India’s growth trap

It is more than about economics

176462270_2ef6f2a837_oAn unimportant issue; an uneventful vote; breathless coverage and a relief rally in financial markets. This has been the story of the symbolic (nay, shambolic) debate in the Parliament on allowing Foreign Direct Investment (FDI) into the retail sector. On the same day, the Government survived the vote in the Lok Sabha and looks set to repeat its performance in the Rajya Sabha, there was the news that the Cabinet could not agree on the constitution of a National Investment Board. Ministries are engaged in turf battles and many investment proposals are languishing in Delhi, for want of approvals. Indian stock markets shrugged off the news. India’s stocks are merely 8 percent below their peak in 2008 whereas India’s economic growth is about 80 percent below the peak growth rate. This has been the story of India in recent years. Its priorities are wrong, there is hyperventilation in the media on these misplaced priorities and investors could not care less. Markets are not holding a mirror on the reality for the government to take notice.

India is stuck in a low-growth environment (low relative to India’s potential). As is the case with China, it is possible for India to reverse this course. The question is whether India’s political and business elites care enough about the country’s future to do the right things. Developments over the last several years provide only troubling answers to that question. That is what generates a lot of uncertainty over India’s growth outcome in the next one to two years, if not longer.

In fact, all Indians – educated or uneducated – must reflect on their own priorities and values that have brought corruption to a widely accepted and even legitimate part of any interaction between individuals and the government in India. It is easy to blame the rulers for setting an example. There is an equally compelling case to be made that rulers simply derive their inspiration from the masses.

Reasons why the public debate on India’s economic woes is not leading to any desirable policy action are two-fold. One is that the debate is focused on the wrong priorities – priorities that excite the pink press. In fact, the easy rule of thumb is that India needs the opposite of what the pink press is focused on. The second reason is that India needs a structural reform of its society before it can successfully reform its economy. Of course, reforming the society is not done through Twitter in 140 characters. Therein lies the challenge.

In this note, the focus is almost exclusively on economic issues even while there is realisation and acceptance that much more needs to happen before the economy can be mended. In fact, the economy may be able to mend itself if social restructuring takes place.

Economic growth has stalled

The Indian government is disappointed that the economic growth rate has fallen into the 5 percent to 6 percent (on the globally accepted metric of GDP by expenditure, India’s growth rate was 2.8 percent in the quarter ended September 2012) range but it is going about restoring an upward trajectory in the wrong way. For instance, it is forcing banks to lend cheaply to households for the purchase of consumer durables. If India were to return to a high growth path, its government must understand why growth slowed down in the first place. The government has repeatedly placed the blame at the doors of the Reserve Bank of India (RBI) for the slowdown. The RBI may have raised nominal interest rates during 2010 and 2011 but real lending rates are increasingly negative. Second, the RBI had to neutralise its “tight-money” policy with open-market operations through which it finances the government debt. It is hardly the case that the central bank has kept money tight.

Of course, some argue that the rise in prices in India – wholesale or consumer – has more to do with supply bottlenecks than with the usual suspects like fiscal deficit monetisation and credit and money supply trends. The truth is the opposite. Second, the financial repression of the Government of India has taken banking resources away from the private sector to finance the fiscal deficit. The high fiscal deficit has forced the RBI to impose a 23 percent statutory liquidity ratio on all scheduled commercial banks. This ratio forces banks to hold government securities. Thus, the banking sector funds the government’s borrowing programme. With another 40 percent of loans earmarked for priority sectors, banks have very little room to engage in commercial lending. Further, with the RBI imposing low cut-off yields on government securities, the benchmark is underpriced and hence bank loans are underpriced.

Policies thwart private capital formation

India does not provide quarterly data on private fixed capital formation. Hence, we use the proxies – the monthly production indices of capital and intermediate goods – to assess what is going on in the investment environment. The contraction in the production of intermediate goods might have ended but it is too weak still to breathe new life into the industrial sector. Production of capital goods is still contracting (Figure 1). These conditions look unlikely to reverse soon and hence, a turn for the better in private capital formation does not look imminent.

Figure 1: Annual growth rate in the production of capital goods, 2006-12

In addition to India’s fiscal deficit and its garnering of banking resources, the non-financial corporate sector has also been stymied by regressive tax policy changes. In the budget for 2012-13 introduced in March 2012, the government introduced General Anti-Avoidance Rules – rules meant to discourage tax avoidance – prompted by an acquisition deal undertaken by Vodafone through an elaborate offshore tax avoidance structure. Other countries have enacted similar legislation but with a high current account deficit, India did not have the room for such policy ‘innovations’. Further, with the Supreme Court striking down the government’s tax bill on Vodafone, the authorities set about amending their tax laws retroactively. That was a huge blow to predictability and transparency in tax policy. The government has put both of these on hold for now. The uncertainty lingers and the damage has been done.

