Devangshu Datta: When muddling along is strategy

India is facing deflationary conditions and that changes the paradigms for both lenders and borrowers. Neither India Inc nor the government has much idea how to deal with them

Indian investors have experienced a washout during the last nine months. Market indices have fallen about 15 per cent from the all-time highs hit after the Budget. Corporate revenue and earnings growth have been negligible. Exports have fallen even though the rupee has lost ground.

Sentiment has been hit as the impasse on the legislative front has continued, with session after parliamentary session ending without movement on the goods and services tax (GST) bill, among other things. Most investors are also coming to terms with the fact that the government is apparently not serious about meeting stated aims like disinvestment targets (which will be missed by miles), or ensuring a pullback on harassment caused by retrospective taxation (the Cairns case, for example). There are also signs of internal dissent with accusations levelled at the finance minister by suspended Bharatiya Janata Party MP Kirti Azad.

Of course, it's not all doom and gloom. Indian Railways is being turned around (even if the proposed Mumbai-Ahmedabad bullet train doesn't make much sense). Coal supplies from Coal India Limited have improved perceptibly, which has helped in power generation (though state discoms are in such a mess that they can't buy power). The "ease of doing business" indices also suggest some red-tape reduction.

So it is business as usual, with the government muddling along as Indian governments tend to muddle along. The problem with an unimaginative incremental governance strategy (if muddling along may be called "strategy") is that this government must deal with at least one unprecedented problem that requires original thought.

India is now facing deflationary conditions and that changes the paradigm for lenders and borrowers.

Deflation implies low or negative nominal growth. This makes it hard for debtors to generate the income required to service loans. If the nominal growth rate drops below the rate at which interest on outstanding loans is payable, defaults start to rise, and rising default can cause a vicious cycle.

This is an old problem in textbook terms. But India has not had to deal with this, within living memory. Neither the corporate establishment nor the government has much idea of how to "muddle along" in this situation.

The state, meaning central and state governments taken together, is the biggest borrower. As of now, the interest rate on sovereign debt is quite a bit higher than nominal gross domestic product growth rate. This means tax collections are unlikely to grow fast enough to service debt comfortably. Raising tax rates, as this government has already done, runs into other problems. Collection buoyancy can be affected as the fabled Laffer Curve turns inimical.

The approved method of dealing with this is to generate primary Budget surpluses. Given relatively low growth in tax collections, this means cutting expenditure for the Centre. Again, no Indian government has ever managed to do this. The Pay Commission handout is also due and that makes expenditure cuts look unlikely. This situation also implies by the way that the GST (which will probably not happen anyway) could trigger chaos if it leads to an initial drop in government revenues.

This situation hurts corporate borrowers too. Nominal revenues for India Inc have stagnated in the past 18 months. Operating profits have not grown quickly enough to allow easy debt service. The situation has deteriorated enough for the Reserve Bank of India to repeatedly express concern. The latest Financial Stability Report (FSR) flags problems in terms of deteriorating debt-service ratios.

If debtors are hurting, creditors start to have problems and the Indian banking sector may now be looking into a deep, dark abyss. The net worth of many of India's banks could be wiped out if stressed assets go sour at the rates the FSR considered in its latest stress tests.

Since the central government owns the majority of India's banks, it is in the odd (but common) position of owing money to itself in many instances. Various state governments and their institutions also owe money to banks. So the government must figure out ways of servicing the loans it can, and recapitalising banks that it controls, in the cases where bad debts must be written off.

The corporate sector has to cross its collective fingers and hope demand picks up. There's plenty of slack with 30 per cent of manufacturing capacity is lying idle. Investments won't pick up until a large part of that slack is absorbed by growing demand. Perhaps the Pay Commission hikes will spark some revival in consumption?

Overseas demand is not likely to be very high - exports show declining trends and global GDP projections for 2016 are muted. Higher H-1 visas will hurt the information technology industry's margins. Foreign direct investment (FDI) commitments will translate into actual movement at a stately pace. Foreign institutional investors have been net sellers of Indian equity through this fiscal and they have been sellers of rupee debt in the past two months.

Technically, the Nifty has held at support at 7,550. It may range-trade for a while between 7,700-8,100. Investors will probably wait for the Budget before they take their calls on 2016-17. Given the circumstances, 2016 is more likely to be a highly interesting year, rather than a deliriously happy one. Still, hope springs eternal and I sincerely hope I'm wrong. Acche din and good governance to all!