FEBRUARY 26, 2014

By TIOL Edit Team

INDIAN economy is not out of woods and faces far grave challenges than what Finance Minister disclosed in the Interim Budget for 2014-15.

Daunting tasks thus await the new Government in balancing the urge to splurge cash on poll promises with the risks of losing grasp over inflation, fiscal management and on both Government and corporate debt.

Both analysts and independent regulators should not get carried away by the media-orchestrated claim of emergence of green shoots made by the Finance Minister P. Chidambaram. For every odd green shoot such as reduction in current account deficit, there are a dozen stubs and many weeds in the field.

If anyone has any doubt on this count, one should refer to two country reports on India released by International Monetary Fund three days after the presentation of budget.

IMF has estimated economic growth at 4.6% in the current fiscal year, as compared to 4.9% projected by the Mr. Chidarmbaram in his budget speech.

According to IMF, the immediate outlook is for a gradual growth recovery and persistently-high inflation. It says: “High and persistent inflation is a key macroeconomic challenge facing India. Further increases in the policy rate will be necessary to tackle high inflation and inflation expectations.”

An implicit but grave message of IMF reports is that the country is facing a serious risk of declining corporate profitability and debt default and its consequent impact on the banks and tax revenue.

Based on four standard measures of corporate financial health – interest cover, profitability, liquidity, and leverage, IMF staff has concluded that corporate stress in India is at its highest since the early 2000s.

As put by IMF's India country report on Selected Issues, "the share of corporate borrowing accounted for by companies with extremely weak financial health indicators (ICR, profitability, liquidity and leverage) has increased. The percentage of debt owed by loss-making firms has reached 17.3 percent. Indian companies whose total debt exceeds five times equity account for more than 18 percent of the borrowing by Indian corporates. These four indicators of corporate health were at their best in FY 2005/06. On an aggregate measure of distress (using the mean absolute deviation of each of the four variables from their FY 2005/06 lows), corporate India's financial health in 2012/13 was at its worst since FY 2002/03."

Declining corporate health constrains the prospects for achieving buoyancy in tax receipts. The way-forward here obviously lies in removing policy uncertainty, unleashing package of reforms including tax reforms and taming inflation.

IMF staff report on India (the 2 nd IMF report) has stated that "revenue enhancement is the key, particularly through better tax administration." It has acknowledged the authorities' expectation that the goods and services tax (GST) and the direct tax code (DTC) bills will be passed by next year.

Whatever the polls outcome, the elected representatives much achieve consensus to implement these reforms for the sake of growth and employment.

Apart from tax reforms, IMF has pitched for structural reforms and removal of supply-side constraints to unlock growth potential and perk up investment climate. It remains to be seen whether the new Government acts timely and decisively on IMF's advice to embrace market pricing of natural resources to impart transparency and efficiency in allocation of resources.

The reports have recommended specific road-map to resolve issues and to put the economic on high-growth track with moderate inflation. The problem here is that Indian authorities don't share fully IMF's concerns. They are reluctant to go the whole hog on IMF's package of reforms due to political compulsions.

The reports have subtly mentioned the differences between the Finance Ministry and IMF on core issues such as balancing inflation and growth, labour reforms and tightening of certain norms for corporate loans.

A politically sensitive reform relates to labour markets. IMF has pointed out that "Tightly-regulated labor and product markets in India have given rise to a large informal sector, sub-optimal level of employment, and low productivity. Our analysis suggests that reforms can increase employment, improve competitiveness, and boost potential growth. A package of reforms reinforces the gains, minimizes short-term costs, and increases the acceptability of these politically-difficult reforms. These reforms will help harness demographic dividend by absorbing India's rapidly-growing labor force".

It has thus aptly underscored that simultaneous reforms to product and labor markets also reduce transitional costs and maximize long-run gains. Compared with individual reforms, a broad package yields a larger income gain, the expectation of which immediately boosts aggregate demand and job hiring.

The new Government thus twin challenges – solving economic problems and initiating long-deferred and pursued half-hearted politically-sensitive reforms.