The five arrows of Modinomics - short term pain, long term gain

India's Apr-Jun 2017 real GDP growth came in at a disappointing 5.7% - we have almost certainly lost the "fastest growing large economy" tag again. Since Indians are on average still very poor compared to the rest of the world, all informed and interested citizens should be rightfully very concerned.

So what and who is to blame? Some would say Modi's BJP government and their terrible policies of economic mismanagement - the biggest alleged culprit often being the unconventional policy of 'demonetization' or the sudden invalidation of most of India's paper currency (by value) in November 2016 with the citizenry being asked to replace their notes in a few months so that tax evaders and even worse malcontents could be (theoretically) tracked. The claim is that since most of the notes returned and since growth is slow, demonetisation was a disaster (even if Modi did not pay a political price for it so far)

Let us unpack claims such as the above, and see if we can connect the dots in Modi's economic policies more broadly. As an analogy let us consider Abenomics, named after Japan's PM Shinzo Abe, which is said to have three "arrows" - monetary easing, fiscal stimulus, and structural reforms (except the last arrow, the other two are designed to give a "sugar high" to the sclerotic Japanese economy). Modinomics on the other hand can be said to have five arrows - and none are primarily designed for instant gratification. Indeed, most are the equivalent of going on a strict diet and exercise routine - you will eventually get in shape, but in the meanwhile you will passionately hate your dietician, gym instructor, spouse/parent/whoever is playing the "bad cop" in your life.

These, then, constitute Modinomics' arrows:

(1) Fiscal policy consolidation while increasing infra spend

(2) Monetary policy hawkishness and low inflation

(3) Structural reforms - GST, RERA, bankruptcy law

(4) Formalisation of economy - demonetisation, digitalisation

(5) State capacity creation and smart welfare

Let us quickly dive into each of the arrows, but before that a few words. Most developed economies' economists, especially of the free market persuasion, understandably focus on the third arrow above i.e. structural reforms, and to a slightly lesser extent on the first two: monetary and fiscal policy. But, and this is also understandable, the last two arrows above are ignored - because developed economies are already largely formal (firms and individuals mostly pay their share of taxes, and have access to organised credit etc), and their welfare states already have good infrastructure as well as basic competence, often developed over centuries. Hence, we can have grand philosophical debates of liberty vs equality in the modern West, with economic liberty having the upper hand in the Reagan/Thatcher era, and the pendulum now perhaps swinging the other way.

But in India we do not have this luxury. For the unified, non-colonial state itself is a new creature to Indians, and therefore we have to struggle with Hobbes before we discuss Locke. In other words, we have to build the sinews of state capacity before jumping to debates for and against free market economics (which, after 1991, for some will only be followed in India when the bloated Air India will be privatised - surely a valid demand, but one can only pity such simpletons and their litmus tests).

Without further ado then, on to the five arrows of Modinomics - a few of the points overlap across arrows so I will try to be as concise as possible.

Arrow 1: Fiscal policy consolidation while increasing infra spend

India has reduced its central government fiscal deficit from around 5% in 2013-14 to 3.5% in 2016-17. Yes, the oil price fall globally has played a part here, but the government has used that windfall to almost end related subsidies, and redirected part of that to public sector infrastructure capital expenditure such as roads, railways, waterways, metros, ports, power etc. Any subsidy reduction can be painful, especially in a poor country. Moreover, infrastructure spend involves long-gestation projects - remember the only-one-full-term PM Vajpayee's push for the golden quadrilateral, rural roads may or may not have cost him popularity. Despite that, another PM from the BJP is today pushing for infrastructure. (Yes, state deficits may yet spoil the consolidated deficit story, but there also some of the red ink is because of the longstanding need for power sector reforms - have a partial bailout for SEBs conditional on power theft reduction, for example). Score one for short term pain, long term gain.

Arrow 2: Monetary policy hawkishness and low inflation

India has often faced near-double-digits inflation, but has moved to a 4% inflation target (with the range being 2-6%). For any central bank to be credible about a new and lower inflation target, they have to be hawkish for some time for the public to know they mean business. Only then, do inflation expectations reset lower. Necessarily, this causes pain in the meanwhile. The same happened when Paul Volcker's Fed broke the back of the 1970s inflation and delayed the Reagan 1980s boom in the U.S. To Raghuram Rajan's credit he started this push in India and to Narendra Modi's credit he replaced him with another hawk, Urjit Patel, despite a lot of pressure from corporates to go for a dove. Finally, despite many bureaucratic inconsistencies and egregious errors, the overall minimum support price (MSP) agricultural policy of the BJP/NDA has been to restrict annual increases. Since food is a big part of inflation indices, this has been critical in lowering inflation - even though this has meant partially reneging on a campaign promise, and led to a lot of understandable dislocation especially given the recent bad monsoons (the limited loan waivers of late are at best minor bandages). Score two for short term pain, long term gain.

