price index was 5.2% in April, down from 5.7% in March, but the consumer price index (CPI) was up to a three-month high of 8.59%. In March, it was 8.31%. Inflation restricts the Reserve Bank of India’s (RBI’s) ability to reduce interest rates, a necessity to jumpstart capital investment.

Among the few positive indicators for the Indian economy is a reduced current account deficit. Non-oil imports in April were $22.7 billion, 21.5% less than a year ago. This will reduce pressure on the current account deficit, estimated to be around $35 billion in 2013-2014 from $88 billion the previous year. But this figure has been managed by imposing a 10% import duty on gold; in April, gold imports at $1.75 billion were 74.2% lower than the $6.78 billion in April 2013. Modi pointed out during the campaigning that this has only spurred gold smuggling. The amount of gold seized at just one Delhi airport has gone up 26 times since the previous year. Although Modi has promised to reverse the impost, even gold will not provide a silver lining to the deficit numbers.

No Magic Wand

At the same time, expectations are very high. When the exit polls started reporting that that Modi’s party was the likely victor, the Bombay Stock Exchange sensitive index (BSE Sensex) recorded 650-point and 557-point jumps on two consecutive trading days. When the actual results were declared on Friday, the Sensex crossed 25,000, a jump of more than 1,000 points in intraday trade. Since September 15, the Sensex has gone up 22%. Deutsche Bank has set a Sensex target of 28,000 by year-end.

All this market euphoria is being caused not by the population at large, but by foreign institutional investors (FIIs) who have been pouring money into the capital markets. They put more than $1 billion in equities in May, before the results were announced. According to The Economic Times, the calendar 2014 inflow could cross $40 billion. (This creates the potential for other problems, however — a stronger rupee and uncompetitive exports.)

The bullish mood was ushered in by a Goldman Sachs report titled, “Modi-fying Our View,” released in November. Its main point was that the country had been raised to “market-weight” because “optimism over political change, led by BJP’s prime ministerial candidate … Modi, is dominating economic concerns.”

Industry has been clamoring for lower interest rates, but governor of the RBI Raghuram Rajan has not yet budged on the issue. BJP treasurer Piyush Goyal has been a stern critic of the high-interest-rate regime. Rajan himself recently told a symposium in Switzerland that “ultimately the interest rate that is set is set by me…. The government can fire me, but the government doesn’t set the monetary policy.” Deepak Parekh, chairman of the Housing Development Finance Corporation, India’s leading housing finance company, has warned that replacing Rajan could lead to a sovereign rating downgrade.

Modi has no magic wand to fix all of these issues, so perhaps the best thing he can do is to indicate that the country is open for business. “India needs a CEO more than it needs a PM,” says Bundeep Singh Rangar, chairman of London-based consulting firm IndusView. “That is what Modi can deliver.”

Regaining Investor Confidence

India’s rise on the global stage has “taken some body blows in the past few years,” says Wharton management professor Jitendra Singh, who will be the next dean of Hong Kong University of Science and Technology. “For the next government, there are three critical deficits they must begin to address immediately: a deficit of governance; a deficit of integrity and trust, and the fiscal and budgetary deficits. While there are many specific issues one might pinpoint, I believe most can be traced back to these deficits.

“To illustrate in somewhat more concrete terms, when the ruling government attempts to make retroactive changes to tax laws, despite an unfavorable ruling from the Supreme Court of India, it is the metaphorical equivalent of taking an axe to one’s own leg as far as the response of the global business community is concerned,” adds Singh. He is referring to Vodafone’s acquisition of the Indian telecom assets of Hong Kong’s Hutchison Telecommunications for $11 billion in 2007 and the tax demand of $2.2 million made belatedly on that transaction. The Supreme Court ruled in favor of Vodafone. In his 2012 budget, finance minister Pranab Mukherjee (now President of India) introduced a clause making such transactions taxable with retrospective effect from April 21, 1962. As a result, deals between companies that no longer existed and others remembered only by geriatrics suddenly became the focus of the taxing authority’s attentions.

Officials began looking Vodafone’s way because India was facing the reality of lower revenues, a byproduct of lower growth. Consider what has happened to Nokia: The company faces two substantial demands today — one a tax on royalty payments and the other a sales tax. While the company is fighting it out in the courts, the India unit has been left out of Microsoft’s purchase of Nokia’s handset assets worldwide. Some 5,000 workers at the Chennai factory have reluctantly accepted a voluntary retirement offer. Meanwhile, a similar plan is also being rolled out at Foxconn India, one of Nokia’s principal suppliers. “We need an environment with regulatory certainty and clarity,” says Karan Singh, partner at Bain & Company India. “We need to regain investor confidence.”

