Image: Vikas Khot
Ruchir Sharma, head of emerging market equities and global macro at Morgan Stanley
Ruchir Sharma generally spends one week every month in a developing country. As head of emerging market equities and global macro at Morgan Stanley Investment Management, few people know the emerging markets better. In 2012, his book Breakout Nations - In Pursuit of the Next Economic Miracle, became a best-seller. Sharma says India’s growth boom from 2003-11 was the result of global factors and the flood of easy money. “The entire boom of the last decade, where growth accelerated from 5-6 percent to 8-9 percent, was totally global in nature. It had nothing to do with India-specific factors. And that boom is now unwinding. Now can we undershoot 5-6 percent for a year or two? Yeah, we can,” says Sharma. The following are excerpts from his free-wheeling interview to Forbes India.
Q. Recently, you wrote an article in Foreign Policy magazine titled “The Rise of the Rest of India”, in which you talk about Indian states that have done well over the past few years. What are the factors that make for a breakout state?
A very simple definition is that the state has been able to consistently grow above the national average over a five- to 10-year period. Often you can associate that growth to some change in policy or leadership which has taken place. It is the same as the concept that I have used in my book Breakout Nations.
Q. Which Indian states are potential breakout states or have already broken out?
The states where the most impressive results have been seen are Gujarat, Bihar, Madhya Pradesh Odisha, Chhattisgarh, Delhi, etc. These are the places where typically you have seen growth. The ones where the most impressive delta, or change, has taken place have basically been Bihar, Odisha, Madhya Pradesh and Chhattisgarh. That area has done well.
Q. What about Gujarat?
Gujarat has done well. But Gujarat was already doing well in the previous decade. It’s impressive [performance] is that it has done better from a higher base. Similarly for Maharashtra, growth rates have been okay, but in the last couple of years they have begun to fall. And Maharashtra is so dependent on the legacy industrial base, or the whole golden triangle of Mumbai, Pune and Nashik, that I don't know how to call it a breakout state necessarily.
Q. Does the Indian constitution need to be re-jigged to give Indian states more economic power?
I'd say that maybe later, but to me that is not the big thing. India has three lists—Central, state and the concurrent list. And the big thing which has happened is that a lot of the items which were in the state list and the concurrent list have been usurped by the Centre over time. And this has got to do with environment, mining, labour and even things like food. The whole culture needs to be a collaborative culture rather than the Centre deciding, or one leader deciding, that these are the five things that India is going to do. We have had centralised leadership in the past. We have had the Indira Gandhi days. Economic growth wasn't great during that period.
Q. So what needs to be done?
The first thing you can start doing is by giving power back to the states. India's constitution envisaged a federal structure. It is just that over time, particularly the 1970s and 1980s, a lot of the state powers were usurped by the Centre in the name of centralisation and in the name of the secessionists taking over. The whole point is that when you have national schemes, you have to give much more flexibility to the states. For example, the Planning Commission is now talking about 10 percent discretion to states [on Central schemes for states]. That can be increased to 30 percent or 50 percent, rather than the criteria and the mandates being set by the Centre.
Q. But can we have breakout states when the country is in a breakdown mode?
Of course not. The national average is ultimately a summation of the states. The only reason for optimism is that at the state level things are a bit better. State level leaders understand how to succeed in various parts of India rather than having a one-size-fits-all national policy. Having said that, there are issues at the state level as well. Many states have their own crony capitalists. At times they are autocratic and anti-democratic. But my entire point is that there is a ray of optimism. Five years ago we were drawing straight lines stating that India's GDP growth has been 8-9 percent and if it continues for 10 years where will we be? If it continues for 20 years where will we be? And so on. Today it is hard to be optimistic on the country because there is so much negativity going around. To me the breakdown is a perception thing more than a reality.
Q. Are there things that can be done to set it right?
One flaw to me is this culture of lack of accountability. If you look at India today the lack of accountability starts from this separation of party and government. This has really been one of the fault lines of India. To run a country with a division between party and government is really very difficult. It fosters a culture of lack of accountability. When you ask the people in the [Congress] party why [some things] are not being done, they say it’s the government's responsibility to do this. And you ask the government and they tell you we don't have the political power to do it. That lack of accountability just flows down. Also, if you look at the world, technocrats have not been very good as heads of states.
