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India’s Centralization Moves

Sept. 22, 2017 Allison Fedirka and Xander Snyder discuss Prime Minister Narendra Modi’s moves to assert greater central authority over aspects of India’s economy and financial institutions. Sign up here for free updates on topics like this.

Xander Snyder: Hi and welcome to the Geopolitical Futures podcast, I am Xander Snyder and I am joined today by senior analyst Allison Fedirka and we will be discussing India and how we have been observing events in India play out relative to the forecast that we made for 2017. So perhaps the best place to start Allison would be to quickly recap how we said India would fit into our 2017 forecast.

Allison Fedirka: Sure thing, Xander. Our 2017 forecast for India focused primarily on political control and the country’s economy given that the country is very diverse and being able to manage that diversity and bring it under control and grow an economy is a huge challenge in India in general, and that is why it figured so prominently in our forecast.

And basically, what we’ve said is that is the Modi government is going to want to centralize control over the economy as well as boost the ruling party’s popularity and empower in the upcoming elections that have since come to pass and that a lot of these bold moves for economic reforms and changes will come at a cost. That he will not necessarily exceed in achieving all of his objectives and that some of the negative fallout from these bold reforms will manifest itself and lower GDP growth as well as some potential political problems for him as well.

XS: So perhaps a good place to start before we get into some of the details on the economic activity we’ve been witnessing would just be to dig a little bit further into that idea of diversity within India because I think that’s really a critical point to understand before trying to explain why Modi will need to assert greater authority over disparate and far-flung regions within the country in order to have a more controlled position on the world’s stage.

So Allison, you recently worked on a “Deep Dive” about India and it was more sort of a general geopolitical lay of the land but it was called “India Falling Short of Great Power”. And how does the diversity within India, where you know for example in eastern China you might have a very large percentage of the population be Hun Chinese. In India, you have different ethnicities and different languages and different states, how does that impact India’s geopolitical position?

AF: So the first thing is that there’s two major takeaways. The first one is to remember that India as we know it today, independent, post-British colonial India, is a very young country. That particular type of identity that India has is very new, whereas the civilizations that comprise India now and have for over thousands of years is very, very old.

And so, part of becoming the country that we know today, India has historically been a bunch of very autonomous states or principalities or kingdoms that existed on their own either in coalitions with other groups enjoying high degrees of autonomy. Throughout the course of their history, at times being conquered by greater powers, being brought into the fold of larger empires, having those empires collapse or fall apart and then having new powers emerge. So, the idea of a united India in a cohesive India is relatively new in that prior to the national borders that were drawn up for independence and what borders have taken shape since then to what we see India today, it’s a very different concept of understanding what is India.

We had a reader that brings us to our second point and our reader we had write in after that Deep Dive, he made a useful comparison with the idea that in some ways it’s easier to try to send understand India as Europe, in that we see places like Europe or even the European Union, you have a bunch of countries comprising this larger entity. And while the individual states in India are not that same as sovereign nations such as France or Germany, the concept of localized identities, the concept of local priorities, local interests, not necessarily aligning with states surrounding it, is very much true in India and that is what creates some of the problems that’s facing the government today.

So you have a history of individual states or kingdoms, a history of enjoying large degrees of autonomy, a history of being able to many times behave or enact policies or do things at the local level without necessarily having to follow everything that a central government would say or to have to worry about how what you’re doing affects other states on the other side of the country. And that is a huge challenge for any government now in charge of India because they will now face this need to construct a cohesive nation that can bring together all of these different states under one semblance of control and have that behave as a cohesive entity as opposed trying to govern a bunch of different states all at the same time, not always necessarily coinciding with interests or doing that are as a whole productive for India.

XS: So we’ll use that just as a brief opportunity to say to our listeners and readers of course, please do reach out to us with comments and critiques and feedback, whatever you’d like of the written pieces that we put out because we really do make an effort to respond to as many of those as we possibly can. We really enjoy interacting with our readers.

