Economic Survey 2014-15 Highlights-II

Economic Outlook, Prospects and Policy Challenges

The Investment Challenge

The stock of stalled projects stands at about 7 per cent of GDP, accounted for mostly by the private sector. Manufacturing and infrastructure account for most of the stalled projects. Changed market conditions and impeded regulatory clearances are the prominent reasons for stalling in private and public sectors, respectively.

This has weakened the balance sheets of the corporate sector and public sector banks, which in turn is constraining future private investment, completing a vicious circle. Despite high rates of stalling, and weak balance sheets, the stock market valuations of companies with stalled projects are quite robust, which is a puzzle.

Combining the situation of Indian public sector banks and corporate balance sheets suggests that the expectation that the private sector will drive investment needs to be moderated. In this light, public investment may need to step in to ramp up capital formation and recreate an environment to crowd-in the private sector.

The Banking Challenge

The Indian banking balance sheet is suffering from ‘double financial repression’. On the liabilities side, high inflation lowered real rates of return on deposits. On the assets side, statutory liquidity ratio (SLR) and priority sector lending (PSL) requirements have depressed returns to bank assets. As inflation moderates and the banking sector exits liability-side repression, it is a good time to consider addressing the asset-side counterpart.

In a cross-country comparison, controlling for the level of development, the size of the Indian banking system, measured by credit indicators, does not seem too high either in absolute terms or relative to other sources of financing. However, going forward, capital markets and bond-financing need to be given a boost.

Private sector banks did not partake in the biggest private-sector-fuelled growth episode in Indian historyduring 2005-2012. This is reflected in the near-constant share of private sector banks in deposits and advances in those years. There is substantial variation in the performance of the public sector banks, so that they should not be perceived as a homogenous block while formulating policy.

Putting Public Investment on the Track – the Rail Route for Higher Growth.

The Indian Railways over the years have been on a ‘route to nowhere’ characterised by underinvestment resulting in lack of capacity addition and network congestion; neglect of commercial objectives; poor service provision; and consequent financial weakness. These have cumulated to below-potential contribution to economic growth.

Very modest hikes in passenger tariffs and cross-subsidisation of passenger services from freight operations over the years have meant that Indian (PPP-adjusted) freight rates remain among the highest in the world, with the railways ceding significant share in freight traffic to roads (that is typically more costly and energy inefficient).

As a result, the competitiveness of Indian industry has been undermined. Calculations reveal that China carries about thrice as much coal freight per hour vis-à-vis India. Coal is transported in India at more than twice the cost vis-à-vis China, and it takes 1.3 times longer to do so.

Econometric evidence suggests that the railways public investment multiplier (the effect of a Rs. 1 increase in public investment in the railways on overall output) is around 5. However, in the long run, the railways must be commercially viable and public support must be linked to railwayreforms: adoption of commercial practices; tariff rationalization; and technology overhaul.

Skill India to Complement Make in India

• What should we ‘Make in India’? Sectors that are capable of facilitating structural transformation in an emerging economy must:
• Have a high level of productivity.
• Show convergence to the technological frontier over time.
• Draw in resources from the rest of the economy to spread the fruits of growth.
• Bealigned with the economy’s comparative advantage; and betradeable.

Registered manufacturing, construction and several service sectors -- particularly business services -- perform well on these various characteristics. A key concern with these sectors however is that they are rather skill-intensive and do not match the skill profile of the Indian labour force. India could bolster the Make in India initiative, which requires improving infrastructure and reforming labor and land laws by complementing it with the Skilling India initiative. This would enable a larger section of the population to benefit from the structural transformation that such sectors will facilitate.

A National Market for Agricultural Commodities

• Markets in agricultural products are regulated under the Agricultural Produce Market Committee (APMC) Act enacted by State Governments. India has not one, not 29, but thousands of agricultural markets.
• APMCs levy multiple fees of substantial magnitude, that are non-transparent, and hence a source of political power.
• The Model APMC Act, 2003 could benefit from drawing upon the ‘Karnataka Model’ that has successfully introduced an integrated single licensing system. The key here is to remove the barriers that militate against the creation of choice for farmers and against the creation of marketing infrastructure by the private sector.

Climate Change

India has cut subsidies and increased taxes on fossil fuels (petrol and diesel along with a coal cess) turning a carbon subsidy regime into one of carbon taxation. The implicit carbon tax is US$ 140 for petrol and US$64 for diesel. In light of the recent falling global coal prices and the large health costs associated with coal, there may be room for further rationalization of coal pricing. The impact of any such changes on affordable energy for the poor must be taken into account. On the whole, the move to substantial carbon taxation combined with India’s ambitious solar power program suggests that India can make substantial contributions to the forthcoming Paris negotiations on climate change.

The Fourteenth Finance Commission

The FFC marks a watershed in the history of Indian federalism. Unprecedented increases in tax devolution will confer more fiscal autonomy on the states. This will be enhanced by the FFC-induced imperative of having to reduce the scale of other central transfers to the states. In other words, states will now have greater autonomy both on the revenue and expenditure fronts. All states stand to gain from extra resources although there will be some variation between the states.

FFC transfers are highly progressive; that is, states with lower per capita NSDP receive on average much larger transfers per capita. In contrast, plan transfers were much less progressive. The concern that more transfers will undermine fiscal discipline is not warranted because states as a whole have been more prudent than the centre in recent years.