When Narendra Modi’s Bharatiya Janata Party (BJP) won a simple majority in the recent general elections, India’s business community was sure that a new reform era was about to begin. The Bombay Stock Exchange Sensitive Index (Sensex) rose 1,745 points (7.81%) in three sessions on the strength of opinion polls predicting a BJP victory even before the results were announced. It surged nearly 1,500 points on the day of the results.
The first statement of the government’s intent was the Union Budget. But finance minister Arun Jaitley rolled out what was widely considered to be a very pedestrian effort. On July 11, a day after the Budget was made public, the Sensex stood at 25,024 following a single-day drop of 348 points. The peak of 26,100, recorded on July 7, now seems like another mountain to climb.
What went wrong? The Budget was expected to mark a new direction for India and its economy — but it did nothing of the sort. “It’s not a radical Modi budget but a [former Congress finance minister P.] Chidambaram budget with saffron lipstick added [saffron is the house color of the BJP],” wrote economist Swaminathan S. Anklesaria Aiyar in The Times of India. “Many thought Jaitley’s maiden budget would produce a vision for five years, major reforms and some bitter medicine. Sorry, there was no great fiscal vision, only minor reform, and sugar-coated pills rather than bitter ones.”
Commented Business Standard: “This was a Budget prepared by incumbent bureaucrats, not incoming politicians. This was a Budget that represented stale continuity when the need of the hour was demonstrable change.” Chidambaram himself took a shot at Jaitley, noting that the BJP had campaigned for an India free of the Congress Party, but proved that it couldn’t even produce a Budget free of the Congress Party.
But Wharton management professor Jitendra Singh says the budget has done “a reasonable job” and provided “a good starting point for bolder steps” that may follow. “Critics, some of whom are quite vocal, need to take a step back and view matters with the appropriate perspective,” he notes.
Saikat Chaudhuri, executive director of Wharton’s Mack Institute for Innovation Management, adds: “Like most people, I was a bit underwhelmed, as I did not see a marked shift or new impetus.” But he notes that critics should “give some benefit of doubt and grant more time, until the next budget, to see the contours of the Modi government’s new thrust. There simply wasn’t sufficient time to understand, analyze and plan for a new direction a month into assuming office.”
The expectations placed on the new government’s budget “would be high to begin with,” says Wharton professor of finance Krishna Ramaswamy. “Their eye on a weak monsoon and unresolved global economic recovery uncertainties might have tempered their desire to make aggressive changes that might affect the deficit.” In particular, he adds he would have looked for “more positive measures” in the tax initiatives.
Fiscal Deficit
The key elements of continuity from Chidambaram’s interim Budget are the fiscal deficit numbers. The February 2014 Budget had set the target for 2014-2015 at 4.1% of GDP. “The target of 4.1% fiscal deficit is indeed daunting,” said Jaitley in his Budget speech. “Difficult as it may appear, I have decided to accept this target as a challenge. One fails only when one stops trying. My roadmap for fiscal consolidation is a fiscal deficit of 3.6% for 2015-2016 and 3% for 2016-2017.”
Not everybody thinks he can do it. “The Budget announcement lacks details on revenue and expenditure measures to lower the deficit, making it difficult to assess the likelihood that future deficit targets will be met,” according to a report by Moody’s Investor Service. Adds an analysis by India Ratings: “The Budget arithmetic is slightly optimistic.”
The economy appears to be swinging into a growth phase, so Jaitley’s numbers may yet have a chance. On the other hand, the Iraq conflict, which has resulted in higher prices for oil (India’s main imports), and a very poor monsoon to date may send the calculations awry.
With so many imponderables, there is some praise for Jaitley’s efforts. “I believe this is a prudent, courageous budget,” says Wharton professor of marketing Jagmohan S. Raju. “The Budget provides incentives in important sectors such as infrastructure and manufacturing, with plans to keep deficits under control.”
