On a night in early August, as a monsoon roared outside, a group of around 100 small business owners gathered at the banquet hall of a hotel in a Mumbai suburb. Some have been in business for decades, but still employ only a few dozen full-time staff -- the consequence, they said, of strict labor laws and union protections that have hampered their ability to grow.
"Having direct employees means a lot of regulatory requirements," said the owner of a heavy machinery manufacturer, which employs 12 people. "You lose the flexibility to control your costs because of tough restrictions on layoffs."
When, later that evening, representatives of the banks arrived to promote their lending products, they were given a rough ride.
"You ask for collateral and all of [the company's] details, but you still reject loans. How do you explain that?" one entrepreneur asked. "Even if you approve a loan, your interest rate is something like 15% and too high. We cannot take such a risk."
These entrepreneurs' frustrations with regulation and the high cost of capital in India reflect the wider maladies of the country's economy. After years of rapid expansion, India's economic growth has slowed, consumer confidence is waning and foreign direct investment has plateaued. To compound the problem, an international trade and currency war is looming, the global economy could be heading for another downturn, and India looks set to be dragged into a protracted conflict of its own making in Jammu and Kashmir, the once-autonomous region that it brought under direct rule in August.
The building economic gloom in India threatens to take the gloss off Narendra Modi's landslide electoral victory in May, which delivered him a thumping majority in parliament and an almost free hand on policymaking. Despite the short-term constraints, however, his government hopes that the size of his mandate will allow him to finally push through difficult, but essential economic reforms that will move the country away from its dependence on waning domestic consumption and toward a more balanced, export-led model -- and toward an ambitious target of becoming a $5 trillion economy by 2025.
"What we will do in the next five years is very different [from the first term]," Sanjeev Sanyal, principal economic adviser to the prime minister, said in an interview with the Nikkei Asian Review. "It is very clearly about growth."
Getting down to business
The Modi government began its second term with a very public show of rolling up its sleeves. Ministers were told they had to be at work by 9:30 a.m., and had to make themselves available for meetings. Lawmakers churned through a packed slate of legislation, passing an unprecedented 28 bills in the "monsoon session" of parliament, a period from June 17 through Aug. 7.
The new laws ranged from new pension allowances for small farmers, to an increase in the number of high court judges, to a new mandatory national minimum wage, and came at such a pace that one opposition lawmaker remarked: "Are we delivering pizza or passing legislation?"
The productivity drive may have been motivated by a need to address the fading confidence in the Modi government's economic stewardship.
Modi's Bharatiya Janata Party came to power in 2014 on a platform that combined Hindu nationalism with promises to revitalize the economy by restarting long-stalled infrastructure projects and by promoting pro-business initiatives, such as the "Make in India" campaign aimed at boosting the manufacturing sector.
Economic growth accelerated in the first few years of Modi's first term, even breaching 8% in 2016 and 2017, and the government was able to push through major -- but controversial -- reforms, including the demonetization of small-denomination bills and the introduction of a harmonized goods and services tax.
By 2018, however, things had started to go sour. In a Gallup poll in April, just ahead of the elections, less than half of those surveyed said that they felt that the economy was improving; among urban citizens, that figure was down to 43%, a dramatic fall from 68% just two years before. The most recent economic survey from the Reserve Bank of India, in early August, showed that Indian consumers are trimming their discretionary spending and preparing for a weaker jobs market. That has translated into poorer business sentiment, the RBI found.
The country is also in the grips of a credit crunch, precipitated by a crisis in the nonbank lending sector. Nonbank lenders make up about a fifth of the total loan market, often servicing small companies and individuals who would struggle to secure a bank loan. Last year, Infrastructure Leasing and Financial Services, one of the country's largest nonbank lenders, defaulted on a series of debt payments, forcing the government to step in.
Since then, fears over the stability of the so-called shadow banking system have grown and nonbank lenders have cut back their activity, in turn hitting the automotive and property sectors which rely on consumer lending.
