Indian shares, after ending July ahead 5% on the MSCI Index despite price-earnings ratios above the emerging market average, were further buoyed with the unanimous passage of a national goods and services tax (GST) by the upper house of Parliament.
The constitutional amendment culminated a decade-long effort under both the previous Congress Party and current BJP governments, and as a signature reform on Prime Minister Modi’s agenda answered criticism of slow progress after two years in office.
Under an April 2017 implementation date, when state and federal authorities are to agree on a single rate and a transition formula for lost revenue, it will replace the existing dysfunctional system of overlapping and proliferating geographic levies ranked in the World Bank’s Doing Business report at 150 out of 170 countries.
An expert group recommended a basic 18% tax and progressive bands on product categories reaching 40% for luxury items, but a new council will revisit this structure before a single code is promulgated for adoption by parliament and state legislatures.
Domestic and foreign companies hailed the move, but worried about a resurgence of disputes in the interim and likely timetable delay which will erode promised competitive and fiscal gains.
As with the revised 7.5% GDP growth figure, they believe the Modi administration’s estimate of another 1.5% bump from the GST plan may be exaggerated, as attention is again deflected from underlying budget and state-run enterprise weakness amid salary hikes and earnings losses.
Higher consumer price inflation, already above the 6% official target as central bank governor Raghuraman Rajan prepares to exit, is another risk should the core sales tax rate increase to 20%. Food costs, with abundant monsoon rains destroying crops, have been the main cause of the spurt, and the energy category has also started to rise in line with global rebound.
The monetary authority has kept benchmark rates on hold, while injecting liquidity into the government bond market in an attempt to lower corporate and household borrowing expense. A number of well-known candidates, including the current Economic Planning head and the World Bank’s former chief economist, are reported to be on the shortlist as Rajan’s successor.
The next governor faces immediate credibility and management tests beyond trying to match Rajan’s reputation. Non-resident Indians will redeem $25 billion in special high-yield accounts offered during the US Federal Reserve’s 2013 “taper tantrum” to boost reserves, which have since recovered to over $300 billion, and the outflow could pressure the rupee.
A second big challenge is the debut of a full-fledged monetary policy committee, conceived under Rajan to strengthen central bank’s political and technical independence. It is charged with upholding the 2-6% inflation target range and ensuring bad loan cleanup and reporting at state banks in particular, where the ratio is 15%.
In recent valedictory comments, Rajan warned against reversion to the “old forbearance days,” and emphasized the urgency of “restructuring large stressed projects.”
Government-controlled banks, which account for 70% of system assets, received $3 billion in budget recapitalization funds in July, but analysts estimate the true hole may be ten times that amount. They have been stuck with troubled property, steel and infrastructure company exposures the past decade that combine with steep overhead costs, up 10% in the last quarter at leader State Bank of India, to hurt profitability and share values.
With these burdens, their annual credit growth has slackened to 5%, and private competitors like HDFC Bank have selectively jumped into the breach, particularly in under-served retail and small business areas.
New entrants may soon be added under a new “rolling license” plan instead of periodic past openings, but they will continue to avoid tycoon “promoters” in or near default, who now face accelerated bankruptcy procedures designed to cut the previous five-year workout period.
Foreign distressed debt and private equity firms have joined local counterparts in sifting through the damage for recovery prospects, but are hampered by heavy up-front payments and constantly changing rules.
On banking, tax, and fiscal-monetary policy, the Modi administration’s consolidation slogan has been popular but routinely belied by the fragmentation in its wake.
Gary N. Kleiman is an emerging markets specialist who runs Kleiman International in Washington, D.C.
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