India – the Greatest Challenge?

This is a guest post from my friend, HBS classmate, and India expert, Vivek Gupta.

India – the Greatest Challenge?

During my two years in the US, I had often put off many purchases after mentally converting their price into Indian rupees. I was therefore utterly shocked when I paid by first restaurant bill after coming back to India. The meal cost me as much in dollars as it would have cost me in a far classier restaurant! When I mentioned this to my friends most of them sighed and said “mehengai” (price rise) or in economics terms  “inflation”.

In his last post, Matt (as usual) presented a very comprehensive analysis of the challenges facing the new Indian government. While each and every one of them is highly relevant, in my opinion the government faces an immediate problem that not only threatens the macro recovery but the public popularity that it requires to implement major changes.  That problem is inflation!

As the chart below shows, after a period of relatively stable inflation (ranging between 3.5-4.5%) between 2000-2006, inflation has been on a steady rise, peaking at 12% in 2010.  What is more worrisome is the fact that a succession of finance ministers (and one Prime Minister) has justified high inflation as a ‘cost of growth’. This explanation emerges, as in the case of Turkey, when the central banker and the minister are at loggerheads over the direction of interest rates. While I have many bones to pick with the Reserve Bank of India, in this case I am inclined to fully side with them.

Source: World Bank

Inflation is inherently inimical to growth. Like other emerging markets, a significant share of India’s growth will have to come from exports, whether it be manufacturing or services. India’s problem (or a blessing in disguise – depending on your views on the Dutch disease) is that it is not excessively endowed with exportable natural resources. As a result, its competitive advantage lies in the cheap labor force and its ability to attract businesses based on this advantage. Surging inflation erodes this competitive advantage. Annual salary increments in India range from 12-16% - a rate at which it not only is unable to attract manufacturing from China but also lose its competitive edge to nations like Philippines in outsourcing and IT enabled services. The Indian IT industry is already rife with anecdotes of instances where US companies are finding that it is cheaper to hire US citizens from the ‘fly-over States’ rather than outsource work to India. As the data below shows, low and predictable inflation leads to steady export growth, a critical factor for India’s future prosperity.

Source: Ministry of Commerce, Government of India

Inflation has also had a detrimental effect on the savings rate in India. As inflation expectations amongst Indians rose, they have increasingly chosen to spend on that TV (or most likely gold necklaces) today rather than wait for tomorrow when its price would be much more.  As a result the savings rate has dropped from a high of 38% to a low of just over 30%.  In an economy that needs to spend close to a Trillion dollars on infrastructure alone, this is bad news. A dropping savings rate makes the government more dependent on fickle foreign funds for funding these VERY long gestation period projects. With Chair Yellen preparing for a rate hike and major economies in the world recovering, the notion that yield-seeking capital will land up in India is not longer assured. To spur growth the government has to convince people that it is worthwhile to save and that their hard-saved money will not become less valuable tomorrow.

Source: World Bank

Policy Actions:

The devil lies in the details and the solutions to India’s inflation problem have many devils. The traditional prescription would be to induct a Volcker-esque Central Bank Governor who would raise rates till the beast was dead. However, as Gov. Rajan (an inflation hawk himself) mentioned during a speech at HBS – the ways in which interest rate changes flow through an economy like India, with its massive unorganized sector and large shadow economy, are still remain a mystery. While raising rates can send the right signals, it cannot be the only solution. Therefore unfortunately, the solutions must lie on the supply side. This will require the government to bite the bullet on many reforms, but if this government, with its absolute majority, cannot do it, nobody else can.

The first policy action must be to create a true market for food products across India. Food constitutes 60% of India’s CPI basket but its production and distribution is notoriously inefficient. India’s APMC act, is probably the only act that encourages and legalizes the use of middlemen in food procurement and distribution. As a result food products can have widely varying prices across India, with governments being overthrown due to high prices in one part while farmers dump produce in another.  While cold chains and road netwoerks need to be developed, merely changing this law will drive investment to solve this problem.  Unfortunately Narendra Modi’s party, which derives its support from the trading class, may not be able to act decisively against them.

Illustrative Onion Prices across various markets in India:

	Madhya Pradesh	Nagaland	Delhi	Mumbai
Price/ Ton (in Indian Rupees)	350	4000	1800	1000
Source: indicat.com

The second policy response must be to pare the subsidies of that benefit everybody other than the very poor. The middle class enjoys many subsidies, ranging from that on cooking gas to diesel fuel. While the government has taken steps to cut down the subsidies (diesel prices go up automatically by half a rupee every fortnight), there is no reason why these (and many of their derivative products like train fares) should be dictated by the government. The government should be moving to a market linked indexed price mechanism, where the prices are determined based on the prevailing benchmarks.  A decision to this effect may have a positive political upside – by making prices independent of government action, it may not have to deal with the political blowback associated with every price hike. Additionally, this will free up precious dollars that can then go from paying oil and fertilizer companies to building the roads and ports that India desperately needs.

What should I bet on?

Matt envisages this blog as providing actionable investment advice and it would not be fair of me to leave without giving you my views on the market. As Matt pointed out, valuation multiples on the Sensex are stretched in anticipation of a upcoming reforms. Although I am hopeful, I would not bet on these reforms being easy to legislate, let alone implement (look at what happened to FDI in Retail).

The story I think will be one of sector specific performance, with my favorite bets being CPG (Consumer Packaged Goods) companies. The domestic consumption story remains intact and is reasonably immune, if not positively impacted by inflation. For those still interested in playing the macro trend, I would suggest buying out of the money calls on Sensex – if the government does manage to push through the reforms, sky is the limit.