By Satyajit Das, derivatives expert and the author of Extreme Money: The Masters of the Universe and the Cult of Risk (2011). Jointly posted with Roubini Global Economics
In the aftermath of the global financial crisis, optimists hoped that the BRIC (Brazil Russia India China) would drive the global economic engine. But China’s economic growth has slowed to its lowest rate in three years. Brazil’s economic growth has fallen from around 7.5% to under 3%. Russia’s economy is heavily dependent on oil and energy prices. India also has stalled. This 3-part paper looks at the development and future trajectory of the “I” in the “BRIC”. The second part looks at the India’s current problems.
In late 2011, the Indian government’s 12th five-year plan forecast growth of 9% between 2012 and 2017. By early 2012, India’s growth had slowed to around 6%, high by the standards of developed countries but well below the levels required to maintain economic momentum and improve the living standards of its citizens.
Elements of the “India Shining” story remain intact – the demographics of a youthful population, the large domestic demand base and the high savings rate. Increasingly, India’s problems – poor public finances, weak international position, structurally flawed businesses, poor infrastructure, corruption and political atrophy- threaten to overwhelm its future prospects.
In recent years, India has consistently run a public sector deficit of 9-10% of GDP, including the state governments and off-balance-sheet items.
Confronted with the global financial crisis and the additional complication of a poor monsoon, India implemented successive aggressive stimulus packages from 2008 onwards to restore growth. The predictable result was an increase in the central government’s fiscal deficit from 2.6% of GDP in 2007/2008 to its current level of over 6.5%. If the individual states are included, the deficit jumps to around 10%.
The problem of large budget deficits is compounded by one of the major causes – poorly targeted subsidies for fertiliser, food and petroleum which may amount to as much as 9% of GDP.
In March 2012, India brought down a budget forecasting a fiscal deficit of 5.9%, well above its previous fiscal deficit target of 4.6%. The budget did not engender confidence that India was steering a credible fiscal course, bringing its public spending under control.
Prior to the budget, Prime Minister Singh announced a separate stimulus package including $35 billion of public sector investment. The spending was to be financed by forcing state-owned companies such as Coal India and the Oil and Natural Gas Corporation to invest existing surplus cash.
The use of additional fiscal stimulus to restore growth is questionable. India’s strong rate of recent growth (an average rate of 14% between 2004-05 and 2009-10) made large deficits, in the order of 10 % of GDP, relatively sustainable. Slowing growth will increasingly constrain India’s ability to run continuing large deficits.
Indian government’s debt is around 70% of GDP. As its debt is denominated in Rupees and sold domestically, India faces no immediate financing difficulty. Instead, the government’s heavy borrowing requirements crowds out private business.
Indian banks are significant purchasers of government bonds. The banks, generally majority state owned, are also forced to lend to Indian state enterprises. This limits the supply of credit to Indian businesses that are forced to borrow overseas, exposing them to currency risk. Given India’s deteriorating external position, the foreign debt is becoming increasingly problematic.
India is running a current account deficit of over 3% of GDP trending higher, towards 4%. This is only slightly behind the US and amongst the highest in the G-20.
Exports have slowed as a result of weakness in India’s trading partners. At the same time, imports, a large proportion of which are non-discretionary purchases of commodities and oil, have increased. India imports around 75% of its crude oil from overseas. Higher oil prices combined with increasing political risk in the Middle East increases the pressure on India’s external position.
Over the last 2-3 years, India has financed this deficit through foreign investment, attracted by the country’s strong growth, rising equity markets and future prospects. India’s deteriorating outlook – slowing growth, large budget, large trade deficits and weak equity performance in 2011 – has reduced the flow of investment. India is also increasingly reliant on short term capital flows which are going into money markets rather than long term equity investments, increasing the risk of instability.
Higher commodity prices, wage rises and domestic capacity constraints have kept inflation high forcing the RBI to keep monetary policy tight and interest rates high. However, increasingly, the authorities face a policy dilemma. Lower rates may assist growth and boost slowing demand but are inconsistent with stability of prices and the Rupee, especially with inflation high and pressure on the currency.
India’s weak external position has manifested itself in the volatility of the Rupee, which was one of the worst performers amongst Asian currencies in 2011. Indian businesses, which have unhedged foreign currency borrowings, have incurred significant losses as the value of their debt rises as the Rupee falls.
The problems are compounded by the fact that Indian companies face large debt maturities in the coming year. The ability to refinance the debt coming due remains an issue in an environment of a weakening economy as well weaker company outlook.
European banks have reduced their lending in Asia, choosing to focus on home markets in Europe. In an interesting development, Reliance Communications was forced to turn to Chinese banks for finance. The transaction was conditional on the purchase of equipment from China.
Refinancing issues are also complicated by the fact that the some of the debt is in the form of foreign currency convertible bonds (“FCB”s) designed to convert into the issuer’s shares rather than be repaid at maturity. Indian companies have over $5 billion of convertible bonds maturing in the current year.
In an environment of booming stock markets between 2005 and 2008, FCBs provided companies with low cost debt. However, the toxic combination of falls in share prices and a fall in the value of the Rupee (in which the shares are denominated) means that the FCBs will not convert and need to be repaid. The repayment in foreign currency will crystallise large currency losses. In addition, refinancing the FCBs will result in much higher borrowing costs, which will significantly affect the profitability of Indian corporations.
The refinancing issue poses a problem for the RBI. India has US$250-300 billion in currency reserves (enough for around 7 months of imports). Foreign debts that must be repaid in the current year are around 40-45% of this amount, which if deducted highlights the increasing weakness in India’s external position.
In an effort to manage the problems, India has eased the regulations on foreign lending to India hoping to attract investment.
