MacroScan - India's Growth Story Ends

The Indian summer of economic growth and resilience seems at an end. The indicators are too many to ignore. GDP growth is expected to be significantly lower than 7 per cent in financial year ending March 2012, down from 8.4 per cent in year ending March 2011. Manufacturing expanded less than 3 per cent as compared with nearly 9 per cent in the previous year. The annual month-on-month rate of inflation as measured by the national Consumer Price Index had risen to 10.4 in April, from 9.4 per cent in March, 8.8 per cent in February and 7.7 per cent in January. Stagflation in the economy seems a possibility.

Externally too there are signs of deterioration. The trade deficit is estimated to have increased by 56 per cent between 2010-11 and 2011-12 to touch 10.6 per cent of GDP. Foreign exchange reserves are falling: by mid-May foreign reserves had fallen by $2.6 billion relative to end-March, $4.9 billion relative to end-December and $15.7 billion relative to a year earlier. And the RBI's reference rate for the rupee has depreciated by more than 10 per cent over just 3 months. That is a slew of bad news headlines.

To many this suggests that, as Europe sinks, India is set to follow. So supporters of the UPA's economic dream team are deserting the sinking ship. The government attributes it to the global crisis, especially the European one. But the downturn is not just the fallout of global trends. In fact, till recently a resurgent India prided itself on being "decoupled" from a global economy that has been wallowing in crisis for close to five years now. Not that India was completely unaffected by that crisis. Rather 2008-09 was a difficult year in many ways. Much lower growth, an exit of capital and a depreciation of the currency gave cause for concern. But that downturn was reversed rather quickly. A resilient economy and a strong countercyclical stimulus from the government, it was argued, countered the destabilisation and restored growth.

The bravado implicit in the decoupling argument was not without basis. For half a decade prior to 2008, India had registered unusually high growth. Though the infamous and low "Hindu rate of growth" was transcended as far back as the 1980s, India's true growth story began after 2003-04. It was as if a paradigm shift had occurred. All of a sudden, a country attuned to 3 per cent rates of growth at first and 5-6 per cent growth rates subsequently traversed to an 8-9 per cent trajectory, with high savings and investment rates. There were many blemishes: a laggard agriculture in crisis, an industry that was diminishing in size and employment intensity and deprivation that was stubbornly high, to name a few. But who could grudge a remarkably high rate of growth that made India the flavour of the season for international investors and increased its foreign reserves.

But this mixed performance did have implications. It signalled the fact that there was a missing robustness in the boom. That inadequacy came from many sources, but principally from the fact that while the stimulus to growth was largely domestic, those stimuli were tenuous. The principal change in the external environment was a surge in foreign capital flows to India (as also other so-called emerging markets). The liquidity thus infused into the system led to a boom in debt-financed investments in housing and debt-financed purchases of automobiles and durables. But private expansion was clearly driven by measures of "liberalisation" that relaxed constraints on the expansion of large capital. It also engineered profit inflation through many means, including the provision of cheap access to the private sector to public assets and mineral and other resources. The crisis did lead to a slowing down and even reversal of capital flows. But simultaneously signs of excess credit accumulation and allegations of corrupt practices favouring sections of capital have dampened the other stimuli as well. It is the weakening of these stimuli that has brought the growth story to an early end.

It is not just that the recovery from the crisis has not been sustained enough. Despite individual years of good monsoon-led growth in agriculture (as in the last year), overall growth is slowing significantly because industry is slowing and services are losing dynamism. Even as growth slows, inflation, which had emerged as the country's principal challenge, is showing no signs of going away. Inflation had initially moderated a bit as compared to the peak levels it had reached last year and the year before; but it is now again bound upwards. With the government committed to raising the prices of oil in line with the spurt in international prices, this problem will only worsen. Lower growth and higher inflation seem to be the prospect in the medium-term future.

It is at this time that two other developments have ‘pooped' the party. The first is a widening of the deficit in exports relative to imports. Exports are slowing because of the persisting global crisis, though over financial year 2011-12 as a whole, exports rose 21 per cent in dollar terms to $303.7 billion as against the previous year's $251.1 billion. But the trend is one of slowdown. In the month of March 2012, exports were six per cent lower at $28.6 billion, compared with $30.4 billion in March 2011. But the deficit is substantial due to a rise in imports, because oil prices are exploding for geopolitical reasons and Indians are rushing into imported gold as a safe investment. But even for the whole financial year, imports grew at a much faster 32.15 per cent to $488.6 billion. Oil imports were up 47 per cent (at $155.63 billion) relative to the previous year's $105.9 billion. Non-oil imports also grew 26 per cent to $333 billion ($263.8 billion). And in this case the trend is one of further increase. Imports during March grew 24 per cent to $42.5 billion ($34.2 billion), with oil imports rising 32.45 per cent to $15.83 billion and non-oil imports by 20 per cent to $26.7 billion.

Over the year, the trade deficit or the gap between exports and imports during 2011-12 grew to $185 billion in 2011-12, which swallowed a large share of India's revenues from remittances and services exports. The current account deficit seems to be widening in recent months. A consequence has been a weaker rupee that has been sliding gradually from the troublesome highs it touched in the not too distant past.

