Under Modi 2.0, Will India Embrace Tough Economic Reforms?

After securing a powerful electoral mandate last week for a second five-year term, India’s Prime Minister Narendra Modi has a unique opportunity to embrace economic reforms without populist hues. This is also an imperative because economic factors will decide India’s power in its subcontinent and elsewhere, according to experts at the University of Pennsylvania and elsewhere.

The results of the latest election show that India’s voters are willing to shrug off the lackluster economic performance of the Modi government’s first term that began in 2014 and give him a second chance, the experts noted. Modi 2.0 has its task cut out: Unemployment is at a 45-year high; acute agrarian distress has caused farmer suicides; the banking system is weak and undercapitalized with poor credit disbursements; and the economy continues to suffer painful effects of the November 2016 demonetization of high-value currencies and the introduction of a unified indirect tax regime in mid-2017.

The BJP-led National Democratic Alliance (NDA) stormed back to power in an unexpected show of strength in elections to the Lok Sabha, the lower house of the Indian parliament, held in April and May. As many have noted, this represents the world’s greatest exercise in democracy; some 600 million of an eligible 900 million voters participated, including an estimated 45 million young people who were voting for the first time. The NDA won 353 seats of the 542 seats that went to polls in the 543-seat Lok Sabha; authorities canceled the election in one constituency after tax officials found a large stash of unaccounted cash in a politician’s house. The BJP won 303 seats, 21 more than it did in 2014; the NDA added 17 seats between the two elections.

These elections, among the most divisive and fractious in recent times, were a contest between Modi and Rahul Gandhi, president of the Indian National Congress, the prime ministerial candidate proposed by a coalition of BJP’s rivals. The Congress-led United Progressive Alliance won just 90 seats, though these were 30 more than in 2014. The Congress Party won 52 seats, eight more than in 2014. Gandhi himself lost his seat in Amethi in Uttar Pradesh, which had been a Congress stronghold for three decades. He, however, won an election in Wayanad in Kerala state, another constituency from which he had contested, so he will return to Parliament. Three days after the elections, Gandhi accepted responsibility for the party’s electoral rout and offered to step down. And, as was widely expected, the Congress leadership did not accept his resignation.

Pivoting Politically and Economically

The BJP’s continuation in power marks “a historic turning point for India politically, and perhaps eventually economically [as well],” notes Marshall Bouton, acting director and visiting scholar at the Center for the Advanced Study of India at the University of Pennsylvania. (He spoke about the elections on May 24 on the Knowledge@Wharton radio show on SiriusXM; listen to the podcast at the top of this page.)

The results also have the seeds of an “economic turning point” since most voters seemed to ignore the previous Modi government’s disappointing performance on the economy. Bouton recalled that when the Modi government came to power in 2014, it had promised “Sabka Vikas,” or economic growth for all. Those hopes were unfulfilled, he pointed out.

“Younger India has aspirations for a stronger India and a stronger person representing India, and they’re willing to give [Modi] a second chance.” –Marshall Bouton

The demonetization exercise in 2016 had overnight sucked out 86% of the cash in circulation and was debilitating for businesses of all sizes, especially small and medium enterprises and the informal sector, which could not easily switch to a cashless, digital system. It shaved off at least 2 percentage points from the country’s GDP growth rate, according to a study by the National Bureau of Economic Research. It also slowed credit disbursements from banks, which were already hurting from an overhang of bad loans and a liquidity crunch. Moreover, industrial capacity utilization dropped to a quarterly average of less than 75% last year from 83% in 2011.

The unemployment rate reached a 45-year high of 6.1% in 2017-2018, according to an expose by the Business Standard newspaper, based on data from the government-run National Statistical Commission. The government allegedly sought to suppress publication of the data, leading to the resignation of two NSC members. Government programs launched with fanfare such as Mudra Yojana, aimed to provide funding for small and micro-level enterprises, have struggled to meet their goals. Businesses also faced teething pains in switching over to the Goods and Services Tax introduced in July 2017. The GST sought to replace an assortment of state and central indirect taxes on goods and services with a unified, single tax structure, but suffered from shoddy implementation.