Wharton professor of operations and information management Kartik Hosanagar praises the budget for providing a boost to manufacturing, saying that such a measure “is exactly what India needs right now.” He adds that more progress is needed on this front. “For example, the import tax on finished products was lower than that on parts, which hurt Indian manufacturers. They fixed that,” Hosanagar says. “They will need to do more, but it’s a good start.” He lists other priorities the Modi government must respond to: “India needs to address its deficit and reduce some of the mass subsidies, and offer subsidies in a more targeted fashion.”
At the same time, it is important to note that Modi’s approach to developing Gujarat, the state where he served as chief minister from 2001-2014, “was not a flashy one,” notes Chaudhuri. “[Modi] spent years developing infrastructure and accumulating land, as well as streamlining policy and administrative processes, before being recognized for attracting industry and economic growth. So he may not be one to offer ‘quick fix’ type approaches, but will emphasize building fundamentals.”
The Union Budget demonstrates a similar focus, adds Chaudhuri, pointing to moves including the formal sanction of the dedicated Eastern freight corridor with industrial parks around it, development of the Ganga waterway for transport, various cluster initiations in biotech and the completion of a number of ongoing, but slow-moving, infrastructure projects. He expects “a clearer vision” of the Modi government’s agenda to emerge over the coming months through policy modifications, culminating in the next budget.
“Given the limited time since being elected and the current state of the economy, I don’t think big-bang reforms were quite possible yet,” says Pankaj Dinodia, CEO of the Delhi-based Dinodia Capital Advisors. “But the Budget has set the tone right and has all the ingredients to put India back on growth track.”
Creating a Catalyst
Manish Sabharwal, co-founder and chairman of staffing services firm TeamLease, notes that the role of the Union Budget is “not to set things on fire but to create the conditions for spontaneous combustion,” namely “a number of genetically diverse and statistically independent tries by all kinds of entrepreneurs — small, big, local, foreign.
“In 1991, we wrongly defined reforms as purely fixing the sins of commission — what the state was doing wrong — but our big problems are the sins of omission — what the state is not doing,” Sabharwal notes. “The four big themes of this Budget — urbanization, infrastructure, education and entrepreneurship — are about the sins of omission. India should have become a very attractive destination [during] the global financial crisis, but we got a heavy dose of friendly fire. Of course, the finance minister could have done more and I am confident he will. But there is a difference between the list of ingredients and the recipe. This government understands that prioritization, sequencing and tradeoffs are the key to execution because they have a decisive mandate for five years.”
But the problems many critics have with the Budget is not the recipe, but some specific ingredients. Take, for instance, retrospective taxation, which was used in the 2011-2012 Budget to impose a $2.2 billion liability on Vodafone after the company had won its case in the Supreme Court. The case has now gone for arbitration.
It was expected that Jaitley’s budget would address the Vodafone issue, which has been a deterrent to foreign investment. Instead, the Budget states that “the sovereign right of the government to undertake retrospective legislation is unquestionable.” Thus, the Vodafone case is expected to drag on. Jaitley did, however, throw a bone to investors, noting that “this government will not ordinarily bring about any change retrospectively which creates a fresh liability.” Curiously, however, the Budget elsewhere introduced some minor taxation changes with retrospective effect.
“It is not as if the current government has created all the vexing issues India finds itself beset with,” says Wharton’s Singh. “The rather pointless tamasha [Hindi for “theatrics”] with Vodafone, which has done grave damage to India’s image in the global business community, was not authored by the Modi government. Neither was the grim situation with the fiscal deficit.” Singh agrees the government could have done more with the budget, but he wants to give it more time to set a longer-term agenda for reforms.
On the subject of retrospective taxation, Singh notes that he can understand why no government would want to tie its hands and rule out the possibility of changing the tax laws with retrospective effect. Even so, a better option for the Jaitley budget would have been to focus on how the Modi government does not intend to move toward retrospective changes in tax laws, he adds.
As for the Vodafone matter, Singh says it would be best if the Modi government settles the issue quickly, as much damage has already been done as a result of what Singh calls an “embarrassing mistake.” He notes that “ignoring the judgment of the Supreme Court of India in favor of Vodafone, the incumbent government went after the company, with quite negative results overall. Settling the Vodafone matter would be a positive symbol of the direction the Modi government is moving in.”
