India's Pragmatic Populism


February 10, 2017 [India, Government, Central Bank]
Charles Roth

Demonetization, "Operation Clean Money," central bank surprises, and a populist budget that also exhibits fiscal consolidation? Negative foreign investor equity flows, and India's stock market is up?

Vidhana Soudha, Bangalore, India

For a country steeped in its customs, India's government and central bank have taken a liking to the element of surprise. The policy announcements have been far from pleasant, causing people degrees of consternation and short-term economic pain. But to their credit the authorities in New Delhi appear willing to run political, albeit calculated, risks for longer-term economic gain.

Rather than cut and run, foreign investors should take a closer look at what the government of Prime Minister Narendra Modi is doing. If populism appears to be on the march in the U.S. and Europe, its current expression in India appears quite pragmatic. And not just on the fiscal front.

For a second consecutive meeting, the Reserve Bank of India Wednesday defied market consensus for a cut in its benchmark repurchase rate of 6.25%, even as inflation dropped sharply in response to the "demonetization" shock of early November. That's when the government announced the sudden cancellation of 86% of the currency in circulation in a bid to reduce the country's outsized black market economy and the corruption that it engenders. The finance ministry in its annual Economic Survey, which was released January 31, 2017, estimated the economic hit from the replacement of India's two-largest denomination bills at 0.25% to 0.5%, slowing growth to 6.5% in the current fiscal year ending March 31. But for 2018 fiscal year, which starts April 1, 2017, the survey pegs growth at 6.8% to 7.5%. That would mark the fastest rate of any large economy in the world.

Inflation in December of 2016 was 3.4%, comfortably below the 4% mid-point in the central bank's target range. Certainly the disinflation and the dip in growth influenced widespread expectations for a cut in the benchmark rate. But the central bank, which unexpectedly shifted its monetary stance to "neutral" from "accommodative," is also taking into account a drop in bank lending rates following the flood of deposits of old bank notes as part of the demonetization program. The RBI, as the bank is known, is also factoring in the marked rise in commodities prices, particularly food and energy, and their expected impact on inflation in the second half of this calendar year.

That backdrop plays into yet another batch of smaller surprises built into the 2018 Union Budget, which was released a month ahead of schedule on February 1, 2017. If government budgets reflect executive branch priorities, Modi and Finance Minister Arun Jaitley are trying to strike a balance between populist, albeit quality, spending, and continued fiscal consolidation. The budget for the fiscal year starting April 1, 2017, pencils in a deficit of 3.2%, slightly under consensus expectations of 3.3%, and lower than the current fiscal year's 3.5% gap. Jaitley reiterated that government remains committed to a medium-term budget deficit of 3%, and a government debt-to-GDP ratio of 60% by 2023 from nearly 69% in fiscal year 2016.

Despite the surge in commodities prices, the budget's allocation to subsidies as a percentage of GDP will decline about a tenth of a point to 1.6%, the lowest level in nearly a decade. It's the mix, though, that appears politically savvy, with a rise in food subsidies offset by a drop in fuel subsidies in a country that imports nearly four-fifths of its oil. The level of support for fertilizer expenses remains unchanged, which is important in a country where the rural population accounts for about two-thirds of all people and the agriculture sector still represents roughly 17% of GDP, according to the World Bank.

Indeed, while the budget included cuts in income taxes on small businesses and the middle class (and a 10% surcharge on those earning more than INR 5 million), it increased agricultural and infrastructure spending, including affordable housing, to record levels. In all, total spending is projected to increase 6.6%, while revenue is forecast to rise 6.5%, thanks to a 13% jump in tax collections driven to a considerable extent by the demonetization program: India's tax department reckons the number of Indians filing tax returns to double this year to 75 million.

As part of its war on "black money," the department has also just launched "Operation Clean Money" to examine the surge in bank deposits for signs of tax evasion. Unexplained sources of old-bill deposits of more than $3,000 are to be slapped with a 50% tax. But tax inspectors are reportedly overwhelmed with work, as deposits surpassing that amount were made into 11 million bank accounts ahead of the December 30, 2016, deadline.

Alongside the budget's focus on rural development, Modi is promoting his demonetization and anti-corruption campaign to bolster his Bharatiya Janata Party's prospects in crucial state elections this year, particularly in the key agricultural stronghold of Uttar Pradesh, where voting among its 200 million people will run through March 8, 2017. A strong showing for the BJP there will bolster Modi's chances for reelection in 2019. Responding to the political opposition's criticism of the demonetization program, Modi, February 8, declared that demonetization and the fight against corruption isn't directed at any particular party, but rather is aimed at helping the poor and "empowering the honest."

His message has been resonating. According to a Time Now-VMR survey, the BJP is projected to win a slight majority of seats in the Uttar Pradesh assembly election, returning it to power in the state, and 63% of those polled also declared support for demonetization.

Perhaps surprisingly, rather than capitalize on the knee-jerk selloff immediately after the November 8, 2016, demonetization announcement, foreign investor equity flows turned negative. But the country's retail investors have been plunking money into domestic equity mutual funds. The net result is positive: the MSCI India Index is up 4.1% in the three months to February 9, 2017. And since the beginning of February 2017, when the budget was introduced, it's gained 2.7%, handily outperforming the 1.8% gain in the broad MSCI EM Index. Modi's populism is so far proving both popular and prudent, at least for local investors looking beyond the recent twists and turns in macro policies.

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