Against that backdrop of “a very mixed record” of the Modi government’s economic performance, “none of us thought this outcome was likely … [although it] was on the spectrum of possibilities,” said Bouton. “We all thought the BJP would take a big haircut in this election because Modi had raised huge expectations in the 2014 campaign about job creation, better governance and so forth – most of which were disappointing.”

Bouton believes the election results show that “younger India has aspirations for a stronger India and a stronger person representing India, and they’re willing to give [Modi] a second chance.”

A Matter of Identity

According to Bouton, a defining aspect of the election was that Indians were looking for a single national leader, and “a desire for a clearer representation of what it means to be Indian.” Those sentiments ran deep and were clearly widespread as evidenced by the record voter turnout of 67%.

Those sentiments also made Modi an obvious choice for many voters. “Nobody could compare to Modi in terms of his political domination of the landscape in India – certainly no regional leader and of course not even Rahul Gandhi,” said Bouton, adding that Gandhi consistently put it in “a very lackluster performance” as the leader of the Congress Party. State-level regional parties also did not have the organizational strength that could compare with that of the BJP, he added.

“There is a new political culture in which people in India are looking first and foremost for a leader with whom they can identify, and who in their minds embodies their aspirations – their political aspirations, their social aspirations and their economic aspirations,” notes Bouton. “That allowed Modi to make the argument that he is that man.”

One survey showed that 32% of BJP voters would not have voted for the NDA if Modi had not been the prime ministerial candidate, according to Milan Vaishnav, director and senior fellow in the South Asia Program at the Carnegie Endowment for International Peace. He was speaking at a panel discussion hosted by the Brookings Institution after the election results. “This idea that Modi is a decisive leader, who is incorruptible, who operates with clean intent and with national interest at heart, is something many voters latched onto,” he said.

“There is a new political culture in which people in India are looking first and foremost for a leader with whom they can identify, and who in their minds embodies their aspirations….” –Marshall Bouton

In the campaigning before the 2014 elections, Modi had promised “Achche Din” or “Good times, good days” and other promises such as weeding out corruption, “[but] this time, none of those promises were made,” Vaishnav noted. “It was all about ‘I am the best person to protect India; I am the Chowkidar, or the watchman for India.’” Bouton points out that Modi seized the opportunity after an attack by a Pakistan-based terrorist group on February 14 in Jammu and Kashmir’s Pulwama district claimed the lives of 40 police personnel. In response, on February 26, the Indian air force deployed Mirage 2000 jets to drop bombs on Balakot, Pakistan. India claimed it had destroyed a terrorist camp and killed several terrorists, a view that Pakistan disputes. These events transformed the key issues on the minds of voters two months before the elections, as Modi and other BJP leaders unleashed waves of nationalist rhetoric, positioning him as a strong leader whose presence was needed to protect India’s security interests.

Exit Congress System, Enter Hindutva

The election outcome represents a turning point politically because of the apparent end of the era where the Congress Party was dominant, either as the party in power or in the Opposition. The 133-year-old Congress Party had embedded itself deep in the Indian electoral psyche, as it had constantly reminded voters that it had led India to independence from British rule in 1947, and that Mohandas Karamchand Gandhi, arguably the most visible leader of the Independence struggle, was a party member.

“This is the first time that we can say for sure that the so-called Congress system based on the Congress party’s dominance in the 1950s, ‘60s, ‘70s and ‘80s with India’s politics is over,” notes Bouton. ‘It is emphatically over and has been replaced by the BJP system, where the BJP and its aspirations and identity now shape the entire Indian political environment.” Citing a map showing the extent of the BJP’s winnings across the country in the latest election, he says, “Practically the entire country is colored orange (or saffron, the BJP’s party color), except for the very farthest southern states and a little bit of the east coast southeastern belt of India.”

The reasons for that shift are clear to see in retrospect. Over the past 30 years that the BJP began to get political traction in India, “the Congress system partly died from old age,” says Bouton. “It had just run out of ideas and compelling political messages for the people of India.”

Another factor that contributed to the Congress Party’s decline is that the so-called Nehru-Gandhi dynasty had dominated it throughout, leaving it with few other national-level leaders. The lineage began with freedom fighter and independent India’s first prime minister, Jawaharlal Nehru, who passed the mantle to his daughter Indira Gandhi (no relation to Mohandas Gandhi). Next came her sons Sanjay and Rajiv, daughter-in-law Sonia, grandson Rahul and most recently her granddaughter Priyanka.