Slowing growth, tighter credit and other economic problems have increased corporate defaults to the highest level in 10 years resulting in bad loans. Non performing loans are now around 2.5-3.00% of bank assets. Analysts estimate that the major banks have around $25 billion in bad loans, an amount which is increasing.
The problem is greatest for government owned banks, which constitute 75% of the banking system. The bad loans are concentrated in sectors such as power, aviation, infrastructure, real estate and telecommunications.
The common element is that these industries are characterised by government involvement and which have suffered from erratic government policy or wholesale interference. In electricity, state owned utilities have accumulated losses of $14 billion, in part because low government mandated rates dictated by political considerations do not cover the cost of generation.
Two of India’s biggest airlines, the State owned Air India and the privately held Kingfisher Airline, are now struggling to pay employees as they struggle under large debt burdens.
The Indian government has already moved to recapitalise State owned banks to ensure their capital position. In the process, the budget deficit and the government borrowing requirements have come under increasing pressure.
The Victor Kiam Syndrome …
Foreign commentators see India’s growth as being driven by tens or hundreds of millions of individual entrepreneurs, rather than the state as in China. They praise India’s export of services rather than cheap manufacture products. Foreigners also admire India’s business innovation, mostly notably the “frugal innovators” that have introduced cheap “nano” mini cars and inexpensive tablet computers.
The reality is more nuanced. India continues to be dominated by state- owned business and the large oligarchic firms, which existed prior to economic liberalisation. Studies have found the economy continues to be dominated by an oligopoly of incumbents, which have maintained or increased their positions.
India’s exports are diversified—both geographically and in terms of the products it sells. But export oriented firms are affected by the economic weaknesses in their major trading partners. With few exceptions, they have not moved up the value chain, continuing to provide the new economy version of cheap manual labour. Innovation remains weak relative to international market leaders.
Export oriented firms face challenges from rising labour costs, as a result of the shortage of skilled workers. In some areas, cost pressures are forcing these firms to relocate overseas, reversing one of the trends that underpinned growth.
Both international and domestic businesses are restricted by India’s infrastructure weaknesses. Cost structures are increased by the need by businesses to invest in power generators (to counteract inconsistent power supply), workforce training (to overcome staff shortages) and even transport and housing infrastructure for their workers.
Domestic firms also continue to face inconsistent and frequently dysfunctional government regulation and competition.
The airline industry provides a case in point. The weaknesses of Air India, the government owned nation carrier, allowed a number of private carriers to prosper – Jet Airways, Kingfisher, Spice Jet etc.
In recent years, a government recapitalised Air India has added new planes, competing vigorously, to regain lost market share. The combination of a government supported competitor, higher fuel prices and poor management has caused the private airlines to stumble. One private carrier – Kingfisher – is now struggling to pay employees and has been forced to cut flights. In the absence of a substantial new capital injection, Kingfisher’s future is uncertain. Few if any airlines are now profitable and shareholders, lenders and the government are at risk of losing billions of dollars.
Domestic difficulties, in part, have encouraged some firms to expand internationally – Tata Motors purchased Jaguar Land Rover; Tata Steel bought Corus; Mittal Steel bought Arcelor; Bharti Airtel bough Zain Africa. The reverse colonialism has encouraged jingoistic, patriotic breast beating. But the commercial logic of some of the transactions is highly questionable. Funded by large amount of debt, the acquisitions have performed poorly financially. Their long term prospects are uncertain.
The Tata CEO’s personal like of jaguars prompted comparison with the famed Victor Kiam who liked Remington razors so much he bought the company.
There remain governance issues at many Indian companies, highlighted by the fraud at Hyderabad-based Satyam, at the time one of the top five IT outsourcing companies.
We have no Infrastructure Today…
India is plagued by inadequate infrastructure. In critical sectors like power, transport and utilities, there are significant shortages. Poor investment and slow government decision making has hindered development.
Political pressure to keep utility costs low has impeded investment. In the electricity sector, state-owned utilities that purchase power from producers and sell to residential users have incurred large losses. State governments are unwilling to raise retail consumer rates despite increases in the price that power producers charge the utilities.
Electricity generators cannot obtain sufficient coal from the state-owned mining monopoly Coal India, which has been unable to increase production to match the demands of new power plants. Some electricity producers have been forced to invest overseas to assure access to coal.
Attempts to increase rail ticket prices have failed. The Railways Minister’s own party opposed the proposal and demanded he be removed from his job.
Increasingly, the structural problems and poor history of projects has made foreign investors cautious, creating a shortage of foreign capital for investment in infrastructure.
While its workforce is young and growing, there is a shortage of skills.
In a dysfunctional public education system 40% of student do not complete school. The workforce is 40% illiterate. India’s overall adult literacy rate is 66% compared to 93% for China.
Some universities, especially the 16 Indian Institutes of Technology, are world class. But their limited capacity means that are significant shortages. Some estimates forecast a shortage of 200,000 engineers, 400,000 other graduates and 150,000 vocationally trained workers, such as builders, electricians and plumbers, in the coming years. In contrast, there are 60-100 million underemployed or surplus low skilled workers in agriculture.
There is concern that universities graduates are good mainly at cramming to pass examinations. Employers have to invest heavily to make them “job ready”. Graduates who travel overseas for foreign qualifications frequently prefer to stay and work overseas where the rewards are greater.
The shortage has led to large increases in salaries for skilled workers. There are also cultural issues. An Indian magazine Business Today published a story entitled “Brats at Work,” complaining about the attitude of young workers.
Higher wages increase the cost of Indian businesses making them internationally less competitive and fuelling domestic inflation. The shortage of skilled workers also makes it harder to improve infrastructure gap. The problems surrounding the New Delhi Commonwealth Games highlighted both the infrastructure and skills shortages.
The real question is whether India has the collective will and ability to overcome its “sea of troubles.”