Words ought to be a little wild, for they are the assault of thoughts on the unthinking
- J.M. Keynes

Tuesday, 27 March 2012

India - It's the politics, stupid

India has fallen from grace in the international investor’s eye. The most visible, if imperfect barometer of investor opinion, the Indian stock market has been moribund. The scorching 21% rally at the start of the year has disintegrated. The rupee has also resumed its slide going back above 50 to a dollar. August publications such as the Economist have put the boot in.

The poor global macroeconomic picture has certainly contributed to the decline in growth but most of the blame lies with the sclerotic and cancerous political environment. Mostly everyone apart from the politicians agree with this diagnosis. However, investors care about prognosis not diagnosis. And this is where things get difficult.

The ‘India shining’ story has been spun well. It is a truth universally acknowledged that the rapidly growing, democratic colossus with favourable demographics and a huge middle class is all set to join the pantheon of global superpowers. The urban Indian especially has taken this story to heart in a fit of optimism bordering on exuberance. Even most critics assume that rise is inevitable, only the duration indeterminate. Therefore they helpfully offer constructive criticism to improve policy and achieve higher growth rates.

Unfortunately not only is the climb to superpower status long and arduous but there is no surety that is will be successful. An optimistic analysis which assumes away the middle-income trap shows that there are still two very different destinations that India can reach. India can be like the US, which is what most Indian policymakers and intelligentsia think, or it can be like Italy.

On the positive side, India has a young, innovative and entrepreneurial generation which is increasingly unafraid to take risks. The state’s power to stifle is greatly reduced in a knowledge-based service economy. Social and political awareness is on the rise as growth lifts more people to middle class. It is also aided by exposure to global trends through advances in technology. This creates pressure to reform through the democratic process. And just as happened in the west, a virtuous circular dynamic is created which leads to a rapid rise in national prosperity.

The rose-tinted view above ignores the sclerotic and cancerous politics hidden behind the sheen of democracy. And it is politics which will determine the eventual fate of India. A fractured polity full of misguided populists and demagogues will eventually ruin the country. The optimistic case is that India rolls back the state enough for Indian entrepreneurs to thrive. As with the US, this will minimise the impact of political corruption, backroom dealing and perennial electioneering on growth and people’s daily lives. The pessimistic case is that Indian politicians and crony capitalists refuse to surrender power and associated perks, shackling the economy into a new Hindu rate of growth (or the Rickshaw rate of growth as Economist calls it). This is the Italian case where a bickering, self-serving, fractured polity envelops the state in its malignant tentacles and drags it towards the abyss.

Unfortunately India seems to be heading in the direction of Italy. The state has not retreated enough from the economy to let the invisible hand function effectively and deliver growth. And the state is hobbled by a lack of courage and fresh ideas because the government at the centre is formed of a weak band of populists cobbled together. The only reason they can cling on is because the opposition is in much greater disarray. A fragmented voter base means that coalitions will continue to rule at the national level. Policy stasis, shady compromises and populist measures are inevitable along with endemic corruption. Advocates of reform and rolling back of the state from the economic sphere fail to recognise that sensible policy decisions are impossible in the current political atmosphere. As the current situation in Italy shows, weak governments are at the mercy of vested interests. Even as Italy tethers on the brink of insolvency, they fervently defend the status quo.

However, all is not lost. The recent regional elections have shown that government largesse does not win elections. This lesson along with the re-election of incumbents in well governed states holds hope for the future. It is imperative for effective governance to be re-established at the centre. However much the states may progress, without effective national leadership, the sum of the parts will never approach the potential of the whole.

As for the India story, even though investors have been battered recently, the prognosis is not dire. Yet. Despite being meagre, the rickshaw rate of growth can sustain the nation in the short-term. India is also more resilient to exogenous shocks (apart from oil price shocks). Therefore there is potential for reasonable returns. The investment decision depends on the timeframe. For the short-term investor, India is not the best place and time to invest. It benefits from global “risk-on” which seems to be reaching a zenith right now. Apart from the domestic political uncertainty, the cracks appearing in China do not bode well. For the long-term investor who doesn’t believe in picking the top or the bottom and doesn’t mind an elephantine pace for returns to accrue, this is a good point to start averaging in (the market is down 37% from the peak in USD terms and P/E is a reasonable 15x). Of course an eye needs to be kept on the political developments. They will determine where the story ends.

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