Tata Motors, India's largest automaker by revenue, posted a larger-than-expected loss in the quarter to June 2019; Maruti Suzuki India saw an 18% slump in sales over the same period. On an earnings call in August, Pawan Goenka, managing director of Mahindra & Mahindra, said that "July was the worst I have seen in the past 18 to 20 years, as a single month. Roughly 10% to 15% of those who would have got loans are not getting loans."
Growth in the first quarter of 2019 was just 5.8%, down from 6.6% in the last quarter of 2018. The RBI cut rates for the fourth time in a year last week, taking its key lending rate to the lowest it has been for almost a decade.
The current slowdown serves to highlight India's need to move away from its reliance on domestic spending as the main driver of its economy. Household consumption makes up almost 60% of India's GDP, and the government has, in the past, maintained that the domestic middle class gave the country a unique growth engine, distinct from the export-led growth that powered the development of China.
That doctrine seems to be changing, as the Modi government moves to embrace a growth model that more closely follows those of Japan, South Korea and China -- one predicated on investment and on trade.
"It is very clear that there is only one model by which you can sustain very high levels of growth for a period of time, which is the investment-led growth model," Sanyal said.
That, he said, means creating a virtuous circle: Improving the country's business environment and reforming labor laws should drive more private sector investments. In theory, that should lead to more employment and higher incomes, which would boost the country's low savings rate.
Fixing the business environment would require the Modi government to reform the tangled mass of regulation that has built up over decades. According to the legal and regulatory database company Avantis, there are more than 1,000 laws that cover business activities, and companies can face up to 2,962 different filing requirements.
Labor laws are also immensely complex, and often change depending on how many employees a company has. For example, companies with seven or more employees are governed by the Trade Unions Act, whereas companies with 10 or more are governed by the Factories Act, making the regulatory requirements quite different for a company of nine people versus one of 10, or one of seven versus one of six. These changes go up in increments, but change quite profoundly at 100 employees, above which manufacturing companies become governed by the Industrial Disputes Act. Under that law, companies cannot dismiss any employees without the prior approval of the government, creating a major disincentive to grow beyond 99 staff.
"In the name of helping small companies, we have created a network of policies that discourage them to grow," Sanyal said.
The government has already begun to rationalize some of its overlapping labor and business laws, and has identified others that need attention -- a move that is likely to be welcomed by businesses.
"To pursue the $5 trillion goal, India must do a lot more to become a less hostile habitat for entrepreneurs, in terms of excessive regulation and a control-obsessed civil service," said Manish Sabharwal, the chairman of TeamLease Services, the country's largest staffing company.
Red tape, however, is only part of the problem. The Indian economy has two major structural constraints that cannot be addressed so simply -- poor infrastructure and endemic inequality. The two are closely linked, according to Amit Joshi, a professor at IMD Business School, and together represent a severe drag on the country's domestic market and its competitiveness internationally.
Joshi gives the example of the country's emerging e-commerce sector. Superficially, the sheer scale of India's population should be attractive -- 1.4 billion people, with a middle class that numbers in the hundreds of millions.
"But, to be very honest, there's only about 25 million households for whom all of these startups, e-commerce sites, and Indian and international firms compete for," Joshi said. "That's because most of the other households either cannot afford it, or do not have the infrastructure -- in this case, that can be digital infrastructure, technical infrastructure or financial infrastructure -- to make these purchases online and to be a part of the digital economy."
The small size of the actual addressable market for companies in potentially high-growth sectors is compounded by weaknesses in the country's physical infrastructure. Successive governments have pumped money into fixing the problem -- Modi pledged the equivalent of around $1.4 trillion in investment during his reelection campaign -- and things have improved, but not as fast as they have elsewhere.