As the Gandhi family’s spell over Indian politics “weakened steadily over the last 20 or 30 years, along came a new definition of what it means to be Indian,” notes Bouton. The Independence movement and the Nehru-Gandhi dynasty sought to project India as “a secular nation in which many religious, linguistic and ethnic identities could co-exist easily,” he notes. “That is now being questioned and indeed has been undercut by the argument that India is essentially a Hindu nation.”

The idea of a Hindu nation is not as much rooted in religion as it is a question of national identity, according to Bouton. That identity has manifested itself as Hindutva, a nationalistic term used to convey a sense of Hindu identity. As Hindus represent 80% of India’s population of about 1.32 billion, the advance of Hindutva also raises questions about the future of minorities in India, he says. Muslims account for about 14% of India’s population. In a speech after the elections, Modi stressed that minorities in India should not have to live any longer in fear.

The Next Five Years

How will the new Modi government channel the “extraordinary mandate” he has secured? According to Bouton, notwithstanding the pains that followed demonetization and GST, Modi appears to have the business community on his side, he notes. “The business community is thrilled [at BJP’s win] because above all, it values stability and certainty.”

“Sectoral ministries such as the ministry of fertilizers, mines, heavy industries, IT, textiles and steel are targets for regulatory capture by well-organized industry interests.” –Ravi Aron

Signs of business support for Modi were evident long before the elections; the BJP went into the contest with significantly deeper pockets than the Congress or other rivals. According to a report in The Guardian, the Association for Democratic Reforms estimates that “the BJP took in more than 73% of the donations declared by India’s seven largest political parties in 2017-18. The ruling party spent more than 260 million rupees on advertisements on Facebook, YouTube, Google and Instagram compared with 35 million rupees by the Congress.”

Bouton notes that while the business community was apprehensive about some actions of the previous Modi government, it also had “a desire to avoid a messy outcome in this election that would have produced an equally messy coalition government with a lot of uncertainty.” The stock markets cheered the election results. India’s benchmark index, the Sensex, gained nearly 450 points to levels of 39,530 in the subsequent eight trading sessions. The rupee, too, gained in value. However, both the stock index and the rupee later declined since the markets recognize that the Indian economy continues to face formidable challenges and uncertainty continues to hover over the world economy because of trade disputes.

Now that Modi has secured his political position, he may devote more attention to economic affairs. “Many expect or hope that Modi in his second term will return to his economic reforms-based governance that he started with right after 2014, and that he will renew some of those reform efforts such as in the land markets and labor markets,” says Bouton. He also expects measures “to improve the status of agriculture” and address agrarian distress.

Ravi Aron, professor at the Johns Hopkins Carey Business School, points to three key areas in which the new government could prioritize economic reforms: labor reforms; divestment and privatization of state-owned enterprises; and unwinding protectionist policies that restrict foreign direct investment.

Labor reforms could address flaws in the Industrial Disputes Act “and the resulting inflexible labor laws [that] have choked the growth of manufacturing labor in India for more than 40 years now,” Aron says. “The extreme inflexibility has made employers very reluctant to hire workers and has created perverse incentives for substitution of labor by capital.” For example, the Industrial Disputes Act requires businesses that employ 100 or more workers to seek prior permission from the government before retrenching workers or closing down their establishments, according to a report that argues for more flexibility in labor laws.

Aron, however, does not expect the Modi government “to do anything” beyond “slightly cosmetic changes” with labor reforms. “There is no political will to take on narrow special interests, or labor unions, that are highly organized and entrenched,” he notes.

Aron points out that the government could also proceed with divestment and privatization of some two dozen public sector undertakings (PSUs) that already has cabinet approval. Privatizing PSUs will release capital for investment in areas like education and health care. It could also help bring improved performance of PSUs, he adds. “Chronic production inefficiencies and poor returns on invested capital plague these PSUs. As a result, they increase the costs of inputs and lead to lower capacity utilization and a high-cost, low-efficiency economy.”