“As long as India sends the message that every other objective would be subordinated to achieve politically expedient ends, investors will not trust the country with their capital,” adds Ravi Aron, a professor at the Johns Hopkins Carey Business School. “The appalling antics of India’s tax babus [bureaucrats] with Vodafone are a case in point. Other companies facing similar cases include IBM, Morgan Stanley and Nokia. These are companies that are welcomed with open arms by the world. The Congress government took a hatchet to their business plans.”

According to Manish Sabharwal, co-founder and chairman of staffing services company TeamLease Services, companies make such investments with the expectation that they will have long payback periods. “Uncertainty around taxation, or the lack of predictability around regulations, holds back the virtuous investment cycle.”

As an example of the second deficit — a deficit of integrity and trust — Singh notes, “When a sitting cabinet minister is sent to jail on charges of large-scale corruption, it cannot but erode confidence….” He is referring to an incident from 2010, in which telecom minister A. Raja was forced to resign after it was found that he conspired to illegally undercharge companies for 2G frequency allocation licenses, which are needed to create spectrum subscriptions for mobile phones. “We need a corruption-free business environment,” adds Wharton operations and information management professor Kartik Hosanagar.

Singh’s third deficit relates to the subsidy issue. India has been likened by some economists to a “dole economy” for the number of subsidies it gives on various items. For example, there are subsidies on fertilizers, petrol, diesel and even cooking gas. Very little of it actually reaches the intended groups, however. “Especially when the economy is slowing down, it is imperative to manage the financial affairs of the country better, and scale down or delay handing out subsidies, so as not to run significant current account and budgetary deficits, which have inevitably led to negative economic consequences,” says Singh.

Deepak Parekh said in 2012 that the government’s flagship job guarantee program, which assures 100 days of employment in a year (at Rs. 100, or approximately $2 a day) to members of a rural household is “a disincentive for [people] to work.” Critics say the subsidy has kept residents of rural areas from coming to cities to take construction and infrastructure jobs; the migrant labor hasn’t been missed because the Indian economy has slowed — but that could change if the market picks up.

Infrastructure: A Top Priority

Modi’s agenda, however, cannot be concentrated solely on undoing damage. To begin with, there are areas he will not be able to do much about. The employment guarantee scheme, for instance, cannot be touched; politically, it’s poison ivy. But there still remain a lot of areas for reform. “The new government must push reforms,” notes Singh of Bain. “We need turbo-charged economic growth.” More specifically, he says Modi must focus on infrastructure, manufacturing, the much-debated but so-far-abortive all-India goods and services tax, education, jobs and health.

According to Saikat Chaudhuri, executive director of Wharton’s Mack Institute for Innovation Management and an adjunct professor of management, when India’s economy was flourishing at more than 8% annually “the numerous problems were not as visible, despite being well-known.” Now that growth has slowed, “it is imperative to start acting in a concerted manner to remove the obstacles,” he notes. “This is a very critical juncture in India’s evolution. The new government’s actions should be geared towards psychological benefits as much as the substantive ones.”

According to Chaudhuri, the immediate priority action points should be: instilling confidence in domestic and global stakeholders by projecting a sense of urgency, as well as conveying a vision for what economic and geopolitical role India wishes to play in the future; kick-starting some type of reform, whether it is around foreign direct investment (FDI) or privatization of labor, in order to send a signal that the government has moved beyond its earlier paralysis on such issues; aggressively moving forward with infrastructure development, and tackling corruption and administrative inefficiency head on.

Over the longer term, Chaudhuri adds, Modi’s government needs to develop a comprehensive slate of reforms to achieve the aforementioned long-term vision, strong and equitable policies for land acquisition and a roadmap for promoting innovation and entrepreneurship.

Hosanagar, who says tackling corruption should be the first priority, agrees with Chaudhuri on the importance of creating infrastructure and jobs. “Infrastructure is the single-most important reason why India falls behind China,” he notes. His other priorities are skills improvement and employment generation. “There are not enough jobs to engage such a young population,” he adds.