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A RISING TIDE? Gujarat is one of the breakout states, but the
staggering point, says Sharma, is that great state-level leaders have so far failed to transform into national leaders
Q. So that brings me to the logical question. Is that leader Narendra Modi?
I am not sure of that. I don't want to get into this thing about who it should be or who it shouldn't be. My entire point is that you have mass-based leaders at the state level. The states are not run by technocrats. The breakout states that I speak about are run by politically smart people, who understand what needs to be done for development, and who get the connection of what is good economics and what is good politics. They see the bridge between the two. To me it’s about mass-based leaders. Whether India can have this at the national level, I am doubtful about [that]. Q. But do successful state-level leaders transform into national leaders?
It has never happened. Never. That's the staggering point. Many leaders have tried to go out. The list is a long one. From Sharad Pawar to Mulayam Singh Yadav and even someone like Mayawati, they have all tried to build a national footprint but they have never been able to succeed. Often having strong regional roots is a liability at the centre, because then they begin to associate you only with one particular state. Even in the Congress, I find it fascinating that there is so much talk as to who could be the next candidate for Prime Minister. I would think that logically it should be a chief minister rather than any of the national leaders.
Q. But no one comes to my mind when I think of the Congress chief ministers...
Exactly. Logically, we should argue that if, by any chance, Sheila Dikshit wins the next election, then she should be the automatic choice for being the next PM candidate assuming that Rahul doesn't want the top job. Someone like her should be the top person for that job. You need someone with a mass base, who understands politics. Q. What has suddenly gone wrong with the rupee? Between January and May it yo-yoed between 53.5 to 55.5 to the dollar. But after that it has fallen dramatically...
All countries with high current account deficits [CADs] have really taken a big hit as far as their currencies are concerned. The whole game began to change, as is well documented by now, after the Federal Reserve decided that it wants to think about tapering off its quantitative easing. After that, US interest rates have risen a lot. The 10-year interest rate has gone up by 100 basis (1 percent) points since May. This has obviously led to people evaluating how much money they want to put up internationally. Q. Economic theory suggests that as the currency depreciates exports go up and imports fall. But in the last two years, our trade deficit has gone up dramatically. How’s that?
The recent fall of the rupee has been very sharp but before this the rupee was adjusting for the high inflation we have had for such a long period of time. Exports are dependent on multiple factors, exchange rates being only one of them. Global demand has been weak. If just changing the nominal exchange rate was the game, then it would be such an easy recipe for every country to follow. But in the real world you need other supporting factors to come through. You need a manufacturing sector which can respond to a cheap currency. Our manufacturing sector, as has been well documented, has been throttled by all sorts of local problems. Q. What are the other impacts of a falling rupee?
One of the factors that has been under-appreciated is that there is a negative effect from the huge foreign exchange loans taken by corporates. So even though there is not much that can be done to stop the rupee's fall you can't at the same time wish that you will devalue your way to prosperity.
There is a negative feedback loop because the corporate sector is heavily indebted in foreign currency. So that is the problem. Q. So there is a corporate debt crisis brewing. You have pointed out in the past that one in four Indian companies does not have enough cash flow to repay debt. How is that playing out?
Those companies are just going to be shunned for a long period of time. People are now just investing in the 15-20 big companies and keeping away from the rest. India has lost a major competitive advantage. India's advantage, which used to be quoted to foreign equity investors, was how we have a huge number of companies to invest in. That has shrunk incredibly now. Some of these companies are not going to be able to survive. That's the harsh reality. Q. Oil prices are at an all-time high in rupee terms. What sort of impact will that have on the fiscal deficit? Can we buy the finance minister’s target of 4.8 percent?
We achieved the [fiscal deficit] target last year, but you have to understand how that was done. The government will have to really freeze spending, and that in turn will compress consumer demand. The issue is whether they have the political appetite to do that. Or the government will have to raise diesel prices. Currently, they are Rs 9-10 behind on under-recoveries. They need to raise diesel prices by such a massive amount to stick to the fiscal deficit target. So can the government meet its fiscal deficit target? Of course it can. But the price in this case will be economic growth.
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A STATE OF CHAOS: Prime Minister Manmohan Singh with Finance Minister P Chidambaram. Sharma says, the government will have to freeze spending to curtail fiscal deficit. But does it have the political appetite to do that?
Q. If they don't increase diesel prices they have a problem. If they do increase diesel prices they have a problem.
Exactly. That's the negative feedback loop I talked about. Moving the exchange rate from X to Y and hoping that exports will pick up is a very simplistic solution. It does not take into account the negative feedback loops that can arise in terms of corporate debt denominated in foreign currencies and also the fact that the oil import bill gets considerably worse.