As the trade and current account deficits in India's external payments widen and the rupee weakens, a second disconcerting external development is under way. Foreign investors who were rushing into India are holding back and even exiting. According to the SEBI, FIIs who were pumping in huge volumes of dollars into the debt and equity market, reduced their net investment to $387 million in March, took out $923 million in April and had brought in only $249 million in May till the 21st. Initially this was because they were selling out in India to garner surpluses that could cover losses or meet commitments at home. But, now, it is because they too are wary of the India prospect and fear a further devaluation of the rupee. The result is a decline in reserves and expectations of a further depreciation. Enter the speculators, who are making sure that the rupee slumps by betting that it will.

Rupee deprecation in other times may have helped by improving the competitiveness of India's exports by making them cheaper. But that is little help in an environment when a sluggish world economy is demanding less goods and services overall. What rupee depreciation does in the current environment is increase the domestic prices of India's imports including that of oil, aggravating inflation. It also squeezes firms that, encouraged by much lower interest rates abroad and the liberalised rules on borrowing, accumulated large foreign debt to finance local expenditures. That was a boon when the rupee was strong. But now, the dollar payments due on those debts are draining far more rupees, affecting corporate bottom lines adversely. That too depresses investment and growth, and threatens to trigger a downward spiral flagged now by a collapsing rupee. A collapsing currency is a sure negative signal for international investors. India has been downgraded and so have Indian banks been. The downward spiral needs to be pre-empted.

However, there appears to be no convincing response from the government thus far. The RBI is wary about stoking inflation by reducing rates to spur growth. Given the deficit on the government's budget and India's relatively high public debt to GDP the government is wary of increasing its spending to counter the crisis, partly because it fears that larger fiscal deficits or higher taxation would upset foreign investors and hasten their exit.

In the event, we have the Finance Minister speaking of the need for austerity and harsh decisions amidst a slowdown in growth. That would only convert falling growth into a recession. Further, the "harsh decisions" involve measures such as cutting subsidies to reduce expenditure and raising oil prices. Combined with the increase in the prices of imports as a result of the rupee's depreciation, these administered price hikes would only fuel inflation, and further aggravate the tendency towards stagflation.

The potential for a cumulative slide has already triggered a bandwagon effect. As noted, rating agencies are downgrading India and international investors, heeding these agencies, seem to be reducing their exposure. Shaken by this response, the government seems set to implement austerity. That could worsen the downturn without correcting either inflation or the balance of payments. But the government is opting for these measures because of the legacy of financial liberalisation in the form of the accumulated presence of foreign finance in the country. All policy is being viewed first in terms of the effect it would have on the confidence of those investors, rather than its efficacy in addressing the problems at hand.

It is here that the similarity with the European predicament is apparent. There too, the accumulation of large volumes of public debt has made sovereign default a possibility if additional credit to meet expenditures was not forthcoming. However, additional credit to "help" countries avoid default was provided only on the condition that they opted for austerity. This imposed huge burdens on the people in the form of increased unemployment, reduced incomes and a collapse of social security outlays.

Cutbacks in government expenditure were expected to reduce deficits and release the wherewithal to finance future debt service commitments. The outcome was contrary to expectations. Rather than reduce deficits and generate surpluses, the output contraction resulting from expenditure cuts reduced revenues, making it impossible for these countries to meet their deficit reduction targets. A cycle of enhanced austerity, lower growth and worsening debt service capacity followed, with no solution in sight. It is clear from this that in bad times countries need to get out of the slowdown-austerity-recession cycle by substantially increasing expenditures to restore growth and employment. This would, over time, also raise the revenues to finance some of their debt commitments.

Though there are important differences between India and Europe, there are two similarities here that need to be recognised. The first is that India's fiscal deficit and debt to GDP ratios have also been declared to be unacceptably high by international finance, which has a large and influential presence in the country. The second is that this large presence of international investors and creditors, not only increases economic instability, but also induces an element of "policy paralysis" because of a reduction in the state's room for manoeuvre. Central to that paralysis is a self-imposed limit on spending resulting from a fear of raising resources through taxation and financing expenditures with borrowing. Even when confronted with slowing growth, the government tends to adopt austerity measures that trap the country in a recession. This has already occurred in Europe. It is a real possibility for India.

The way out, as clarified by economists with divergent inclinations, is to escape from this vicious cycle by expanding spending, and finding ways other than expenditure contraction to address inflation or balance of payments difficulties. But that requires not only ignoring the demands of finance, but also countering its speculative manoeuvres. In contexts like India, controls on the movement of footloose and speculative capital are a must to give the government the required room for manoeuvre. But that does not seem to be the route the government is adopting. So the downturn, as in Europe, may soon turn into a full-fledged crisis.

* This article was originally published in the Frontline, Volume 29-Issue 11: June 02-15, 2012, and is available at
http://www.frontlineonnet.com/fl2911/stories/2012
0615291100400.htm