In the countdown to India’s 2019 general election, one question seems to matter in every economic report, government survey, policy statement or rating agency assessment: Does it strengthen or weaken Prime Minister Narendra Modi’s ability to return to power? The logic is simple: If the Indian economy performs well — not just the stock markets but also small businesses and the farm economy — Modi could convert economic growth into electoral gains.

That approach seems to have marked the formulation of the 2018-2019 Union budget, which was announced on February 1, and the annual Economic Survey released the previous week. The Economic Survey pegged India’s GDP growth rate between 7% and 7.5% for the coming year, making it the world’s fastest-growing major economy. That would mean an increase from the current year’s GDP growth rate of 6.7% for the $2.63 trillion economy. In contrast, China’s $17.6 trillion economy is seven times larger.

Wharton management professor Saikat Chaudhuri is optimistic about India’s economy. “While 2017 was marked by a number of jolts and major changes to the system, such as demonetization and the introduction of a goods and services tax (GST), their impact will settle as new realities and equilibria set in, allowing firms and individuals to plan accordingly. I am optimistic, as the various reforms and infrastructure projects will start bearing fruit. As companies adjust and receive benefits, this will lead to increased economic growth and greater influx of foreign capital.” Chaudhuri is executive director of the school’s Mack Institute for Innovation Management.

Cautious Optimism

Wharton professor of operations, information and decisions Kartik Hosanagar is “cautiously optimistic.” His caution stems from what he calls “multiple missteps” over the past 12 to 14 months. India’s demonetization efforts weren’t successful and had an impact on small businesses and on GDP growth. Also, the GST rollout had many hiccups but they should help in the long run, he notes.

“The optimism is because my hope is that these are short-lived hiccups,” says Hosanagar. He lists the positives as the government’s success in attracting foreign investment and “serious efforts” to rein in the bad loans plaguing the banks. “Ultimately, if 2018 sees a return to the GDP growth rates prior to demonetization, that’ll be a win,” he notes. “Success will be a return to the original status quo rather than unprecedented growth. I am not expecting much more.”

“The biggest wild card is what happens to the BJP in the upcoming state elections, which will also shape the Lok Sabha elections [in 2019].” –Saikat Chaudhuri

What Could Go Wrong?

The biggest spoiler could be a rise in oil prices, which could worsen India’s finances. The country imported nearly $81 billion worth of crude oil and other petroleum products in 2016-2017; these imports could grow 4.5% in volume this fiscal year, according to the ministry of petroleum and natural gas. Crude prices have risen from a low of $27 a barrel in January 2016 to more than $60 in the last week of February. They will probably continue to rise with global economic growth and Saudi Arabia’s forthcoming public offering for its state-owned oil company Aramco.

India’s finance minister, Arun Jaitley, has been criticized for raising the targeted fiscal deficit to 3.5% for 2018 in his budget proposals, up from 3.3% estimated earlier. Other dampeners come from rising global bond yields and their drag on the S&P 500 and Dow Jones indices, speculation over a faster pace of rate increases by the U.S. Federal Reserve and its potentially negative impact on fund flows to emerging markets.

The latest monetary policy committee report from India’s central bank, the Reserve Bank of India (RBI), warns of rising consumer price inflation, even as it notes that economic growth is likely to increase. India’s stock markets have taken badly to the projected inflation as well as a budget proposal to impose a 10% tax on long-term capital gains. Stocks lost nearly 7% of their value in the first two weeks of February.

Before India’s GDP growth can rise, the economy must digest some far-reaching structural reforms that Modi’s government introduced over the past year or so. The constraining effects of the massive demonetization program of November 2016 persist. This move demonetized high-value currency notes, which sucked out 86% of the money in circulation in what was largely a cash economy.

At least two measures have had a painful birth: the GST regime that took effect in July to replace multiple state and central taxes, and the Real Estate (Regulation and Development) Act (RERA). Businesses have struggled to adjust to the GST regime, and it has become a drag on economic activity. The government has since rolled back or significantly eased many GST measures that were seen as hurting small and midsized businesses. Similarly, the RERA reforms aimed for greater transparency and protection for homebuyers, combined with the demonetization, but these stalled transactions and new construction activity.