While the focus is usually on the non-financial corporate sector, in terms of output and employment it is much less important than the unorganised sector that is dominated by thousands of small and medium-sized enterprises. They have not had it easy either. The World Bank’s “Ease of Doing Business” annual survey shows how difficult it is to start and operate a business in India (Figure 2). On most parameters, India has become a more difficult place for businesses. India’s global rank of 132 is out of 185 countries.

Figure 2: World Bank ‘Doing Business’ rankings, 2012-13
(Source: World Bank)

Since the relentless rise in the government deficit is the wellspring of all the macro-economic ills that India is facing, confidence in India’s growth and inflation prospects rest on the actions being taken on the deficit front. India’s financial year runs from April to March. For the year ending March 2012, the fiscal deficit was 5.9 percent of GDP and the revenue deficit was 4.5 percent of GDP. The rise in the revenue deficit is more worrisome than the rise in the overall fiscal deficit). The budget for 2012-13 set a target of 5.1 percent and 3.5 percent for each of these, respectively. These targets are bound to be missed. The question is by how much? The government claims that it is targeting a gross fiscal deficit ratio of 5.3 percent for the year ending March 2013. Most analysts expect that the best outcome would be 5.6 percent More likely, the deficit will be closer to last year’s 5.9 percent, if not higher.

Aversion to fiscal restraint

In September, the government commissioned a study headed by Vijay Kelkar to outline a medium-term fiscal roadmap. The committee suggested sale of government assets, immediate increases in the prices of subsidised fuels and a phased out implementation of the legislation on Food Security. (One government asset sale has happened but the buyers turned out to be other government entities!) It also announced a token increase in the open market price of diesel but has not yet liberalised fuel prices. The one genuine reform the government undertook was to introduce a cap on the number of subsidised cooking gas cylinders per household to six. Unfortunately, there are signs that this ‘cap’ might be doubled by the end of this year.  On the other hand, the government has refused to defer the implementation of “Right to Food” legislation. The Congress party sees it as a key election weapon. Under the legislation, the government will provide subsidised food for millions including for those above the poverty line.

Fluid and hazy political scenario

Under the present dispensation, the commitment of the Congress party to structural economic reforms is deeply suspect. Bipartisanship with the Bharatiya Janata Party (BJP) on matters of key national interest is impossible as both parties have a habit of opposing what they proposed when they were in office. Technically, the coalition led by the Congress Party has been in a minority since the anti-reform West Bengal based Trinamool Congress Party withdrew support. However, it has survived since no one is prepared to make a move to unseat it.

A strong showing by Narendra Modi, the BJP Chief Minister of Gujarat, has fuelled speculation as to whether he could lead the party to victory in national elections. The situation is too fluid, not least because the BJP is not united in projecting him as its national leader.

Were the Congress party to suffer major setbacks in other states, the government either would resign or be forced to resign as key parties (e.g., Samajwadi Party led by the former defence minister Mulayam Singh Yadav from Uttar Pradesh) withdraw their support. National elections in the summer of 2013 are possible. It is hard to envisage that the outcome of those elections would usher in political stability in the country since the two major national political parties – the Congress and the BJP – have become considerably weaker in recent years. They do not boast leaders of national stature who can rise above narrow differences. A fractious outcome would pave the way for an even more dysfunctional coalition government than the present one. Non-Congress and non-BJP smaller regional parties could even form the government with outside support from one of the two major national parties.

Such a coalition would be fragile and focused on staying in office for reasons of personal aggrandisement. Economic decisions will be deferred or be populist in nature. The prospect of further deterioration in fiscal indicators is real. If that proves to be the case India’s credit rating will likely be lowered and the rupee will come under renewed downward pressure. In other words, the worst for the Indian economy lies ahead.

Close parallel to Indian cricket

To an extent, the fortunes of the Indian economy mirror that of Indian cricket. Both were on an improving trajectory from 2004. However, the improvement was more superficial than real. Instead of capitalising on the improving image and strengthening the foundations, the administrators of the game (and, to some extent, the players too) were more interested in monetising the on-field success rather than sustaining it. The victory in the World Cup in 2010 only delayed the acceptance of the inevitable and masked the underlying deterioration in Indian cricket, caused by the advent of the cash-rich and values-scarce Indian Premier League. Similarly, the Indian economy’s quick recovery from the global crisis of 2008 only delayed the recognition of the underlying strains. Indian cricket team went on to become the world’s top-ranked Test playing team only to follow it up with a 0-4 and 0-4 back-to-back eight test defeats against England and Australia. Similarly, the growth rate of the Indian economy has come crashing down from around 12.8 percent in the first quarter of 2010 to 2.8 percent in the third quarter of 2012.

Indian cricket team was clueless against the visiting team from England. Likewise, Indian policymakers are clueless to address the challenge of reviving economic growth. Both face a long road to recovery, provided there is recognition that core values and ethics that underpin a nation and its cricket team have been grievously eroded in the last decade.

Photo: Meena Kadri