Modi's Fiscal Reconstruction

The Indian PM is planning the most audacious rethink of fiscal policy ever seen in India. Even if he is partially successful, Narendra Modi's reconstruction of the Indian fiscal policy will have far-reaching implications for the incipient economic recovery underway in India.

In particular: (1) The PM's focus on reducing 'leakages' from the subsidy system looks likely to stymie the rural wealth effect that has been such a powerful driver of consumption over the past five years. (2) The big blast of government-funded capex that is likely to be announced in the Budget is likely to compensate for the private sector's reluctance to embark upon capex. (3) The PM's willingness to use fiscal incentives to push states towards land, labour and subsidy reforms creates the genuine possibility of structural reform in a country where the political class does not really want reform. What is the PM trying to do?

Based on my meetings with policymakers in Delhi, I reckon Mr Modi is pursuing four distinct goals, as he and his team rethink and reconstruct the fiscal policy:

1. Higher tax/GDP ratio: India's tax-to-GDP ratio has been between 8 and 12 per cent over the past two decades. This makes India similar to most sub-Saharan African economies as for most developed economies this ratio is upwards of 25 per cent. This unflattering comparison with more mature countries highlights the sheer scale of tax evasion in India. Using GST (the constitutional amendment for which has been tabled in the Parliament) and clever IT infrastructure, Modi seems determined to lift India's tax/GDP ratio.
2. Lower leakages: The PM's advisors are convinced that by moving India's subsidy mechanism from subsidies in kind (for instance, cheap food, fuel and fertiliser) to subsidies in cash (through direct benefit transfers to recipients' bank accounts), they can save at least 0.4 per cent of the GDP (which amounts to around $10 billion). In fact they say that if they go after the misspending by institutions like the Food Corporation of India, around 1 per cent of the GDP (i.e., $20 billion) can be saved every year.
3. More government capex: The savings outlined in the above point alongside savings arising from the drop in crude prices gives the PM a kitty equal to 1.5 per cent of GDP ($30 billion). If you add to this the 1.5 per cent of GDP that used to be allocated by the Planning Commission but now seems likely to be spent at the finance ministry's discretion, you can see how the PM can command an annual kitty equal to 3 per cent of GDP (around $60 billion).
   I believe that this corpus will be spent in two ways, the first of which is big-ticket capex by the government. PM's advisors point out that over the past ten years, whilst government spending in general has grown at 13 per cent CAGR, government spending on capex has grown at a pitiful 0.05 per cent CAGR. Set alongside the very public failure of the PPP initiative to build India's infrastructure, there appears to be a yawning need for the government to embark upon big-ticket capex. We, therefore, expect the Budget on February 28 to launch a blast of government spending on T&D, defence, railways, freight corridors and low-cost housing.
4. 'Competitive federalism': The second area where the PM seems likely to direct funds is towards incentivising the states to follow his reform agenda, which includes launching Rajasthan-style land and labour reforms, moving subsidy programmes onto the DBT platform, addressing state electricity board losses and, perhaps most controversially, lending support to the NDA's agenda in the Parliament. This is where Modi's reconstruction of the Indian fiscal policy is at its most inventive form and the odds, we believe, are in favour of the PM using fiscal incentives to browbeat the states towards delivering his chosen agenda. As the Wall Street Journal noted in its editorial on January 29, 2015, "The invitation to the states to get a headstart is part of the government's policy of 'competitive federalism', which, in the best case, will put pressure on upper house legislators not to stand in the way."

Will Narendra Modi succeed in pushing through this audacious rethink of fiscal policy?

Whilst the PM's rethink of fiscal policy is audacious, I am circumspect about whether any more than half of this agenda can be delivered upon. There are at least three powerful groups that seem likely to oppose the PM's agenda:

1. Non-NDA state chief ministers are being emasculated in the construct that the PM has in mind. They will not take kindly to this and, at least in the short run, they will block whatever they can in the Parliament in the hope that the PM will back down.
2. The rural elites - many of them politicians at the state and local level - have benefited mightily from the expansion of subsidies (and the corresponding expansion of leakages) over the past ten years. Given that India spends $70bn per annum of subsidies, most estimates suggest that at least half of this ends up in the hands of politicians and their henchmen. It is highly unlikely that these politicians will sit and watch the gravy train be de-commissioned by Narendra Modi.
3. It is not clear to us how much of the RSS and indeed the BJP are on-side with the PM's audacious agenda. Most of the BJP is made up of fairly conventional politicians and their interests are more aligned with other run-of-the-mill politicians (as per the previous point) than with the PM.

All of that being said, given the challenges that the PM is facing in the Rajya Sabha (one opposition MP told me three weeks ago that "for the next two years we will shout down everything that is tabled in the Rajya Sabha"), unless Mr Modi uses a re-invented fiscal construct, he will find it hard to push legislation through Parliament.

Investment implication 1: The likely breakdown of the rural wealth effect
Whilst the exact sums are a matter of debate, it is safe to say that subsidy leakages have over the past decade resulted in the tens of billions of dollars per annum being pilfered by the rural elite (which is a combination of politicians, local thugs and local businesspeople - such as car dealers, cement distributors, FMCG distributors and builders - working in cahoots with each other, often in groups linked by close family or social ties). Since they could not 'consume' such large sums of money without attracting the attention of the taxman, a lot of this pilfered wealth went into buying land and gold.

As the PM seeks to reduce leakages, there is a real risk that he will break this rural wealth effect that has driven the consumption of cars, SUVs, jewellery and other big-ticket items. Furthermore, the post-May 2014 cooling off in rural land prices could also impact housing finance companies (many of which have recently seen a spectacular rally in their share prices).

At the other end of the consumption spectrum, it seems likely that the use of direct benefit transfer to transfer money to low-income families could give them more disposable income. That in turn could boost the consumption of small-ticket items such as FMCG goods.

Investment implication 2: The government kicks off the still sluggish capex cycle
The government is likely to play an active role in building roads, freight corridors, affordable housing, T&D infrastructure and power plants. Once the cash inflows from these projects stabilise, the government might then sell down the asset to the private sector. As stated in its mid-year economic analysis, published on December 19, 2014, the government says, "It seems imperative to consider the case for reviving public investment as one of the key engines of growth going forward, not to replace private investment but to revive and complement it." (Source: http://finmin.nic.in/reports/ MYR201415 English.pdf)

As a result of this, engineering, procurement and construction (EPC) companies - whether they be in the roads sector, T&D sector or affordable housing sector - seem likely to see an upsurge in their order books. Alongside this, with the balance sheets of the private sector infra asset owners in tatters, it seems more likely than not that public sector asset owners (for example, Power Grid, Concor, BEL, Coal India, NTPC) are going to be the kings of the new wave of infrastructure building in India.

Saurabh Mukherjea is CEO of institutional equities at Ambit Capital. The views expressed here are personal.

This column appeared in the March 2015 Issue of Wealth Insight.