When Prime Minister Narendra Modi was elected in 2014, investors expected him to enact sweeping economic reforms. While progress has been slower than expected, India is moving in the right direction, writes Will Ballard.

In early February, the first ballots were cast in six state elections in India, including Uttar Pradesh, the country’s most populous state.  The multi-stage voting process, which runs until March 11, has come to be seen as a tacit plebiscite on Prime Minister Narendra Modi’s government, and one policy in particular: demonetisation.

History will remember November 8, 2016, as the day Donald Trump was elected US president. But on that same day in India, attention was focused on another shock event: Modi’s announcement that all 500- and 1000-rupee banknotes – which accounted for some 86 per cent of all the country’s cash by value – would be scrapped.

Over the following weeks, thousands queued for hours to deposit their banknotes before the December 30 deadline. ATM machines had to be painstakingly recalibrated to accommodate replacement notes, which are smaller than the old ones.

According to the Reserve Bank of India (RBI), circulating cash accounted for 13 per cent of GDP before the move, suggesting the abrupt withdrawal of banknotes – and the ensuing chaos – will have taken its toll on economic activity. The scale of the impact is not yet fully clear, but ratings agency Fitch has cut its forecast for India’s GDP growth for the fiscal year to March 2017 from 7.4 per cent to 6.9 per cent.

Consumer-focused businesses that trade in cash, especially in consumer staples, are likely to have suffered a severe short-term hit, along with the real estate sector. Many property transactions in India remain cash-based and shares in listed developers fell sharply on the day after the announcement, some by as much as 20 per cent. Year-on-year sales fell 44 per cent in the fourth quarter 2016, according to Knight Frank India.

Black economy

By removing large-denomination notes, Modi and his ruling Bharatiya Janata Party (BJP) say they are clamping down on India’s black economy, an untaxed pool of money that feeds nefarious activity across the country. Income tax officials were notified of any deposits of cash worth more than 250,000 rupees during the demonetisation window.

Modi has sought to portray the move as a blow struck against organised crime in the name of the country’s downtrodden. “I know the forces up against me,” he said in a speech shortly after demonetisation was announced. “They may not let me live. They may ruin me because their loot of 70 years is in trouble.”[1]

In truth, there is little evidence demonetisation has made a difference in the fight against tax evasion and other forms of corruption; it is likely most of the cash in the black economy had long since found its way into property or other assets. Those hardest hit by the scheme were the unbanked poor of rural India, who rely on their cash savings to survive.

Modi should have sufficient political capital among this constituency to ride out the frantic demonetisation process, however. And he may be correct in his assertion the policy will bring dividends over the longer term. To understand why, it is important to consider Modi’s wider economic programme. While his reforms may at times seem piecemeal and ill-considered, look closer and there is a coherent strategy at work.

Tax reform

When Modi was elected in May 2014, businesses and investors were optimistic he would follow through on his campaign promises to cut the red tape that has long hampered growth in India. His rhetoric put emerging-market investors in mind of the sweeping reforms enacted by P.V. Narasimha Rao during India’s economic liberalisation in the early 1990s. The S&P Bombay Stock Exchange Sensitive Index (Sensex) rose 30 per cent in 2014 and hit record highs following Modi’s election triumph.

Progress since then has been disappointingly slow. But progress there has been. Modi’s most significant achievement so far came in August 2016, when he successfully amended the constitution to introduce a national Goods and Services Tax (GST) from April 1 this year.

The GST could represent a big step forward for the Indian economy. India currently has a federal taxation system. Companies that operate in more than one jurisdiction face a plethora of state taxes, including the octroi, an entry tax that is responsible for one of India’s familiar sights: snaking queues of lorries waiting to cross state borders.

The GST will replace the octroi and several other local taxes with a national regime, streamlining the system and effectively turning India into a single market for the first time. Large companies whose operations span multiple jurisdictions will be the most obvious beneficiaries. Take the automobile sector. In India, cars are mostly sold outside the states in which they are made. Under the old rules, manufacturers would be charged for moving goods across states as well as on the final sale. The GST will remove this aggregating effect and companies will be able to pass some of the consequent tax savings on to the consumer.