Q. Our current account deficit did not appear overnight.
This is the irony, that the crisis has been badly managed. These fault lines have existed for a while. The CAD has been going up continuously over the last two to three years, above levels which most economists consider to be sustainable. And we ignored that. In our desire to keep growth artificially high in 2009 and 2010, we engaged in a lot of stimulus spending. We let our fiscal deficit blow out. We violated the FRBM [Fiscal Responsibility and Budget Management Act] and have never ever gone back to that. The Prime Minister has ignored so many fault lines.
Q. Could you elaborate on that?
He dismissed crony capitalism as being something which possibly is the rite of passage that any country going through an early stage of development will have to go through. Every such country will have its own robber barons. So what is the big deal that India does? He dismissed inflation by saying that the rise in food prices is a sign of prosperity. He went on about how savings and investment ratios are so high that growth is unlikely to ever dip below 8-9 percent. And on each one of them any sort of serious economic analysis would suggest that these arguments were flawed.
Q. And this has had a huge impact?
We know that if you have crony capitalism, it can lead to a backlash against wealth creation. Look at issues like the ban on iron ore exports, the mining of coal, etc. Some of this is because we have had crony capitalism and that has led to a backlash against wealth creation.
Q. What about the inflation argument offered by Manmohan Singh?
The whole business about inflation rising because of a rise in prosperity is a real myth. Why has China not seen this massive inflation problem despite 30 years of great growth? Why did Korea and Taiwan not see any sustained inflation pressure? Or even Japan during their very high growth phases? Why? This is a total myth. India's inflation rankings have deteriorated considerably. Our inflation used to be always below the emerging market average for the last 20-30 years. It's only in the last three to four years that we have been way higher than the emerging market average. Not just a bit higher, but way higher.
Q. You recently wrote that “A not so funny thing happened; while the world was watching for an emerging market crisis to erupt in China, the crisis erupted in India instead.” Explain…
For the first half of the year a lot of focus was on China. China has had a massive credit binge over the last five years. In recent times we have seen that in the US, Spain, etc. Typically, countries which have had a massive credit binge are vulnerable. When you increase your debt over a short span of time of three to five years, you accumulate a lot of bad assets. And that leads to trouble for the entire banking system. So people have been very worried about the high debt to GDP ratio in China. Even I have been concerned about it and written about it. There were people sending out alerts on a China crisis. I think very few people were sending out alerts about the India crisis.
Q. Nobody did.
Exactly. That's the irony to me. Everyone was looking for a crisis in China and it ends up erupting in India first.
Q. Indian economic growth has fallen to around 5 percent. Do you see us going back to the good old Hindu rate of growth of 3.5 percent?
No, that's not been my case. Hopefully, things have changed. There is a lot of natural buoyancy. What I do find more impressive compared to 30-40 years ago is the quality of state chief ministers. They have improved a lot in comparison to the 1970s and 1980s. In fact, even the 1990s. The moment we think of the third front we all get a bit scared because we think of a motley crew which ran the government in the mid-1990s. If you look at state chief ministers today, they are generally better. My entire case, which I have even made in the book, was that the entire boom of the last decade, where growth accelerated from 5-6 percent to 8-9 percent, was totally global in nature. That had nothing to do with India-specific factors. And that boom is now unwinding. Now, can we undershoot 5-6 percent for a year or two? Yeah, we can. We overshot for a while, we can undershoot for a while. That is still my base case scenario. I am not willing to give up on India and say that India is going to go down the route of 3 percent growth which existed till 1980. Also it is important to remember that the aspiration levels of people here are too high now to tolerate that kind of an outcome. They will force something to happen to change that outcome.
Q. Any view on the Food Security Bill which was recently passed by the Lok Sabha?
I have no strong views on that. My concern is about the fact that you can't keep writing cheques which the country can't cash. We need to understand that we can only spend that much. And if we have to spend extra then we have to show stuff that we can cut elsewhere. The big damage of the Food Security Bill is not the bill itself but why the Prime Minister did not use this as an excuse to, say, okay, if you want to pass this, you have to raise diesel prices by x amount, so that we offset some of the cost.
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(This story appears in the 20 September, 2013 issue of Forbes India. To visit our Archives, click here.)