Finally, Aron sees opportunities in select industries for greater private sector involvement and a reduced government role that is limited to monitoring. “Sectoral ministries such as the ministry of fertilizers, mines, heavy industries, IT, textiles and steel are targets for regulatory capture by well-organized industry interests,” he notes.

Attracting Foreign Investors

India could attract more private capital from the U.S. and other countries “if Mr. Modi uses this opportunity to make India a more attractive place to invest,” according to Bouton. He credited Modi with helping India improve its rank in the World Bank’s Ease of Doing Business index over the last five years; India’s now ranks 77^th among 190 countries compared with 134^th in 2014.

However, India needs to do much more to become business-friendly. “It’s still one of the most complicated and difficult places to do business in,” says Bouton. “There would have to be a very substantial further liberalizing of the investment environment.”

Specifically, there is a compelling need to unwind protectionist policies that restrict FDI, especially in retailing, Aron says. “Indian policy makers have created a bewildering array of policy distinctions between single brand, multi-brand, brick and mortar and online, online marketplaces and wholesale cash and carry businesses,” he adds. “These are largely protectionist policies meant to help domestic businesses.”

“There is no political will to take on narrow special interests, or labor unions, that are highly organized and entrenched.” –Ravi Aron

Regulatory easing would also help. Aron points to e-commerce rules that impose limits on the types of businesses that online retailers could undertake. “This is an area where the government can move swiftly and without fear of political or populist backlash.”

India has also failed to capitalize on the ongoing U.S.-China trade war, according to Bouton. “The lost opportunity there is particularly painful when you consider that American companies that have invested heavily in China over the last 30 years are now looking for other places to put their investments and to put their supply chains,” he says. “India could benefit enormously from that new situation. But it’s going to need to move very aggressively to make that possible.”

For global investors, Bouton believes the best way to tap into opportunities in India is to cater to its “very aspirational near middle-class or middle class” population. It also helps that “the consumer sector is least affected by government regulation and intrusion,” he adds. “In the last two or three years, the big U.S. investments in India have all been in the consumer sector. That’s the surest way to get a piece of the Indian economy and of its growth trajectory without getting hobbled by regulation.”

Bouton says the Modi government could boost such investments by pulling back from protectionist measures that hinder foreign investments. Commenting on Modi’s “Make in India” campaign, where global companies were invited to set up manufacturing facilities in India, he notes: “If he wants to do that, he’s got to reverse course and again liberalize the investment environment, in which case it becomes possible for American and other companies that are making in China and Vietnam and elsewhere to come and make in India.”

Future Challenges

To be sure, Modi faces constraints in implementing economic reforms. “There are very few public resources available right now for the government to provide, for instance, a fiscal stimulus,” Bouton says. He notes that India’s PSUs have limited resources and the government does not have the luxury of stretching its current account balance. “Many in India are calling for a big fiscal stimulus at this point, but that’s going to be very difficult for [Modi] to do without substantially increasing the current account deficit.”

Modi will be able to push through legislation with the NDA’s dominance in the Lok Sabha and potentially the Rajya Sabha (the upper house of Parliament) as well. However, it will have to depend on individual states. “A lot of economic policy is implemented at the state level in India and that makes it much more complex to bring about real results,” says Bouton.

The biggest challenge the new Modi government faces is the slump, or anemic growth, in private investment. A large part of that is because many Indian companies are nursing high debt burdens and are in the process of deleveraging. Those high debt loads have saddled many banks, especially public sector banks, with nonperforming assets large enough to prevent substantial new lending. The government would need to undertake a massive recapitalization of public sector banks in order to stimulate private investment, but it faces an uphill task on that front, Bouton notes.

According to Aron, the Modi government should try to tackle the toughest economic reforms in the first year of its new term. “The opposition is in disarray and the next election is at least four years away,” he says. He notes that benefits from investments in education and healthcare could accrue to the government within its five-year term.