Now Allison, I think you make an interesting point here, which is despite looking at a country in the modern global arena as a nation state, you still might have countries that have a different degree of nation-statehood, how developed has it become in this direction? And that’s an important thing to just keep in mind generally when looking at how a particular country might be constrained.

Now in the case of India, one of the motivations for greater centralization of power that we believe Modi is compelled to seek, has to do with the economy. And one of the more interesting moves that the central government made late last year in 2016 was this demonetization effort. And the government basically said we’re gonna take 500 and 1,000 rupee bank notes just out of circulation. So if you have those, you have until a certain date, you can come to a bank and turn those in. And if you do, we’ll credit your bank account. You will of course then be required to pay taxes on those funds if they haven’t already. And presumably if you’re hoarding large amounts of cash currency, you haven’t paid taxes on that.

And that was really one of the aims of the government was to bring in a lot of black market economic activity into the real market or the legitimate economy, whatever you want to call it. And that was sort of one aspect of it. But we’ve written about this before Allison and there’s a few different other angles with which to consider the demonetization moves, what are those?

AF: So a couple more other aside from just the we get more income tax revenue from the people, one is more political and then one is more related directly to the economy. On the political side, keep in mind that this move of demonetization occurred a few months before the regional elections that took place in India earlier this year. And it is not uncommon in India or other countries for that matter, where you can use cash to influence political campaigns, you can use cash to influence votes, to mobilize voters, to sway voters in a variety of different ways.

And when you do that, when you do a demonetization the way India did, when you take a large amount of that cash out of circulation, that timing coincided with a lot of the campaigning as well. So in that sense, it would take a lot of black-market currency circulating out of major campaigns, out of major mobilizations for influencing voters and what not which was seen at the time as one way for Modi to help influence the outcome of elections as well as try to combat some of his opposition candidates and party members in the local elections. So that was the political angle that was really a more immediate repercussion of the demonetization.

And then on the more economic side and the more medium term and what we’re  starting to see now is, as you mentioned, when you went to turn in your money, the government was able to get a lot of information from individuals and from companies. And basically, they’ve been able to use this tax identification information to lay the groundwork of the next wave of reforms and efforts to make the economy transparent specifically with regards to shell companies and the real estate sector. So you know when the monetization happened, everyone said oh this is crazy, this is not a well thought through plan.

And yet here we are almost a year later and it has laid the foundation for the next move that the Modi government plans to make that we talked about in that forecast which is this idea of cracking down on the real estate markets and the shell companies and trying to clean up again another component of the prevalent black-market economy that exists in India and trying to make it more transparent and up to international standards to draw in outside investment.

XS: So that was one of the first moves, the demonetization effort that the central government made. And then more recently, what we’ve seen has been is an initiative to identify basically fraudulent shell companies. And the activity that is developed is someone will set up a shell company in someone else’s name that will then own a piece of real estate for example. But that shields the actual owner of that piece of real estate.

And one of the reform initiatives that has been enacted, has been essentially to identify and target about 200,000 shell companies and order them to close because they were illicitly or illegally owning real estate. And even more, hundreds of thousands of more shell companies are under examination right now. And I think the common thread that we see between the issue of real estate shell companies and demonetization is bringing illicit or black market activity back into the real economy in a way that helps the central government identify economic activity but then also assert greater authority over it.

AF: Yes and we’re seeing other moves by the government on the domestic front to try and assert greater authority over the domestic economy in addition to the measures you just spoke about.

One of the other major moves we’ve seen is the introduction of the goods and services tax which is also a government move targeted directly at the domestic economy more than anything else and is another attempt to combine economic reforms with this idea of centralizing power. So, with the goods and services tax that was introduced basically before this, there were many different tax schemes, overlapping tax schemes at the central, municipal and local levels and you were paying multiple different types of taxes for different goods and it was a very disorganized and very costly system.