The past year also saw the RBI tackling a so-called “twin balance-sheet” problem of distressed assets on corporate balance sheets and the effects of high nonperforming assets (NPAs) on bank balance sheets. An Insolvency and Bankruptcy Code was enacted in 2016. It may make it easier for insolvent companies to be wound down.

“If 2018 sees a return to the GDP growth rates prior to demonetization, that’ll be a win. So success will be a return to the original status quo rather than unprecedented growth.” –Kartik Hosanagar

Meanwhile, credit use by industry has been contracting since September 2016, although that trend seems to have been reversed in the past two months. Capacity utilization in manufacturing has hovered at some 72%, leaving slack before new investment can be justified. As a result, fresh capital formation has suffered.

Many experts are upbeat about a $32 billion recapitalization program for public sector banks, which will enhance their lending capacity. Corporate earnings are also expected to rebound this year (the results’ season begins in April), after an underwhelming two- to three-year patch. According to stock market experts, that has already been factored into stock valuations. Two more positive signs: Moody’s has upgraded India’s sovereign rating from Baa3, the lowest investment grade, to Baa2, and revised its outlook for the country from “stable” to “positive.” In addition, the World Bank has lifted India’s rank to 100 in its “Doing Business 2018” rankings, up from 130 last year.

Maximizing the Positives

Hosanagar hopes that the economy will digest these structural reforms and rebound. “All these ongoing measures are good for the long run. The question is how well they’ll implement bank recapitalization and corporate bankruptcy measures,” he says. “Overall, I think these can be big positives. The devil is, of course, in the details. Any loss of consumer confidence in banking will be detrimental. So while the thinking behind bank recapitalization and corporate bankruptcy is correct, they have to implement the changes carefully.”

The Economic Survey warns: “Against emerging macroeconomic concerns, policy vigilance will be necessary in the coming year, especially if high international oil prices persist or elevated stock prices correct sharply, provoking a ‘sudden stall’ in capital flows.” It emphasized three areas of policy focus for the medium term: employment generation; education to create a robust work force; and raising farm productivity. “Above all, India must continue improving the climate for rapid economic growth on the strength of the only two truly sustainable engines — private investment and exports,” it added.

The Mack Institute’s Chaudhuri notes that the reforms will make room for India to grow globally. “At the same time, it will be important for Modi to tackle some key lingering reforms such as pension and labor laws, to truly send the right signals and unshackle the system,” he says. “One advantage India has is that other major economies are mired in uncertainty; China has slowed down and requires systemic changes, Europe is dealing with Brexit, and the U.S. is faced with the effects of President Trump’s protectionist policy moves and rhetoric. So relatively speaking, India looks quite attractive and can use the opportunity to march ahead.” Hosanagar adds: “Global interest in India is high. Well-performing Indian companies will be able to access capital in global markets.”

While structural reforms prevented India from participating in global economic growth last year, that could change this year. “Compared to where we were in 2013, when we were counted among the Fragile 5 (the other four are Turkey, Brazil, South Africa and Indonesia), the macroeconomic situation has surely improved, thanks to the policy reforms,” notes Navneet Munot, chief investment officer of SBI Funds Management, a prominent mutual fund investments manager. “In 2018, if the global economy does well, India should be able to participate, and maybe get to the trend-line [GDP] growth of 7% to 7.5%.”

According to Munot, “The most critical driver is corporate profit growth.” He notes that earnings growth declined to an aggregate level of 3% of GDP and has been muted the past few years. “Corporate profits would grow if the domestic economy revives and is able to ride on the synchronized global growth, exports revive, and the domestic investment cycle turns [positive],” he says. He expects increased government spending with elections in mind, which in turn would encourage private capital investments.

“Compared to where we were in 2013, when we were counted among the Fragile 5 (the other four are Turkey, Brazil, South Africa and Indonesia), the macroeconomic situation has surely improved, thanks to the policy reforms.” –Navneet Munot

According to Saurabh Mukherjea, CEO of institutional equities at Ambit Capital, a financial services firm in Mumbai, the year to March 2018 will be the first in five years to see double-digit earnings growth for the Nifty, the National Stock Exchange’s index of the top 50 stocks. “This government has no option but to make a determined effort to reflate the economy,” he says. “It has rolled back the GST regime aggressively, and it has made life much easier for small businesses. With the bank recapitalization [program], public sector banks could lend to road projects sponsored by the government, and steel and real estate companies. Thus, public sector banks will be used indirectly to stimulate the economy.”