Arrow 3: Structural reforms - GST, RERA, bankruptcy law

Let us quickly look at land, labour, capital, then at regulations, finally at taxes. The Modi government tried to reform land procurement policy but failed - the cost of building a highway or expressway, just to take one example, increased a lot. But, however imperfectly, the earlier UPA law did enshrine stronger land property protection and whatever one thinks about the balance between eminent domain-driven development and the broader basis of classical liberalism, this battle was sidestepped. On labour laws, only marginal progress has been made so far - mostly by states - and at at the central level we may see some more tinkering and consolidation of regulations. But we can write this off too for now. On the capital front, however, we see more movement. Indebted promoters know they need to pay up or lose control. The NPA resolution is going forward. New avenues of monetisation, be it INVITs/REITs/more FDI liberalisation, have opened. We have a new bankruptcy law and it is in the early stages of fructification. More financial instruments have been allowed. EPFO and others are investing in the equity markets. On regulations, new ones such as RERA have meant that eventually customer confidence in real estate purchases would be high but right now developers are on a pause to understand the regulations and to raise working capital - this means that the second largest generator of employment in India by some metrics is currently in doldrums, but for sensible reasons. On direct taxes, some corporate taxes have been cut but more could be done. Finally, on indirect taxes, the big bang reform of GST which caused many factories to be closed for weeks in June-July 2017 (reform kicked in on 1 July), and which will result in a broader tax base, higher collections and a more integrated market. I do have some reservations about the GST, primarily about the impact of a same-rate tax on competitive federalism, but now that we have the database for inter-state credits, that can and should be modified later. It is, on net, undoubtedly, one of the biggest reforms in Indian history, which nonetheless caused momentary confusion. Score three for short term pain, long term gain.

Arrow 4: Formalisation of economy - demonetisation, digitalisation

Demonetisation, as mentioned at the beginning, has been much criticised (and praised) purely from a partisan lens. However I see it as one part of, not the entirety of, a larger package to lead to a more formal, digital, organised and less-cash economy. The divergence in productivity between the most productive and unproductive firms in India across most sectors is very high, partially because the unproductive ones tend to be in the unorganised sector. Yes, they do not pay taxes always but they also do not have access to formal credit and skilled labour markets. The end result is a low-productivity equilibrium, which needs to be broken (read the book "Power of Productivity" and especially the India chapter therein, however dated it is still relevant). It is true that, as noted by some, that there are limits to formalisation for a still poor country. No digital push and tax cut along with sticks and scares such as demonetisation will lead to a fully formal economy overnight in India - however, that is a straw man. We are by no means at the optimal frontier of formalisation even for our per-capita income. It is not just labour laws but more broadly economies of scale that keep India uncompetitive compared to China, despite the latter having higher labour costs. Yes, demonetisation caused a lot of chaos and short-term job losses, and we will never empirically isolate the impact of demonetisation (given that GST etc followed in quick succession), but it has forced many more Indians to corporatise and pay their employees by check or wire. Score four for short term pain, long term gain.

Arrow 5: State capacity creation and smart welfare

The JAM trinity (bank accounts for almost all, Aadhar number for all, and soon some kind of smartphones for all) is leading to a revolution in state capacity and welfare delivery/efficiency in India. The recent Supreme Court judgment on privacy will not substantially change this, as all fundamental rights can and do have reasonable restrictions. This arrow not just ties to arrow 1 (smart welfare leads to fiscal savings), but also painfully undercuts the many corrupt middleman and leads to much higher last-mile delivery of benefits to the actually needy. Yes, technology by itself cannot be a panacea - we still need to take on public sector unions in government schools, for example, if we want to improve education quality (now that attendance is near universal for lower ages), but the JAM concept is a good start, and lot has been achieved for three years - of course, due credit must go to former PM, UPA's Manmohan Singh and to Nandan Nilekani, for getting this off the ground (Nilekani's India Stack is also an unprecedented policy innovation). However, Modi despite his campaign rhetoric, sensibly embraced the UID project. But not only subsidies have been made more efficient, they have been cut more broadly - especially as a ratio of GDP. Diesel, petrol, kerosene, LPG - almost all subsidies have been cut in one way or the other. The Benami act and the RERA (referred above) are also making rotation of 'black money' into real estate somewhat unviable, partially due to UID-enabled Big Data, or at least the threat of it. Score five for short term pain, long term gain.

Of course, a lot more can and should be done. Education reform especially on the vocational side, public health push (where good changes have been the sanitation/ cleanliness push, along with smokeless kitchens - but more needs to be done), and most importantly a big increase in policing and judicial capacity - all are required. Finally, a (relatively) declining defense budget is not good for anybody as well, as India may lose geo-economic leverage against a future standoff with China.

But a lower fiscal deficit, lower inflation, stronger rupee, a simultaneously lower current account deficit and better infrastructure did not happen out of nowhere. For every exogenous piece of good luck (oil), there are offsetting factors (monsoons). If the short-term growth slowdown in 2017 is partially due to Modi (yes, it is), so was the 2015-16 acceleration partially because of him, and so will be the one in 2018-19 and onwards (as channels restock, industry/consumers benefit from lower interest rates, and business/credit cycle turns).

But many analysts, wonks and investors are likely to broadly agree that to the admittedly limited extent a political leader can influence - within just three years - the long term economic destiny of a country as large and diverse as India, Narendrabhai Damodardas Modi is off to a rather good start.