And the idea behind this new system is to kind of streamline everything, bring it all under one system, make it a very, clear-cut, four-tier tax system. And depending on kind of good or service you have, you fall into one of those tiers. And the sell that was made by the government to the people over this was, you’ll see a few things happen because of this. You’ll see your good prices go down because instead of having all of these overlapping and redundant taxes or paying taxes twice, this process will help to reduce the price of goods and this idea of spurring the economy making goods cheaper for people would be good for the Indian economy.

It also helps give the central government more power because now they’re more in control over the nation’s tax system in general. This complements the personal income tax moves that they’ve made already and also helps to give them a little bit more control over taxes in general in the country as opposed to giving a lot of that control or allowing states in the country to have a lot of control over the system, which was in part the case prior to this. Its help cut down on the bureaucracy which is also in terms of things like logistics and what not, helps facilitate the flow of goods and increase the efficiency of delivery of goods.

So that is the concept of this measure like many of the measures like demonetization, it took several months to be implemented and to feel the effects. Again this is not an easy task so while this is the concept of the change, the implementation has proven to be somewhat difficult for the government. They’ve had to postpone on more than one occasion, the dates for filing some of this tax information. There’s been some complaints about the complexities of this as well as just you know general investigations of companies actually complying with this.

So it’s a very large undertaking and it’s only about two months old, two and a half months now actually,  and the effects of this have yet to fully be seen in terms of how much will it actually help the economy? Can they successfully implement this new system and will it yield the results that they want? And those some of the more domestic measures that the government is really concentrating on at this time.

But that’s more of the consumer side of people wanting to buy different goods and services. I know there’s also some financial moves and banking regulations and on that side of the economy as well that the government is trying to clean up there and I was wondering if Xander you could speak on that?

XS: Yeah well you mentioned how a lot of these activities at least one goal is to increase transparency and encourage foreign investment. But there’s also the issue of domestic investment and that’s where the reforms in the financial sector to attempt to address India’s non-performing loan situation kinda plays into it.  What we’ve seen over the last course of the last about two years or so has been a decline in domestic investment, of gross fixed capital formation. And this has been caused in large part by a growing NPLs in the financial system.

Now the way NPLs work is basically a borrower gets to a point where they can no longer service their debt or can’t service their debt in full so they can only afford partial payments. This kind of has a double-edged sword to it. On the one hand, it obviously weakens bank balance sheets because one of their assets becomes non-performing, it’s no longer generating income for the bank. It’s also bad for the business because it ties their hands and forces them to redirect large portions of whatever revenue they are generating towards servicing debt instead of reinvesting in their business activities.

But the other thing to keep in mind is banks are required to hold capital in reserve against all of their assets. So if a lot of these assets are non-performing, that means there’s a lot of capital that gets tied up on bank balance sheets being held back in reserve, in order to support those assets that could potentially be lent out to more productive enterprises but it’s not allowed to because they need to be held back in reserve against these bad assets.

So some of the reforms that we’ve seen to address these problems have not yet gone as far as what we saw in Western Europe in Spain, in Ireland, by establishing a bad bank that in those countries basically purchased a lot of these bad assets and said ok we’re going to siphon these off and give them to restructuring specialists and that will free up bank capital to begin lending back into the economy. India hasn’t gone that far yet, but we’ve seen the central government mandate a fairly comprehensive review of assets, an asset quality review, to create some sort of standard definition across banks saying what a bad asset is.

So what was happening for a while is you can imagine if you’re a bank manager, you make this loan and you are responsible for managing into the credit portfolio, you don’t want to write it off because that means a loss for the bank and that doesn’t reflect well on your own performance. So what was happening was banks were basically terming out these loans, restructuring them, extending them so that the borrower never really had to face the full implications of repayment. And that kind of made a lot of banks financial positions look better than it really was. And the central government said no, no, no we can’t do that. We need a common definition. And that was one of the initiatives that we saw implemented a little bit earlier this year.