In some industries, taxes are likely to rise during the standardisation process. Telecommunications firms could be negatively affected, as the service tax rate is likely to increase from 15 per cent to 18 per cent in this sector.[2] Taxes on pharmaceuticals companies may also rise. Overall, however, the economic benefits to India – in the form of efficiency gains and lower consumer prices – could be enormous. HSBC estimates the GST could add 0.8 per cent to India’s GDP over the medium term.

Bankruptcy law

The GST plan still faces some parliamentary hurdles; indeed, it has already been watered down. The original intention was to introduce a single tax, but after resistance from state governments the GST will now comprise four different tax tiers for various goods, ranging from five to 28 per cent. Only around half of India’s state legislatures have ratified the tax and there are concerns the remaining states – whose political power derives in large part from their tax-raising capacities – will hold out for further concessions.

This is where the wider logic of Modi’s reform project becomes clear. Some of the earlier reforms enacted by the BJP will empower state governments in other ways, potentially smoothing the passage of the GST bill. In May 2016, for instance, Modi passed India’s first national bankruptcy law, which should improve the country’s flawed and interminably slow insolvency regime and potentially free up new sources of funding for local government budgets.

According to the World Bank, Indian investors’ recovery rate in insolvency situations is 26 per cent, lagging behind China (37 per cent) and the average among high-income nations in the Organisation for Economic Cooperation and Development (73 per cent).[3] The new law provides a framework that will enable creditors to recover debts within 180 days by giving banks the opportunity to take control of struggling companies.

This will enable the financial sector to tackle its most entrenched and damaging problem: the proliferation of non-performing loans (NPLs). India’s banks have seen a marked rise in NPLs in recent years amid widespread defaults among industrial companies. According to the RBI, commercial banks’ NPL ratio hit 9.7 per cent in September, up from 7.8 per cent in March.[4]

Modi’s munis

So how will the new insolvency regime benefit state governments? If it is properly implemented, the law will enable banks to start shifting their capital from non-performing assets into more productive investments, such as municipal bonds. Modi has encouraged local governments to issue more of these bonds, and introduced new regulations designed to kick-start the municipal bond market last year as part of his ‘Smart Cities’ initiative to boost infrastructure spending.

The new bankruptcy regime could help support this project by enshrining creditor protection in law. If banks and other investors become more active participants in the nascent municipal bond market, states could have access to a valuable new source of funding, reducing their dependence on tax and therefore offsetting the potential hit from the imposition of the GST.

In this context, the logic of demonetisation is clear. The flood of high-denomination notes into the financial system has strengthened its overall capital base and will enable banks to spur productive investment in the Indian economy. At least 95 per cent of the demonetised cash has now been brought back into the financial system, exceeding the government’s expectations.[5]

These various interlocking policy elements suggest Modi is advancing a coherent plan of economic reform, albeit a slow and occasionally flawed one. But it’s worth keeping an eye on the state elections this month. Gains for opposition parties such as the Bahujan Samaj Party (BSP) in Uttar Pradesh could make it more difficult for Modi to force reforms like the GST through the upper house of the Indian parliament, where the BJP currently holds only 73 of 250 seats, without further amendments. Investors in India are cautiously optimistic about Modi’s economic programme; now he must convince the voters.


[1] ‘India: Narendra Modi’s bonfire of the rupees,’ Financial Times, November 2016

[2] Industry executives expect the service tax rate to rise to match the 18 per cent tier of the GST, according to reports in the Indian media. ‘Your mobile bills may go up once GST is in place’, The Economic Times, November 2016

[3] ‘Doing business 2017: equal opportunity for all’, World Bank, 2016

[4] ‘Financial stability report 2016’, Reserve Bank of India, December 2016

[5] ‘View: Is demonetisation a success or failure?’, Economic Times, January 2016

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