At the end of May, India celebrated three years of market-friendly "rule" under reform-minded, business-friendly conservative Prime Minister Narendra Modi. Investor sentiment is at its strongest level in more than a decade on the world's fastest-firing major economy. India has plenty of ground to make up on $11.1 trillion China, its population peer, but its $2.1 trillion economy is finally fulfilling some of its long-stalled promise.
So it really is a shock that its forward momentum has slowed dramatically, and unexpectedly. Growth for the three months through March came in at 6.1% compared to the same time last year, a full percentage point below forecasts by economists, as the effects of demonetization kicked in.
It's likely that listed companies and the "organized sector" will have significantly weaker performance than expected when they report results. India watchers had also expected an upgrade to the figures for full-year growth, but that came in at 7.1% for the fiscal year through March.
Will growth get back on track? More than likely. But the continuation of the "reform to transform" approach under Modi is the key for further long-term progress, Commerzbank believes. His "cautious and incremental approach" has yielded fruit, and the message to investors is that India is "open to business and welcomes international investment," its economists say -- something that has certainly not been true before in a highly protectionist nation.
The world's biggest democracy is also arguably the most bureaucratic nation in the world. Modi is trying, bit by bit, to cut away some of that red tape.
India as of July 1 will implement a new national sales tax, the country's first such nationwide levy. The Goods & Service Tax is the equivalent of the Value Added Tax seen in around 150 nations worldwide. It will remove an "overwhelmingly complicated" existing state-tax structure, Société Générale says, slashing transit costs and making it much easier to do business across India.
It's the biggest tax reform since the crisis-afflicted 1990s, so quite a victory for Modi. But its greatest significance may be that it lights the path to further more meaningful reform. India also brought into effect a new bankruptcy law in December that makes it easier for banks to take control of insolvent companies.
That has resulted in an immediate legal victory in bad-debt proceedings against a steel company, Innoventive Industries. And that in turn has already spurred great interest from foreign investors in Indian nonperforming debt, as The New York Times explains in a fascinating piece, with one asset manager anticipating an "onslaught of deals" in the ensuing shakeout.
Not that the new sales tax is going to be easy. In classic Indian style, those government pencil pushers have been given plenty to do.
There will still effectively be six tiers, from 0% for essential goods through 5%, 12%, a standard rate of 18% and then 28% for luxury items -- which have another penalty on top of them that brings the rate to over 40%!
Most VAT nations opt for a single rate, and many emerging nations require only large companies to charge it. But in India, all companies that generate turnover of more than 2 million rupees ($31,000) must register for the tax. It's possible that a move meant to lead to a tax consolidation will result in the proliferation of small companies as business owners try to make sure they remain under the cap, in the "informal sector."
I wrote in March that no one could quite figure out how India's unprecedented experiment to abolish most of its money had not affected the economy. It was "anyone's guess" how manufacturing could be performing so strongly, one economist said, with others questioning the validity of official figures. Well, it turns out there was just a lag.
It's hard to have much of an economy when no one can pay for anything. That's what happened last November, when India rendered 86% of the cash in circulation worthless. It declared that the 500 rupee ($7.50) and 1,000 rupee ($15) notes were useless as tender unless they were put in the bank.
That ultimately brought the money into the official system, in a nation where the "informal economy" makes up 45% of India's economy, and at least 80% of all transactions happen in cash. With a strict rationing of the amount of cash you could withdraw every day, e-commerce and phone banking immediately saw a boost. But farmers, dealing almost exclusively in paper money, were also left with entire crops that spoiled. Day workers sat idle instead of being hired on an impromptu basis for construction projects.
India is currently one of the biggest contributors to global growth, the International Monetary Fund notes in its latest forecast, anticipating growth of 7.2% for the country this year. That helps drive overall 5% growth in emerging and developing economies in general, generating all of the 3.8% global growth.
It's likely the March quarter disappointment was merely a blip. Once the sales tax goes into effect, there will likely be a flood of pent-up consumer demand, since consumers are putting off high-value purchases that will get cheaper when the tax comes in. Retailers and wholesalers are keeping inventories lean until then.
Demonetization has also driven lending rates lower, now banks have more deposits on hand. That and pay raises for government workers also feeding into a strong rest of the year. Nomura's economists say that their "heatmap" shows that growth is back on track, in particular rural consumption, with the cash shortage only acute in the first quarter. They expect a V-shaped spike will lead to 7.5% growth in the second half of this year and 7.7% in 2018.
Bad debt is the bugbear. Banking and construction both held back growth in the first quarter. Investment is particularly weak in areas such as construction, engineering and infrastructure, as well as iron & steel, the sectors where the most companies have already had to restructure debt to remain afloat.
Nonperforming loans are "the biggest elephant in the room," according to the IMF, holding back the government from implementing its policies successfully. Many Indian companies have ended up with high leverage as a result of overambitious borrowing and less vigilant lending, especially from public-sector banks. Those state-backed banks are subject to political interference and pushed to over-lend by populist politicians looking to endear themselves to borrowers.
The government has tried to reduce the size of the mountain of bad debt, but "often hope seemed to be the strategy, and economic growth the eventual rescuer," the IMF notes. Faced with another financial crisis, 20 out of the 26 state banks would likely struggle under their debt load, their capital ratio falling below the mandatory 9% threshold.
Borrowing costs are high, and banks don't make money because they can't collect on debt, ex-Goldman Sachs partner J. Christopher Flower told The New York Times. Credit ends up in the wrong places and stays there, bad debts clogging the system.
The bankruptcy law is one step "in helping India modernize and function properly," Flower said.
Investors are hopeful there will be many more in a long march taking that $2 trillion economy at least some way toward that $11 trillion churning around China.