The five biggest challenges Jaitley faces

Last Updated: Wed, Jul 09, 2014 10:43 hrs

To the unrestrained delight of investors and financial markets, Narendra Modi prevailed in the audition for India's newest Messiah.

The incumbent has been received rapturously, with commentators running out of superlatives and comparisons - Thatcher, Reagan and several Indian gods.

The Bharatiya Janata Party's (BJP) convincing victory saw it gain a rare majority in its own right. In conjunction with its allies, the BJP (282 seats) now controls around 333 seats (61% of the legislature), an unprecedentedly comfortable majority in India's generally fractious coalition politics.

The win was built on Modi's charisma, the development plank and based on appeals to Hindu chauvinism and the young, increasingly urban classes (India's 'selfies'). The electorate was tired of corruption, lack of progress, incompetent leadership and resistant to the perpetuation of the Nehru/ Gandhi brand of dynastic politics - 'sexually transmitted democracy' as writer William Dalrymple put it. A tired, ineffective and dysfunctional Congress-led government had conceded defeat a long time ago, unwilling to waste political capital in what they saw as a lost battle.

But governing will prove more difficult than winning power. Meeting the weight of popular expectations may prove impossible.

First, the new government's policies remain vague.

Knowing the election was theirs to lose, the BJP did not release its manifesto until late in the campaign. Devoid of detail, it promised greater growth and prosperity, elimination of corruption and removal of business red-tape. In a concerted effort to avoid leaving anybody out, it promised assistance to women, rural citizens, the disabled and the disadvantaged. It promised a 'Rurban' strategy to supply "urban amenities to... rural areas, while retaining the soul of the village."

The policy programs contain internal contradictions.

There is a promise to reduce the budget deficit while maintaining current government spending, eschewing the difficult task of restructuring of large government programs for rural employment and food security. The BJP favours foreign capital but will protect India's millions of small grocery shops and traders, disallowing direct investment in the retail sector, approved by the previous government.

Second, the new government's room for manoeuvre is constrained by India's current economic realities. Growth has fallen to below 5%, down from double digits. Consumption is weak. Business investment is 9% of Gross Domestic Products (GDP), down from 17%. Major Indian businesses have chosen to expand internationally, rather than domestically.

Industrial output is stagnant with sales in key sectors such as automobile weak. The agricultural sector, which has benefitted from good rainfall, strong production and high prices, is slowing.

India needs to create around 1 million new jobs each month just to absorb new entrants to the workforce. This does not take into account reducing unemployment and under employment or providing work for people migrating from rural areas to cities.

The lack of a substantial manufacturing sector constrains much needed job creation. India's National Manufacturing policy sought to increase manufacturing's share of GDP to 25% from 16% and create 100 million jobs within the next decade. In fact, India has de-industrialised with manufacturing declining to 15% of GDP. In the last decade, employment in manufacturing and the large agriculture sector has decreased.

Export demand has picked up, in part due to increased competitiveness following the significant devaluation of the Indian Rupee, but remains fragile due to continued weakness in major trading partners.

The current account deficit has narrowed, mainly due to lower imports driven by, in part, the previous government's restrictions on gold imports. But the capital account remains vulnerable with weak capital inflows which are flattered by expensive bank deposits from non-resident Indians.

Policy options are also limited. The budget deficit remains at 4.6% (even after a liberal accounting) restricting the ability to initiate a major fiscal stimulus package. In reality, once state governments are included, the real budget deficit is closer to 8-10%. The fact that the government has not run a surplus since independence in 1947 and under 5% of the population pays tax make it difficult to restore India's public finances.

With continued pressure on food and energy prices, monetary policy remains focused on combating inflation with limited scope to lower interest rates to stimulate activity.

Third, the banking system remains under pressure, constraining the supply of credit. Unresolved bad debts may require recapitalisation of state-owned banks, increasing budgetary problems. The combination of a weak financial system and many highly leveraged infrastructure firms means that raising funds for essential projects will remain difficult.

Fourth, India faces key external risks over which it has little control, including potential rises in energy prices driven for example by problems in Ukraine and the Middle-East, capital outflows resulting from further reductions in the US Federal Reserve Bank purchases of government bonds or a ratings downgrade. Investors have forgotten that in 2013 when the US Fed Chairman raised the possibility of a reduction in bond purchase, Indian financial markets came under sustained pressure.

Fifth, the structural change agenda remains daunting. Key areas requiring radical reform include land acquisition, labour markets, and banking and state ownership of key businesses. Fiscal reform needed includes politically difficult changes in the tax base including more reliance on sales taxes and review of many poorly targeted subsidy and social welfare programs. Attempts at significant change have largely defeated successive governments over the last 25 years.

Indian stocks, up over one-third since September 2013, and the rupee, up about 15 per cent over the same period, have a lot of good news built in to the price. It will be interesting to see if the new government is able to meet the market's high expectations.

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