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Sajjid Chinoy: The market needs a reality check

The translation from political stability to an economic turnaround could be far more challenging than markets are assuming

More Columns by Sajjid Chinoy

For a change, the is only the second-most important contest of the summer. Rightfully, the country is riveted instead by the electoral horse race that is currently unfolding. Expert opinion is still divided. Polls have consistently pointed to an increasingly strong performance by the opposition alliance. Yet, some political analysts point to how wrong polls have been in the past. Some talk about a wave building up in the country. Others allude to a momentum shift in the recent phases. Safe to say there is little consensus on the outcome. But one can make a more minimalistic assessment that more is expected post election than was presumed, say, six months ago.

In turn, the presumed political stability and economic implications thereof have set on fire. The equity market has continuously hit new lifetime highs in recent weeks (18 lifetime highs in six weeks!) and, thereby, significantly outperformed other emerging markets (see chart). Much of this has happened well after the restoration of macroeconomic stability in India, confirming it's being underpinned largely by election expectations. The underlying presumption is simple, but risks being simplistic. A more stable political formulation post elections is expected to engineer a relatively swift and sustainable economic turnaround. The new government is expected to start by unleashing a wave of reforms. And debottleneck stalled infrastructure projects on the ground. All this should jump-start the next capex cycle. The resulting supply will create conditions for the Reserve Bank of India (RBI) to ease monetary policy. And the good days will be back again.

Markets could well be right about a more politically stable formulation. But the translation from political stability to economic outcomes is far more tenuous and uncertain than is being presumed. Here's why. There is widespread consensus that resolving implementation bottlenecks on the ground is key to jump-starting the next capex cycle. And the presumption is that a new government will be able to de-bottleneck the residual constraints on the ground. It would, if only the constraints were under its jurisdiction! We looked at the top 50 projects (in value terms) currently stalled on the ground, as reported by the Centre for Monitoring the Indian Economy. These account for a whopping 70 per cent of the total value stalled on the ground. Guess what? Fifty five per cent of these projects were stuck because of problems with land acquisition. Land acquisition is a state subject over which a new government - however strong or well intentioned - will have little jurisdiction. Another 25 per cent of projects have been stalled primarily in the power sector, because of the lack of access to coal and raw materials or, in most cases, because they had problems selling higher-cost power to state electricity boards. There is a more fundamental problem here. Plant load factors for thermal power plants have been falling sharply over the last two years reflecting both the general economic slowdown but also the financial stress of different state electricity boards. The latter, in turn, require sustained increases in power tariffs in different states which is, of course, a state-related issue, over which a new central government will have little leverage. All told, 75 to 80 per cent of the problems on the ground are outside the direct jurisdiction of the central government.

Even assuming that projects are finally cleared, other constraints have come to bind. There is a meaningful debt-overhang in the infrastructure sector. Debt-equity ratios for firms in power, telecom and roads are at 15-year highs and a sustained deleveraging will be required to create the balance sheet strength to finance the next capex cycle. Among the BSE-200 non-financial group, for example, 17 per cent of firms have operating incomes that are less than 1.5 times their debt-service obligations. It is this balance sheet constraint that has prevented some projects already cleared from being executed.

The corollary of all this is rising impaired assets on public sector bank balance sheets. For the banking sector to participate in the next capex cycle, a significant capital injection into public sector banks will be required off the budget for which - unless growth and revenues pick up or subsidies are sharply rationalised - there is little space. But, growth itself is a function of the capex cycle leading to a chicken-and-egg problem.

Compounding all this is the fact that both fiscal and will have to remain tight for the foreseeable future. The current finance minister has shown admirable fiscal restraint for the last 18 months but, arguably, there was little choice. Not having done so would have risked a sovereign ratings downgrade and India would have lost its investment grade status. The last thing any new government would want is for India to suffer a downgrade in its first year. So fiscal consolidation will be non-negotiable. This is clearly a good thing from a macroeconomic stability perspective, but could constitute a meaningful drag on growth.

In fact, the first budget will be both crucial and challenging. How does one boost public investment and simultaneously achieve a 0.5 per cent of GDP consolidation according to the fiscal road map in an environment of weak growth and tax revenues? Presuming realistic tax revenue assumptions, the only way is to either slash subsidies or double-down on privatisation and disinvestment. Depending on the size of the electoral majority of any new government, both could be tricky.

Similarly, there is no scope for monetary easing. In fact, with the momentum of core CPI above eight per cent at a time when growth is below five per cent, rates may well have to be raised further if either growth actually accelerates (causing output gaps to widen in the near term) or a supply shock (for example El Nino) plays havoc with food inflation, which risks a more generalised inflation spiral.

In other words, the economic reality on the ground is at odds with the euphoria currently characterising equity markets. To be sure, there has been much progress over the last year. The twin deficits are in much better shape, diesel prices have been rationalised for an unprecedented 14 consecutive months, a large stock of stuck projects have been cleared, and the has gained enormous credibility on the foreign exchange front and moved towards inflation targeting.

Most of all, this appears to be India's 1992 moment when Bill Clinton famously said, "it's the stupid". For the most part, the elections have been fought on economic visions and different governing ideologies. This is a massive structural advancement.

Make no mistake, markets and economic variables may well rally temporarily. Assuming a strong election result, confidence could rise, some animal spirits could be stoked, more capital may well be committed, some deleveraging will be accelerated amid buoyant capital markets, and some shovel-ready projects could be implemented. And this could generate a quarter or two of a growth pop.

But a more sustained recovery will be far more challenging and time-consuming given the facts on the ground. Markets and analysts, therefore, need to be patient. Because ignoring economic reality and conjuring up unrealistically high expectations could only lead to greater disappointment later.

The writer is Chief India Economist, JP Morgan

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