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Private Equity

India: The reform score card

Three decades ago India began serious economic reforms. In 1991 it was a foreign exchange crisis that forced change, Since then, the country has progressed in fits and starts towards being a market-led economy, albeit one with a strong role for public ownership and significant government intervention. In the spring of 2019 Narendra Modi’s government will stand trial with voters in the largest democracy in the world. Here’s our view on the scorecard so far.

“A fast start but losing momentum”

The current government was voted to power with high expectations in May 2014. PM Modi had built a formidable reputation as a business friendly, reform oriented leader during his tenure of 14 years as the Chief Minister of the state of Gujarat – the state growing its GDP at an average rate of 10% during his tenure. The new Government was expected to make good on its promises to reduce corruption, deregulate the economy, mobilize foreign investment, reduce the role of state-owned enterprises, and strengthen India’s trade ties with the world.

The Government delivered on several big reforms early in its tenure. However, it has lost momentum in recent years, reflecting the political reality that big reforms are disruptive in their immediate aftermath, often with negative political consequences, while the payouts accrue only over long term.

Despite legislative hurdles, the Government was able to pass several key reform bills in its early years in office, helping improve business confidence and improving India’s position by 65 places in the Global Ranking of World Bank’s Ease of Doing Business scorecard. Key reforms implemented by the Government include:

1. Goods and Services Act, 2017

India had a complex indirect taxation system with multi layered taxes on interstate movement of goods, which distorted incentives and created inefficiency. Successive governments tried to introduce a uniform Goods and Services Tax (GST) with limited success. In July 2017, after much legislative debate, India’s biggest ever tax reform was finally rolled out by the Government. The GST Act replaced a multitude of indirect taxes at Union and State levels with a simpler code, dismantling regional trade barriers to create a single US$2.6 trillion market. The objective of GST was to simplify the indirect tax system, add more indirect taxpayers, make tax evasion difficult, bring tax transparency to consumers and reduce the tax rates on many mass-use goods and services.

GST implementation had initial teething troubles including an unstable IT platform and complex filing requirements. It also disrupted activity in the months before rollout with businesses cut production and liquidated inventories as they prepared to adjust to the new system. This led to economic growth temporarily slowing to 5.7% in the quarter prior to the rollout from 6.1% in the preceding quarter. Growth subsequently quickly recovered to 6.5% and 7.2% in the following quarters.

After an initial period of instability in the wake of the new law, tax collections have been growing steadily over the last few months driven by higher compliance and lower tax rates. Even though GST implementation caused a short-term disruption, there is all round recognition of its long term benefits to the Indian economy, which are already becoming visible in tax revenue buoyancy. We rate GST as an exam pass.

2. The Insolvency and Bankruptcy Code, 2016

In 2017, India’s NPA ratio was higher than any other emerging market (barring Russia) and even exceeded the peak levels seen in Korea during the East Asian crisis. Several sectors as energy, infrastructure, metals and mining, procurement, construction, in particular, were stressed with mounting corporate debt defaults.

To tackle endless delays in resolving stressed assets and the lack of accountability of promoters of defaulting companies, the Government implemented the Insolvency and Bankruptcy Code (IBC). This consolidated the existing framework of laws related to insolvency and bankruptcy into a comprehensive, strengthened and time bound mechanism for resolution of stressed assets.

The IBC provides a mechanism for the resolution of stressed assets within 270 days from the time of default and filing of application of insolvency under the Act. Before the introduction of IBC, it took companies about four to five years to dissolve operations; this time frame is now compressing to one year. This has not only increased the ease of doing business but also imbibed a stronger sense of trust in lenders and investors.

3. Real Estate Regulation Act:

The Indian real estate sector has evolved rapidly over the course of last two decades. Whilst customer needs have improved transparency and best practice, comprehensive regulation for the sector was missing. The Government plugged this gap by implementing The Real Estate (Regulation and Development) Act, 2016, commonly referred to as RERA. The Act not only lays down a code of conduct for all market participants but also promotes transparency through standardization of metrics, practices and filings while putting in place a regulator to enforce compliance. The Act protects the customer interest and levels the playing field among the developers, paving the way for a fair marketplace. Again, despite complaints from less scrupulous operators this reform rates a clear pass.

