Singapore: The primary concern of Indian companies is not the absence of big-bang reforms under the Narendra Modi government. Rather, Indian companies are more worried about high non-performing loans (NPLs) in the banking system and their impact on banks’ ability to fund growth, said Devika Mehndiratta, Singapore-based senior economist at Australia and New Zealand Banking Group Ltd.

Mehndiratta, who spent two weeks in India recently meeting corporate executives as well as officials from the Reserve Bank of India (RBI), said in an interview that companies are also uncertain whether increased government spending on infrastructure will indeed kick-start investments.

Edited excerpts from an interview:

What were the key takeaways from your recent visit to India?

We expected some sombreness in sentiment, given the disappointing corporate results and some fizzling out of the exuberant expectations from the new government. But we were struck by how much growth concerns still dominated. This weak growth sentiment ties in with the loss of momentum in the PMI (purchasing managers’ index) recently. Importantly, contrary to common perception, it is not so much the lack of big reforms that is bothering corporates. Expectedly, the election-time exuberance had worn off and most of the corporates we met viewed the first-year performance of the Modi government with increased ambivalence. However, the general feedback around the Modi government’s performance was that things are at least moving in the right direction. Our interaction with Micromax, India’s largest smartphone vendor, was an exception—that industry is experiencing solid demand and also some evidence of “Make in India" as the company is moving to producing smartphones and tablets in India rather than importing from China.

What then were the key concerns raised?

The key concerns were: high NPLs in the banking system and uncertainty about whether increased government spending on infrastructure will indeed kick-start investments. Corporates are worried about bank NPLs not because they think these pose a risk to the financial system, but rather how these could continue to constrain lending and, hence, investments—stressed loans among public sector banks stood at 13.5% of total assets as of March 2015. With regard to the second point, there is uncertainty about whether the increased government spending on infrastructure will actually revive growth. A lack of reliable activity data in India, especially with the much-discussed divergence between the new and old GDP (gross domestic product) series, is only further clouding corporates’ assessment of the growth environment.

Recovery continues but at a slower pace than expected. Is that a risk in itself? Added to that, investment recovery remains anaemic. So, will we get stuck in a cycle—a lack of a vigorous economic recovery leading to weak growth, which in turn raises NPLs, undermining the financial sector, which further impacts growth?

It’s certainly a risk that could materialize if the growth recovery stalls—that’s not our base case, however. There’s still some time to go before bad loans peak but banks and RBI seem to be reasonably confident that the recent measures to speed up NPA recognition will be enough to contain the issue. Thankfully, there are some green shoots visible on investments—for example, capital goods’ imports or projects under implementation tracked by SMEs (small and medium enterprises)—if the improvement is sustained and the government fast-tracks raising the targeted off-budget finances for stepping up infrastructure spending—e.g. tax-free infrastructure bonds, etc., we will be able to avoid getting into that vicious cycle you have described.

Based on your interactions with companies in India, what do they think the government should do to support growth? Do Indian companies believe that the government has a plan to turn around the economy?

One of the key concerns was around the constraints on the banking system and, hence, some felt that the government needs to inject large capital into public sector banks. Some felt that the government ought to be bolder in stepping up spending by allowing a larger fiscal deficit. Then, of course, there was the usual “hope" that the RBI might cut rates more if the monsoon turned out normal. I emphasize “hope" because many seemed to agree with our view that the scope for further easing was limited.

Much faith is being put in the infrastructure stimulus that the government outlined in the budget. Indeed the central government has stepped up awarding new highway projects out and since, unlike the PPP (public-private partnership) projects in earlier years, the new batch already has much of the land acquired and are fully funded by the government; construction activity on these should be able to start reasonably soon. We estimate spending worth 0.1% of GDP in total for 2015 to come in on new highway construction by the central government. The question is—is this large enough?

Given the shortening political time-table after this year as major state assembly elections come up in the next two years, has the government failed to utilize its honeymoon period well? Instead, do you think that India could have gone for a much slower pace of fiscal consolidation and then leveraged government spending to revive growth?

