I have been worrying lately about the state of the Indian economy and couldn't resist my urge to add my bit to the ongoing debate. With inflation adjusted GDP growth rate as high as 10.4% in 2010, suddenly the brakes seem to be jammed on the country’s growth. Let me try to deconstruct this situation.
First off: Some fundamentals
It is a well established fact that macro-economic phenomena like GDP growth and inflation go hand in hand. For a high growth economy like India with growth projections pegged in the 8-10% range, inflation levels of up to 10% are considered normal. In a typical fast growing economy, growth in industrial output drives GDP growth i.e. more income for the nation (and more money in the hands of its people). This should trigger a growth in domestic spending due to greater liquidity, which means more money chasing fewer commodities thus driving prices up. Governments and central banks typically reign in the inflation through Monetary and Fiscal policies. The central banks, which sets the benchmark interest rate i.e. The rate at which it lends to other banks in the country plays a significant role in regulating the economy through monetary policies. When in expansionary mode, it simply prints more money, lowers the benchmark interest rates thus lowering borrowing cost for banks and in-turn for the consumers. This typically leads to more money available for consumption thus causing inflation. On the other hand, when in contractionary mode, it rises interest rates thus making borrowing dearer for banks and in-turn the consumers. This has a decelerating effect on the economy and in-turn curbs inflation.
The fiscal policy on the other hand is a potent tool in the hands of the government, which determines how it will allocate funds for its annual spend. The source of income for the government is largely tax revenue and sovereign debt. When in expansionary mode, the government raises more money through higher taxation and borrowing. This typically drives interest rates up thus, grows GDP primarily due to increased government spending on subsidies and infrastructure projects among other things and impedes inflation due to rising interest rates. When in contractionary mode, government liberalizes (i.e. lowers) tax rates and borrowing thus bringing down interest rates but slows down GDP due to reduced public spending. Both Monetary and Fiscal policies need to have a balance effect in order for the economy to be in steady state and grow. If one of them goes off the rail it will threaten the equilibrium and sustainable growth of the economy.
Let is now examine some factors that are ailing the Indian Economy:
Political Stymieing: The gerontocratic political class running the county is going through its worst period of impasse with every proposed reform blocked by short-sighted vote-bank politics. Our pseudo egalitarian, left of center politicians seem to be unhappy with every possible reform proposed by the government. We have seen several promising bills such as liberalizing FDI in retail to the recently proposed railway fare hike being shelved due to their apparent threat to the ‘Aam Aadmi’. The ruling congress partly seems to be hapless and at the mercy of its coalition partners and simply rubber stamping their demands. All of these developments have significantly dampened investors spirits and have threatened to take India off the ‘high-growth’ map.
Budget Deficit: The government is unable to reign in growing budget deficit due to wasteful and costly public spending. Some examples being soaring subsidies for fuel and fertilizers. India’s fiscal deficit stands at 5.9% of GDP fueled primarily by subsidies (2.4% of GDP). One of the glaring issues is diesel subsidy; it is not uncommon for industrial users of furnace oil (an unsubsidized commodity) to buy diesel instead of FO due to its lower price. Too, diesel cars are selling in disproportionately larger volumes that petrol cars due to lower diesel prices. This are glaring example of subsidies not reaching the intended beneficiary. Government is unable to take a unified stand on this issue of rationalizing wasteful subsidies.
Faulty Monetary Policies: The RBI became notorious for repeated interest rate hikes. Since March of 2010, RBI hiked its benchmark interest rates 13 times. Each time with the hope of reigning in inflation but with limited success. It is now widely accepted that RBI’s stand on inflation was flawed. The primary driver of inflation being food prices, which were caused by supply side constraints and nothing to do with money circulation. Hiking interest rates with the hope of restricting money supply and in-turn curbing inflation was to no avail. Inflation remains stubbornly high at 8.8% as of Feb 2012. While unable to impact inflation, the interest hikes have succeeded in stalling economic progress. At 6.9% growth for Q3 2011, India registered its slowest GDP growth in years thus ringing the alarm bells for policymakers.
Global Sentiments: Global investor sentiments have sagged due to politico-economic crises in Europe. Global demands have sagged, badly impacting trade and more importantly investor sentiments. A relatively small economy like Greece (and now Portugal) threatened to bring down the EU and questioned the very existence of a single currency Eurozone. While Europe by itself may not be India’s largest trade partner, the crises impacted our economy at more than one level. For one, India payed the price for being a high growth economy. A high growth economy attracts hot-cash (short & mid term portfolio investment), lured by prospect of superior returns. When global economic outlooks sag, the tell tale sign is capital flight from high-growth economies, and India was no exception. Capital flight threatened the Rupee and made it the worst performing currency in Asia in 2011. It fell by more than 17% against the dollar, reaching an all time low of Rs. 54.20 to the US$ on 15th December 2011. India relies on capital inflows to fund its current account deficit, but self inflicted wounds and investors’ worries about troubles elsewhere have been driving capital away and New Delhi, already in turmoil, is running out of firepower to deal with the impact.
So this brings us to the obvious question: will India Inc resurrect? A well diversified, highly industrialized nation with strong domestic consumption fueling growth, Indian can in no way be written off. At one point 8-9% GDP growth was considered entitlement and nobody considered the possibility of a slow down. I still believe that impressive growth figures are achievable at least over the next decade, fueled both by both domestic consumption and global demand. A strong feature of Indian economy is the fact that it is one of the most well diversified economies in the world. Sectors ranging from mining to telecom are registering strong YoY growth; Too, primary, secondary and tertiary sectors are all contributing to the growth of the economy (though lately the tertiary AKA service industry is taking the lead). The country is also benefiting from a largely young population. A UN report claims that between 2010 and 2030, India is likely to add 241 million people in the working age population as compared to 10 million for China and 18 million for Brazil! All these facts lead us to only one obvious question: Will better policymaking at the center resurrect India's growth....OR can India grow despite the policymakers at the center?!
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