Clearly, the Vodafone controversy is a test case for foreign investors. “There has been no other single largest deterrent to foreign investment in India than the Vodafone case,” says Dinodia. “Every single company that has looked to set up operations in India has hired an advisory firm to do a deep dive into the Vodafone case and see the probability of them [ending up in a similar situation.] I think the expectations were high that the government would give a clear and direct answer with regard to retrospective amendments. While I don’t think they have sidestepped the issue, it will need to be addressed with further clarity in the next few months in order to bolster investor confidence. Just saying that it won’t happen in the future is sometimes not enough.”
Higher FDI Limits
Foreign investors are also being wooed by a move to raise the foreign direct investment (FDI) limit in defense and insurance from 26% to 49%. Observers say it’s a good beginning, and potential Indian joint venture partners are keen to pursue projects. But the U.S.-India Business Council (USIBC) points out that U.S. companies may not be queuing up at India’s doors. This is only an incremental step, according to the group, and U.S. defense firms would not be enthusiastic about transferring sensitive technology or conducting innovative research unless they have ownership of the joint venture — i.e. a minimum 51% ownership.
The USIBC has welcomed the increase in the insurance cap as a sea change. But the “full Indian management and control” stipulation in the Budget may not sit well with some foreign firms. At the same time, India is one of the most underinsured markets in the world — less than 5% of its population has life insurance coverage. While foreign insurance companies could be looking at further relaxations in the future, not all Indian firms are happy with the change. Insurance is a capital-intensive business; not all of them have the deep pockets to match foreign funding. They could be reduced to minority partners when the laws so permit.
One other provision of the Budget could cheer foreign investors. “Foreign portfolio investors have invested more than $130 billion in India,” Jaitley said in his speech. “One of their concerns is uncertainty in taxation on account of characterization of their income. Moreover, the fund managers of these foreign investors remain outside India under the apprehension that their presence in India may have adverse tax consequences. With a view to put an end to this uncertainty and to encourage these fund managers to shift to India, I propose to provide that income arising to foreign portfolio investors from transaction in securities will be treated as capital gains.”
Jaitley’s two-hour plus oration was the longest Budget speech on record. Among other notable provisions: The public sector banks will recapitalize, but the government will maintain 51% control. There is $33 million for a statue of Sardar Vallabh Bhai Patel — the country’s first home minister and deputy prime minister, known as the “Iron Man of India” — being built in Gujarat. On the revenue-garnering side, there have been steep increases in imposts on cigarettes and tobacco products and aerated waters. “These are healthy measures,” said Jaitley. India may be the first country to put carbonated drinks on the same platform as cigarettes.
Waiting for the Fine Print
The Budget also sets aside $1.66 billion for a fund to finance start-up ventures, but the details are unclear.
Bharati Jacob, managing partner at VC firm Seedfund says: “It is very refreshing to hear words like entrepreneur, start-up, incubator and accelerator in a budget speech — outside of the word entrepreneur, all others were used for the first time. It is also great that the government has recognized entrepreneurs as a distinct class and also recognized the role they play in job creation, since jobs are the need of the hour for India. [But] I would like to see finer details [of the $1.66 billion] before getting excited about it. What is it meant for? How will it be deployed? If the government uses the money to become a venture investor, it will be disastrous. That job should be left to professional investors. On the other hand, if the government were to use this to create physical incubators — such as the Startup Village in Kochi — managed by professionals, we might see greater impact. So I would wait to see the fine print before getting excited.”
E-commerce companies, too, are waiting for the fine print. Jaitley has allowed manufacturing companies to sell their products on e-commerce platforms without any additional approvals. But the issue of FDI in e-commerce remains in limbo.
“The Finance Minister’s statement of allowing manufacturing units to sell their products through e-commerce platforms without any additional approvals is a positive statement of intent for the e-commerce industry,” says a spokesperson for Amazon India. “It recognizes the role of e-commerce companies in the growth of the manufacturing sector. Following this statement, we are hopeful of a more positive and liberalized policy on e-commerce in the near future aimed to help grow the manufacturing industry.”