Preparing for Elections

The forthcoming state elections and the 2019 general election to the Lok Sabha, the lower house of India’s parliament, is the elephant in the room. On the day Jaitley prepared to deliver his budget speech, the ruling Bhartiya Janata Party (BJP) faced setbacks in by-elections for five seats that had fallen vacant in two states – Rajasthan and West Bengal. Some experts saw a connection between those poll results and Jaitley’s budget proposals to boost farm incomes, employment, health care for the poor, tax breaks for small and midsized businesses and tariff protections for industries vulnerable to cheaper imports from China.

Specifically, the budget raised minimum support prices (MSP) that the government would guarantee for rice and wheat farmers, and extended the MSP to all crops. It also proposed to deliver health care coverage to 100 million poor families, or about 500 million people at Rs. 5 lakh each (about $7,800), making it the world’s single- largest health care program.

Jaitley’s proposals also permitted contract labor in all sectors, and aimed to create 7 million new jobs through various programs. He cut taxes for businesses with annual revenues up to Rs. 250 crore ($40 million). He raised customs duties on imports of numerous items including mobile phones and parts, passenger and commercial vehicles, watches, footwear and fruit juices. For example, the customs duty on cranberry juice is up five-fold to 50%, and a 20% duty on mobile phones, up from 15% earlier, will make an iPhone 4% costlier.

Although those import duty protections were presented as part of Modi’s earlier “Make in India” program, critics called them a “Protect in India” program. “This vastly exceeded in breadth Donald Trump’s strategy of trying to create jobs through protectionism, and may be no more successful,” wrote Swaminathan S. Anklesaria Aiyar, consulting editor of The Economic Times newspaper. Many also saw Jaitley’s budget as resisting the temptation to overtly distribute pre-election freebies, but others saw such efforts as thinly disguised. “In the end, politics defined the economics of the Union budget,” wrote Anil Padmanabhan in the Mint newspaper. A “Budget Clock” the paper created showed that Jaitley devoted the bulk of his 110-minute speech to farm distress, poor and social marginalized, education, health care, jobs and small-scale industries.

Wild Cards

According to Munot, a big variable is oil prices. “Oil has helped India significantly over the past three years,” he says. “If oil prices move up, a lot of the improvements we have seen on the fiscal side and current account side, currency stability and strong foreign exchange reserves – all those will be impacted.” India’s oil ministry had estimated the country’s crude oil import bill for the current year at $86 billion last July, assuming a per-barrel price of $55. It had then said that every increase of a dollar in the price of crude oil increases India’s import bill by Rs. 7,969 crore ($1.2 billion).

“The biggest wild card is what happens to the BJP in the upcoming state elections, which will also shape the Lok Sabha elections [in 2019],” says Chaudhuri. “The open question for me is whether Modi can show some large-scale wins and benefits resulting from his various recent moves and policies since coming to national office. They would defy the negative image increasingly held by a large section that not much is happening overall beyond populistic moves, that things are slow, and that Modi is unable to recreate what he did in Gujarat in terms of economic growth.” He notes that that pressure has been intensified and Modi has “risked alienating a chunk of his base” through actions such as demonetization and GST.

Chaudhuri believes Modi needs a second term to deliver on expectations. “The question will now be whether people will buy his narrative and emphasis, or see him as drifting too far from their interests which got him elected in 2014 at the national level. For that, some concrete gains such as strong economic growth benefiting a wide spectrum of society will be critical, as it will vindicate his policies and actions.” He adds that Modi spent his first term as chief minister of Gujarat in laying the groundwork with infrastructure development and policy reforms. “It was thereafter that he aggressively courted investments and brought his state into the limelight. So even if that is the plan for India as a whole, without a second term, it will come to naught.”

In Hosanagar’s view, “the biggest wild card” for the right economic drivers will be how the BJP fares in the forthcoming state elections. “If BJP loses important state elections, that’ll slow down reforms. Another challenge is the rapid and ongoing polarization in political discourse much like it happened in the U.S. in the last 10-15 years.” He points to grievances aired recently by senior Supreme Court justices, who accused the chief justice of departing from conventional procedure in selecting judges for cases involving BJP president Amit Shah. “Such incidents will ultimately affect faith in the system as a whole.”