It’s hard to say if the lack of action by the Modi government on politically sensitive reforms, e.g. labour law and deregulating fertilizer prices, is because of a lack of intent—that would be worrying. Or that the intent is there and it’s just that the Modi government is waiting strategically for a better time. We assume and hope it’s the latter—that is, the Modi government has gone slow on “big" reforms to avoid further jeopardizing the fate of more pressing and politically sensitive laws already stuck in the Rajya Sabha—e.g. land acquisition and (or) to garner wins at the upcoming state elections until 2017 to step up the NDA’s (National Democratic Alliance’s) number power in the Rajya Sabha with the ultimate aim of pushing these tougher reforms. If it’s the latter, the more politically difficult reforms such as allowing more corporates to hire and fire without government permission may have to wait until 2017—with some chance of this being tackled in the window of about 12 months between the bunched-up state elections around May 2016 and the next lot in 2017. As far as other big reforms such as privatization of public sector banks go, our interaction with the ministry of finance suggests that this is not on the government’s agenda—not now, nor later.

On your other question—should India have opted for a slower pace of fiscal consolidation to pump prime growth? Yes—not so much in terms of a larger size of pump priming but rather timing. Given that the investments were clearly hurting and the long lags with which public investment actually hits the ground after announcements on the budget day, the government should have maintained its capex spending plans in the 2014-15 interim budget even if that meant a small slippage in the fiscal deficit target.

Instead, they adopted a “by hook or crook, we’ll meet the 4.1% of GDP target for 2014-15"—i.e., by cutting precious capex—even though the tax collections were coming in much lower than targeted. Of course, the reason the Modi government adopted that approach was to avoid being seen as fiscally irresponsible by international rating agencies—and, to be fair, there was indirect pressure from the RBI, too, to meet the fiscal deficit target. But I think international rating agencies would have actually accepted a small slippage if the government clearly demonstrated that it was to make space for much-needed capital spending, and by sweetening any overshoot of the deficit by displaying firmer commitment to subsidy cuts by, for instance, eliminating people in the highest income bracket from receiving LPG (liquefied petroleum gas) subsidy. But (it is) quite likely that tougher decisions such as labour laws and deregulating urea prices (will) wait until 2017, when the government hopes to have stronger numbers in the Rajya Sabha.

How soon do you see recovery becoming more firm?

Well, according to the “new" GDP series, growth is already running at 7.5% for the quarter ending March 2015! Of course, the problem is that there are doubts around the methodology and, hence, reliability of the new series that has made any judgement around growth difficult. Looking at other indicators, we think the slowdown bottomed around end-2013 and growth has picked up since but only very gradually as the investments engine was broken and with exports facing global headwinds. I think by end-2015, we should see the recovery turn firmer.

You met with officials from RBI during your recent trip. What were the key takeaways from the discussions with them? Is RBI concerned about growth? Did RBI give any indications that a weak recovery would see them resorting to more rate cuts?

In our conversation with the central bank, we didn’t sense any serious concern about growth. This was again reflected in RBI deputy governor (Urijit) Patel’s comments in a TV interview last month when he noted positive recovery signs such as a pick-up in the latest reading of “core" sector production growth and upcoming IPOs (initial public offerings). In a sense, RBI has handed over the “responsibility" of boosting growth to the government. Although RBI has said that a further easing could be considered if incoming inflation suggests year-end inflation would come in lower than 6%, we think the scope for a further easing looks limited. We have been wary of the sustainability of low food inflation given structural factors—the upside surprise in June food and hence headline CPI inflation suggests the chances of inflation ending the year clearly below 6% are low even if we get a normal monsoon.

Do you think that an emerging economy like India should have tolerated higher inflation and cut interest rates to stimulate growth?

I think what we need to keep in mind is that RBI—rightly or wrongly so—has had an eye on not just interest rates for borrowers but also the real rates facing savers. If you look at real rates—these have actually increased over the monetary policy easing cycle last year! In allowing so, the central bank seems to have consciously ensured that financial savings—bank deposits—become more attractive versus non-financial and non-productive savings—gold. Has RBI erred too much on the side of caution on inflation? A little, possibly yes, but I think the broader objective of being more inflation-focused was necessary, given the mini currency crisis that India got caught in the taper tantrum of 2013. India’s central bank needed to win back credibility on getting the messy macro house—high inflation, jump in gold imports, policy paralysis—in order and avoiding a larger currency crisis.

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