Inflation fears blurring Modi’s ‘Made in India’ vision

Author: Ranjit Goswami, IMT Nagpur

On 15 August 2014, India’s Prime Minister Narendra Modi delivered his inaugural Independence Day speech. At 80 minutes, it was the longest speech by an Indian Prime Minister since Jawaharlal Nehru’s time. The speech touched upon the various challenges that the world’s largest democracy faces, from female feticide to sanitation. He talked about the need for a new institution in the place of the Planning Commission, created back in 1950, and the need for girls’ toilets at every school, to tackle the high drop-out rates of girls.

But the crux of the Independence Day speech came towards the end, when Modi stretched out his hands in a gesture that can be explained from his challenging early life, when he had been briefly associated with Indian theatre. The message was one that has been relevant to India for a long time: ‘Come, make in India’. India needs to increase jobs, sustain growth, and lower its trade deficit by boosting manufacturing exports, which requires that manufacturing be given higher prominence in the Indian economy.

Surprisingly, the speech was silent on another key issue: the sticky and stubbornly-high inflation that India has been experiencing — a critical plank on which the 2014 general elections were fought.

The silence is understandable. Inflation in India — or rather the Consumer Price Index (CPI) which, due to its composition, places nearly 50 per cent weight on food products — is not something that can be tamed in 100 days. In South Korea, food products account for 14 per cent of the inflation basket; in China it is 32 per cent. Core inflation, as measured in the US and many other developed countries, excludes volatile food and energy prices altogether. As India’s integration with global markets strengthens, the country is likely to witness pressure from food inflation as global commodity prices equalise.

Inflation is always the biggest tax on the underprivileged sections of the population. Under any measure of poverty, irrespective of the methodology or its validity, India remains home to the largest number of poor people globally.

India did not miss the ‘manufacturing boat’ by accident. Looking at manufacturing value-added as a percentage of GDP for 2013, India’s 13 per cent was lower than that of China (32 per cent on 2011 data), South Korea (31 per cent), Indonesia (24 per cent), Singapore (19 per cent), Japan (18 per cent on 2012 data), Bangladesh (18 per cent) and Sri Lanka (18 per cent). Of these, India’s per capita nominal GDP is greater only than that of Bangladesh. On per capita manufacturing value-added nominal GDP, India therefore is 33 per cent of Sri Lanka, 23 per cent of Indonesia, 9 per cent of China, and 2–3 per cent of Japan, South Korea and Singapore.

The main reason Indian manufacturing doesn’t thrive is high, sticky and stubborn inflation, coupled with high fiscal deficits, which increases the domestic cost of capital. Among the nations mentioned above, India’s cost of capital, at 8 per cent, is the highest, as interest rates in Bangladesh and Sri Lanka are at 7.2 and 6.5 per cent respectively. In a contemporary world, this is contrary to negative bond yields in Germany and France, and negative nominal deposit rates in the EU due to ECB easing. The US and Japan have been continuing easy monetary policy, and China too sees an abundance of capital with moderate inflation. While India’s current account deficit figures have shown some improvements since last year, uncertain gold demand and increasing crude prices can put pressure on the Indian rupee, which over the years has steadily diminished in value, thereby posing risks for foreign direct investment inflows too. India has been, and remains, starved of productive capital, with high inflation.

Another problem with India’s high cost of capital is the attendant increase in the debt service ratio for government. Despite the fact that India’s debt-to-GDP ratio was much lower than that of Japan’s in 2012 (49.7 per cent of GDP in India to 196.5 per cent in Japan), the Indian government has been forced to spend a much high proportion on servicing its debt. As per 2014 budget, 20 per cent of government expenditure is on servicing state debt, which hampers its efforts to spend more on either investment or welfare.

McKinsey has previously highlighted that, between 2006–2010, the majority of India’s top 1000 manufacturers had returns on invested capital (ROIC) lower than their weighted average cost of capital (WACC). The situation worsened considerably during 2010–2014, until sentiments improved with the formation of a stable government under Modi. The long-term weighted average cost of capital during 2006–10 was 12 per cent. It is no wonder that the banks that did lend to manufacturing or the infrastructure sector in India have been staring at huge non-performing assets.

On top of the above, India has always encouraged returns on speculative investments. From 2006 onward, the return on India’s equity index, Nifty, has been nearly 14 per cent, mostly tax exempt — compared to 5.6 per cent of Hang Seng Index of Hong Kong, or 6.8 per cent of SSE Composite Index of Shanghai, the latter two being taxable. It is true that in between the return has been patchy. The return on gold — despite depressed global prices — has also been more than 14 per cent (tax-free) in Indian rupees. Until 2013, there was no import duty on gold, despite its huge drag on the current account deficit. Returns on real estate, more speculative in nature, has been much higher — although there is probably no pan-India real estate indices for this period.

Work by the Massachusetts Institute of Technology has debunked the myth that the availability of cheap manufacturing workers trumps productivity. While Germany’s manufacturing workers receive wages that are 66 per cent higher than their American counterparts, Germany remains more competitive with a huge manufacturing trade surplus. On the supply side, while the pool of workers entering India’s job market is both huge and cheap, this abundance of low-cost labour may not constitute that much of a competitive advantage when issues of productivity, infrastructure and supply chain efficiency are considered. Currently, more than 50 per cent of India’s manufacturing workforce does not employ electricity in their manufacturing activities.

Sentiment in India has been looking up, but this optimism is currently limited to the speculative parts of the economy only. India faces other challenges, from environmental degradation to judicial interventions in transfers of natural resources to the private sector for manufacturing. The Governor of the Reserve Bank of India, Dr Raghuram Rajan, has made it clear that fighting inflation remains the top priority of India’s central bank.

Ranjit Goswami is Officiating Director at the Institute of Management Technology (IMT), Nagpur.