"The last decade or so has seen significant improvement. Nonetheless, roads, ports, airports, train networks are still lagging the rest of the world. ... In an absolute sense, the infrastructure of India has improved, but people look at China and say, 'Look what those guys did in 20 years -- why can you not do it?'" Joshi said. "The internal markets may be a little more forgiving, but for exports, it's much more cutthroat."
For many of India's forward steps -- including a jump of 23 places in the World Bank Doing Business rankings, which rate countries on a range of metrics related to the ease of operating an enterprise -- the competition has kept pace or moved ahead, and the country is still playing catch-up. That has hindered political attempts to kick-start growth in manufacturing and to push up exports.
Modi's flagship policy, "Make in India," was launched in 2014 with great fanfare. "Come, make in India. ... Sell in any country of the world, but manufacture here," Modi urged in an Independence Day speech at the Red Fort, ahead of unveiling a raft of policy measures -- from easing restrictions on foreign investment, to state-of-the-art "smart cities" and rigorous intellectual property laws -- that he said would lift the country to become a center of global design and manufacturing. Make in India aimed to create 100 million new jobs and to grow the manufacturing sector to account for 25% of GDP by 2022.
The years that followed saw a boost in foreign direct investment into India -- FDI flows rose from $28 billion in 2013 to more than $44 billion in 2015 -- but they have since plateaued. Manufacturing's share of India's GDP actually fell in 2016 and 2017, chilled by demonetization and the introduction of the general sales tax, and now sits at just under 15%.
Deeparghya Mukherjee, assistant professor of economics at the Indian Institute of Management, Nagpur and visiting research fellow at the Institute of South Asian Studies, National University of Singapore, told Nikkei that competitiveness issues -- in particular, shortages of highly-skilled labor and challenges with contract enforcement -- were partly to blame for the initiative failing to meet its potential. India is ranked No. 163 in the world for "ease of enforcing contracts" in the Doing Business rankings.
Mukherjee, who was broadly positive about the initiative and credited it with attracting FDI, also said that its impact had been limited by trade policy. Modern supply chains snake across borders, with goods often being processed in multiple countries on their way to market. "India's trade policies, as of now, are far from fine-tuned to address gainful participation in value chains," he said.
Dealing with that would mean a significant philosophical shift in Indian policymaking. Arvind Panagariya, professor of economics at Columbia University, told Nikkei that India needs to shift itself away from a habitual preference for protectionism and to become a proponent of free trade. He prescribes doing away with import substitution incentives, reducing industrial import tariffs, pursuing a free trade agreement with the European Union and creating special economic zones similar to those in Shenzhen, China. "I don't think that level of policy shift has happened yet," he cautioned.
Removing protections for Indian businesses would be very controversial, and would likely meet opposition from small business owners, who make up a significant pillar of the BJP's electoral base. Nationalist groups, who are also major backers of Modi, have also tended to oppose opening up the economy to foreign investors.
When, in July, the government announced that it was considering its first foreign currency bond -- a benchmark issue that it hoped would open up international debt markets for Indian corporates -- the right-wing Hindu organization Rashtriya Swayamsevak Sangh, a founding member of Modi's BJP coalition, campaigned against it, arguing that it would leave the country beholden to foreign creditors.
The RSS' public opposition to a relatively uncontroversial policy demonstrates that Modi's commanding majority in parliament does not mean that he will have an easy ride, and he may have to compromise on some of his objectives in order to appease the constituencies that propelled him to power.
"Modi is a guy who's not scared of extreme steps, whether it be from the political perspective or the economic perspective, as we saw in the first term, as well as what you're seeing right now with Article 370," said IMD's Joshi, referring to the revocation last week of the constitutional article granting Jammu and Kashmir autonomy. "But I think he will have to walk a fine line between messing with his core constituents and at the same time opening up the economy for medium-term gain.
"The question remains whether he can do it. If he does it, he'll have to do it in the next couple of years. As we get closer and closer to the next election, he's not going to mess around."