According to Sabharwal, “The next government should have two goals around jobs — increase the total number of jobs and expand the share of formal jobs. Expanding the total number of jobs is crucial because the farm to non-farm transition will not accelerate until we raise manufacturing employment from 12% of total employment and reduce self-employment from 50% of total employment.” He adds that increasing the share of formal jobs is also crucial because “100% of net job creation in the past 20 years has happened in informal jobs. Informality is not only the slavery of the 21stcentury, but it has also created a huge productivity drag on the economy, with subscale enterprises that don’t have access to credit or create career corridors.”

Wharton marketing professor Jagmohan S. Raju says greater efforts toward job creation would give “each citizen the opportunity to contribute to the nation’s growth. Jobs provide dignity and the self-confidence that will also lead to equality.”

But with job creation also comes the need to institute labor reforms — and it won’t be easy, Aron notes. “Organized labor, which accounts for just 9% of all labor in India, is a formidable political force. Any government that tries to reform labor does so at its own political peril.”

Aron looks at some disquieting numbers. “Data from (the Centre for Monitoring Indian Economy) show that capital investment growth is the lowest it has been in an 11-year period, with firms shelving more than $100 billion in projects. In nine of the past 12 months, capital goods production — a leading indicator of the extent of production-related investment in the economy — has contracted.”

Labor reform could be one catalyst. Investment is another. “Massive investments are needed in the physical infrastructure to lower the cost of manufacturing inputs,” Aron notes. “The government owns large chunks of public enterprises, where capital is locked up producing very low returns. In the case of public firms, such as Air India, there is chronic erosion of capital.” Even as Modi was sweeping the polls, an RBI report indicated that the government should reduce its holding in public sector banks (PSBs) to less than 50%. Socialistic elements in Parliament had allowed divestment in PSBs only on the condition that the government retain majority holding. With the Left a spent force — it has been decimated in the polls in former stronghold West Bengal — disinvestment may well become the first feasible reform.

More ‘Dwarfs’ Than ‘Babies’

Along with the big picture, it is necessary to look at the small picture. The real wealth of a nation comes from entrepreneurship, not mega-investments by government or big business, observers say. According to Bharti Jacob, managing partner at SeedFund, there is urgent need to encourage and enable entrepreneurship in India. “The government should stay out of it,” she says. “But it should create an environment that encourages innovation and new company formation.”

“India is a hostile habitat for entrepreneurship in terms of regulations that make it complicated and painful to start and run a business,” adds Sabharwal. “The biggest manifestation of this is the substantially stunted firm size. (Companies with less than 49 workers account for 84% of manufacturing employment). India has more dwarfs — companies that are small and will stay small — rather than babies — companies that are small but will grow. The reason obviously includes the labor laws, but the inspector raj, the compliance raj and the permission raj, which have remained unchanged since 1991, are also responsible.”

Laurent Demortier, CEO & managing director of Avantha Group-owned company Crompton Greaves, says the country also needs to bolster research and development capabilities. “With the increased global footprint of the Indian manufacturing industry, India should incentivize R&D and aim to make the country a global R&D hub in select sectors. This will encourage product innovation to make a home in India.”

According to Vinayak Prasad, co-founder ofFrog8, a company in the payments space, the new government needs to force regulators to stop taking baby steps toward enabling adoption of electronic payments. “Cash is still king and extremely costly,” he notes. “The requirements of [identity verification] make it very expensive to get customers. Digital [identity verification] is key, and the government or regulator needs to be more aggressive.” Prasad is talking about one end of the problem. The other end — inclusive banking — is probably more important; 41% of the population in India is unbanked. The only way to get them into the fold is to marry technology to banking. Banking spread has been hindered by over-regulation. “The RBI is in anxiety management mode,” says Prasad.

Sabharwal talks about another issue. “India only has 50 cities with more than a million people while China has 400,” he notes. “We have 600,000 villages; 200,000 of them have less than 200 people. Politicians dream of taking jobs to people, but what we need is to take people to jobs. Unlike Chinese New Year, where 300 million people get on a train and go home, we don’t have a mass migration at Diwali, Chaath, Eid or Christmas. We should.”

India “(does) not need a business-friendly regime,” Aron notes. “What we need is an administration that pursues a rational regime of laws that will grow the economic pie as well as redistribute it equitably. In early 2000, the share of manufacturing in FDI inflows was more than 60%; it fell to about 40% in 2005 and to 20% in 2008. The drought of investment in manufacturing and in increasing the productive capacity of business in India is a self-inflicted misery…. It is time that we went from ‘made in spite of India’ to ‘well-made in India.’”