4. Digitization of Payments

Prime Minister Narendra Modi was elected on a poll promise of fighting corruption and cleaning up the “black” economy (undeclared transactions outside the tax net), which some estimate to exceed 20% of official GDP. India has a large unorganized sector and cash was used for >95% of all consumer transactions by volume. A number of reform initiatives undertaken by the Government in the first 3 years of its tenure have helped accelerate digitization of payments in India:

– De-monetization of high value notes (~86% of currency value in circulation), which was aimed at reducing informal economy, counterfeiting, terrorism funding. Demonetization had a profound impact on business activity across categories and incomes of the poor. The rural economy, particularly the agrarian part, almost entirely cash driven, saw significant disruptions. The biggest impact was seen across discretionary categories such as consumer durables in which demand declined by 50% in the days following demonetization. Unorganized labor in the country, which is largely paid in cash saw a large drop in incomes and significant layoffs.

– Zero transaction costs on card usage for transactions below US$30 ticket size

– Accelerating the deployment of card acceptance infrastructure. Targets were set by the government for the Banks to increase Point of Sale terminal (PoS) penetration. Banks were directed to deploy 1 million additional PoS terminals in the year after demonetization

– Low balance savings accounts (Jan Dhan accounts) were opened for financial inclusion to ensure access to financial services (>275m accounts opened) The impact of the push for digital payments has been significant – in case of Actis’ portfolio company Pine Labs, the largest processer of retail merchant payments in India, transactions have been growing at c.30% every year. The pain of demonetization though has been considerable and focused on poorer people. Taken together this is a mixed outcome.


“What happens next?”

Over the last two years, India has seen the reform process slow considerably, despite the Government being in a stronger position politically with multiple victories in state elections and higher representation in the Upper House of Parliament. This was driven by the need for the ruling party to strike a balance between its commitment to reforms and political realities, as disruption caused in the economy from the early reforms forced the Government’s policy making push to slow down closer to election year. A common view is that the Government will look to resume its reform agenda if it wins a second term in the elections due in the next few months. Key reforms that could get kick started early in its next term include:

Labour Reforms

The Government came to power in 2014 on the back of promises to create 10 million jobs each year for the country’s burgeoning youth population. Driving job creation in India requires a significant overhaul of its antiquated labor laws which stifle permanent job creation and encourage industry to hire temporary workers. This complex legislation has held back India’s industrial ambitions, and the manufacturing sector accounts for less than a fourth of GDP, and more than 90 percent of workers deployed in the informal sector. The government had an ambitious agenda of streamlining the 44 different labor laws into four codes when it came to power. However, progress on labor reform has been modest so far as it has proved to be a political hot potato. Opposition to labor law reform has been fierce both from the opposition parties and within the ruling party and this crucial reform has remained elusive. Most recently, the Government had to scale back its effort to increase the maximum number of workers that can be laid off without seeking the Government’s permission from 100 to 300. In our view, labor law reform will a key area of focus for the Government if it wins another term, in its efforts to unshackle businesses and drive sustainable job creation in the country especially in the area of manufacturing. More wood to cut here.

Direct Taxes

Reforming India’s income tax law and making it more taxpayer friendly is another policy objective where progress has been slower than desired. India’s income tax law is complex, resulting in inefficient personal interface between taxpayer and officials and, thus also the room for corruption. The Government is keen on both simplifying the law, and making its administration taxpayer-friendly. Simplification of the law itself has been a gradual process through incremental changes in the Annual Budget, while the Government has sought to digitize tax assessment through greater use of technology to reduce processing time. However, there is a lot that remains to be done and acceleration of reform implementation will be the priority for the Government in its next term.

Our verdict-the Modi government rates a pass on reforms to date. A clear mandate would allow further progress. Yet as always with fundamental reform the time horizons for success may well be longer than the attention span of financial markets.

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