Jaitley’s initiative is not so much about e-commerce as manufacturing. “The manufacturing sector is of paramount importance for the growth of our economy. This sector has a multiplier effect on creation of jobs.” said Jaitley in his speech. According to a report by Barclay’s Capital: “The Budget appears to reflect the strong intent of the government to boost the manufacturing sector…. We expect specific action plans to follow in the next few months. The National Manufacturing Policy proposed by the previous government — but yet to be implemented — intended to boost manufacturing to 25% of GDP (from 15% currently) and create employment for 100 million workers in the next 10 years. If the current government sticks to similar targets, it could be a complete game-changer.”
Laurent Demortier, CEO and managing director of Avantha Group company Crompton Greaves, says that the government should have done more. “If India needs to be a world-class manufacturing hub, the ecosystem has to facilitate that and incentives for innovation have a big role to play in actualizing this ambition,” he notes. “The big disappointment is the lack of incentives for R&D and innovation.”
Job Creation
The manufacturing focus, as Jaitley points out, is necessary for job creation. The Budget also proposes a national program called Skill India, intended to provide training for younger workers, with a focus on employability and entrepreneurship. The proposal gets right to the heart of India’s greatest challenge and opportunity: While the world is aging, India is adding to its numbers in the working age group. The problem, however, is that workers’ skills don’t match the requirements of jobs that employers are seeking to fill.
“Job creation is about fixing India’s five geographies of work — physical, sectoral, enterprise, education and legislative,” says Sabharwal. “Fixing the physical geography of work is about urbanization and infrastructure; there was a lot in the Budget about that. The sectoral geography of work is about increasing manufacturing employment … and reducing low productivity agricultural employment …, and there was a lot in the Budget about that.”
According to Sabharwal, the enterprise geography of work is about more productive companies. “Today, our 62 million enterprises only translate into 900,000 companies. Of these, only 7,500 have a paid-up capital of more than $2 million,” he notes. “There was a lot about improving the ease of doing business and giving access to credit to entrepreneurs via small banks and the start-up fund.” He adds that the education area also had significant representation.
The missing piece, he says, “was probably action around the legislative geography of work. But action on labor law reform began many days ago on the website of the central ministry of labor and in states like Rajasthan. So, overall, I think the Budget was consistent with their election manifesto and what most people believe is needed. Obviously the magic lies in execution. But, as Victor Hugo said, there is nothing as powerful as an idea whose time has come. Skilling and employment at the heart of the policy are ideas whose time has come.”
Wharton’s Hosanagar notes that the government has demonstrated its willingness to take bold and decisive steps, some of which will be symbolic of the measure of its commitment. He points out the fare increase in the railway budget that preceded the Union Budget as one among “several unpopular measures.” A $340 million allocation to clean up the Ganges River is consistent with the priorities Modi outlined in his election campaign, he adds, although he describes the allocation for a Vallabh Bhai Patel statue as “populist.”
Cleaning up the Ganges might be a more welcome action and offer a sensible long-run benefit to all, according to Ramaswamy. “It would have been best to show the right way by leaving the statue-raising to privately-funded groups,” he says.
Singh believes that the Ganges cleanup plan is symbolic in many ways. “Indeed, the Ganges can best be viewed as a symbol of much that has gone wrong in India in recent decades, with words sometimes becoming substitutes for decisive action, while serious problems linger beneath the surface,” he says. “We need to see a cleaned-up Ganges, and that will have a salutary effect. This is worth repeating: The importance of symbols in any change program cannot be overstated. This could well prove to be a visionary example of change leadership, though only if the desired results are achieved.”
While there is no dearth of critics, Sabharwal and many others are willing to give Jaitley another shot. “We believe a single Budget or one year’s efforts cannot bring the economy out of the low-growth phase; a concentrated effort will be required,” says India Ratings chief economist Devendra Pant. Adds Dinodia: “Hopefully this was a good trailer to a great movie that will be shown in the next full Budget to be presented in February 2015.”
As Jaitley himself told the media in Delhi: “This is the beginning of our journey, not the end.”