Relations with Neighbors

India’s desire to strengthen its relationships with its neighbors in South Asia, especially Pakistan, also hinges on its economic might, according to Bouton. “The single most important thing Prime Minister Modi can do to enable India’s strong participation in the international system, and in particular to gain leverage in his relationships with India’s neighbors, would be to improve the economy,” he says. He believes that India should be able to achieve a GDP growth rate higher than the 7%-7.5% bracket it has been at for the last few years. “It should be in the 8% or 9% or even 10% bracket.” However, the degree of success India has in improving its relations with its neighbors depends also “on the character of the regime in that country, whether in Bangladesh, Sri Lanka, the Maldives or Nepal,” he adds.

“The single most important thing Prime Minister Modi can do to enable India’s strong participation in the international system … would be to improve the economy.” –Marshall Bouton

Among its neighbors, India’s biggest challenge is with Pakistan. Bouton notes that while Imran Khan, Pakistan’s prime minister, publicly congratulated Modi on his victory on May 23, the very same day Pakistan launched a ballistic missile.

“Pakistan has not admitted to India’s pre-eminence in the subcontinent and one cannot foresee the day when they will,” Bouton says. “The only way to change that over time is for India to have such a preponderance of power in the region.” Secondly, India ought to make it clear to Pakistanis that they would benefit from greater integration with a dynamic Indian economy, he adds. He expects Modi to reach out to Pakistan with “an olive branch” in the coming months.

Economic success is the best lever Modi could use also in trying to build a more balanced relationship with China. The two countries had a tense face-off in the summer of 2017 over China’s military presence in the Doklam Plateau, a border area between Bhutan and China that India sees as a buffer zone. “The two countries nearly came to blows,” Bouton says of that episode. “[Modi] needs to keep things from getting too shaky. I think he appreciates [China’s president] Xi Jinping has had the same objective. But the rivalry is still very intense, and it will continue.”

India’s ties with the U.S. are also critical, and both Modi and Trump are convinced of that, says Bouton. “President Trump has clearly put a lot of stock in the relationship and has moved on a number of directions to ensure it continues to develop, although not so much on the economic front,” he adds. “There has been some nervousness on the Indian side about whether President Trump would be consistent in his hitherto positive approach to India. Hopefully, they can now feel more confident about that.”

The Lure of Populism

While Modi is the first prime minister in almost 50 years to lead his party to win a majority in successive elections, he has done so by pushing forward a Hindu nationalist agenda. His re-election also continues a global trend of populist candidates winning top seats, including President Trump in the U.S., Jair Bolsonaro in Brazil and Joko Widodo in Indonesia. Therein lies a danger: “Populists are highly skilled at staying in power and pose an acute danger to democratic institutions,” according to a report in The Atlantic, based on a study of 46 populist leaders or parties worldwide between 1990 and the present.

Modi should embrace hard-nosed economic reforms and not succumb to politically expedient populism, Bouton notes. In a recent op-ed article in The New York Times, columnist Ruchir Sharma noted that although Modi in 2014 led the BJP to power “on a Reaganesque promise of ‘minimum government,’ … he has wielded the tools of state control at least as aggressively as his predecessors.” He noted that during the latest campaign, Modi “went toe to toe with rivals, vying to see who could offer the most generous welfare programs, and it appears to have worked.”

Bouton notes that although many expected Modi to be “a consistent powerful reformer” back in 2014, he turned in a more populist direction “because in India, if you want to get reelected, that’s the expectation voters have of you.” The government had its back to the wall, facing criticism that it had failed to deliver on its promises of doubling farm incomes, raising minimum support prices for crops and making procurement more efficient.

Not surprisingly, the government’s interim budget unveiled weeks before the election included a Rs. 75,000 crore ($10.6 billion) package of cash handouts to small farmers, where each would get Rs. 6,000 ($88) a year. “Having criticized the previous Congress-led government for pushing money into airplanes and dropping it over the farm sector, he’s done exactly the same in the last year to try to quiet the agrarian distress before the election,” Bouton says.

But now, with the election behind him, Modi may not feel the need for populist policies. If he wants to be “truly transformative,” he must focus on reforms that will power the Indian economy in the near term into a substantial middle-income economy, and eventually into a First World economy, according to Bouton. “At the same time, for political reasons, [he has to ensure] Indians feel confident about what the government is doing for them. It’s a very delicate and difficult transition that must be made. One can only hope that now [that he is] so empowered, Modi will feel able to try that.”