Another thing has been bankruptcy reform. So in order to get to the point where you can actually remove those bad assets from a bank balance sheet, if the borrower is in a position where it really cannot afford to repay them and won’t be able to afford to repay them in the future, you need to find a way to remove them. And one way is to allow companies to go through a bankruptcy process. That way while the bank still incurs a loss, they can at least take the capital they were forced to hold back in reserve and begin lending it again to more productive enterprises in the economy.

So one of things that the financial system kind of got hung up on was there wasn’t really a clear cut bankruptcy process in India like there are in a lot of western economies and this has been something that the central government has been pushing through and actually mandating banks push some of their borrowers through in the event that these loans really do not look like they’re going to get repaid in the future.

So those are some of the initiatives on the financial institution side that we’re seeing the central government take. And as you can kinda tell, the dynamic that’s developing is despite the risk caused by these non-performing loans, the government is attempting to use it as an attempt to assert greater control over their financial system so that they can better direct nationwide lending activities and allocation of capital.

AF:  So all of these things that we’ve kind of laid out here do feed back into our forecast, with the final component being this idea of stunting GDP growth or being detrimental to GDP growth. Keep in mind that, last year India experience just over 7 percent growth. And the forecast for this year prior to any of these major reforms, was again to keep it around anywhere from 7 to 7.5 percent depending on whose estimate you went by.

And some of the warns or concerns about demonetization and some of these other reforms has been that it could be detrimental to GDP growth. And so far, those warnings are not misplaced. If we look at growth in second quarter this year compared to last year, it was 5.7%. If we look at first quarter growth compared to last year, it’s 6.1 %. So not only is it under 7% but second quarter was slower than first quarter.

The PMI index for services, the composite PMI index, these are indexes that help measure productivity in production and the benchmark for this is if it’s above 50 you’re growing, if it’s below 50, you’re not growing. And these indicators since especially July have been under 50, they’ve improved from July to August but still all of these markers remain under the 50 point benchmark that is so important for understanding if there’s growth in these areas or not.

It’s come to the point where there are now discussions of a potential stimulus measure by the government. The details are not out yet, that’s still at this point just a discussion with one of the big concerns being is it too early to do stimulus? Will that do more harm than good? How will that affect inflation? Will it really solve any of India’s problems? Can India sustain the growth rates that it has right now and still be ok?

So there’s still a few moves left for the government in terms of trying to grow the economy as well as several other reforms and implementing the current reforms that they have to their fullest to see where this will take the Indian economy. But that is where it stands right now and the forecast we have still appears to be on track in this sense.

XS: So if you’re interested in learning a little bit more about India’s financial position, we’ve written some on this, this year. As I mentioned the piece that Allison headed up, the “Deep Dive” called “India Falling Short of Great Power”, does a very good job of laying out India’s geopolitical position and that’s sort of a good overall summary to begin to dig into India in greater detail.

Earlier in the year, we wrote another Deep Dive on India’s non-performing loan situation called “Turning Economic Risk Into Opportunity In India” So if you want to dig more into the financial side of what’s going on in India, check out that Deep Dive.

And I think there’s just two other Reality Checks that we’ve done that are shorter pieces that are worth mentioning and one of them is a piece Allison that you wrote last November on the demonetization effort and it was called “India’s Money Maneuver” and that piece will provide a little bit more detail as to the strategy and thinking behind that move by the central government.

And lastly, as we mentioned at the beginning of the episode, the degree of diversification of variety of ethnicities and languages within India really is an important aspect of understanding the country. And last year, Jacob Shapiro, one of our co-workers at Geopolitical Futures, wrote a Reality Check called “India One State, Many Countries” that lays out the dynamics of that diversity.

So be sure to check those out if you’re interested in learning a little bit more. So this has been the Geopolitical Futures podcast, I am XS. Allison, thanks for chatting.

AF: Likewise, thank you.

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