Exclusive: Storm-Clouds Gathering

By M H Ahssan

What the world recession will do to India’s economy

It is an acknowledged truth that the world’s financial breakdown has proved the need for public ownership of banks, limits on borrowing abroad and strict prudential rules at home. Or so some Indian policymakers now reckon; and they have a case. Because India has been constrained in this manner, its economy has remained relatively undamaged by the global financial meltdown. India’s banks are sound and its foreign debt is manageable.

Meanwhile, in common with others, India’s stockmarket has crashed, losing 60% of its value this year. Foreign portfolio investors, who last year put in $17.4 billion, have turned tail. This has put pressure on the rupee, which has lost some 20% of its value against the dollar since January, when the market peaked. The global financial freeze has accelerated the currency’s fall. Part of the problem may be that, unable to raise capital abroad, Indian companies have been turning to Indian banks for money. They then sell rupees for dollars to finance their foreign operations. To support the currency, the Reserve Bank of India (RBI), the central bank, has been selling up to $2 billion a day from its foreign-exchange reserves, which have dropped by nearly $63 billion from a high of $316 billion at the end of May. All this, on the back of two years of tightening monetary policy, has brought India its own credit crunch.

In response, since mid-September, the RBI has been trying to boost liquidity. Another benefit of a tightly controlled financial sector is that the central bankers have many options. On several occasions they have cut the minimum amounts that lenders must deposit with the RBI. For the first time in four years the RBI has also been cutting its main short-term lending rate, now at 6.5%. The rise in wholesale prices, which hit a 16-year high of 12.9% in August, is still well above the RBI’s comfort zone, though dropping fast. But with investors struggling to find cash, the RBI is now worried about growth.

Even before global confidence dived, India’s economy was slowing. In August industrial output was up by only 1.4% on a year earlier, nowhere near the 6% that had been expected. The RBI has already revised its forecast for GDP growth this year downwards, from 9% to 7.5%, and even that may be optimistic. Most independent forecasters see a further drop next year, possibly to 5.5%. That would be worrying, but India might still be the world’s second-fastest-growing big economy after China.

Things could be worse. The weakening rupee is a blessing for India’s exporters, especially its important computer-services industry, whose main market is American banks. Even so, merchandise exports are struggling; in October they were 12.1% down on a year earlier. But at least India is less reliant on trade than most emerging nations: exports amount to only about 22% of India’s GDP. This is yet another historic weakness that India can feel briefly relieved about. More broadly, however, its economic performance justifies pride.

Like a rocket
Consider the growth figures. Between 1982 and 1992, on the back of some modest liberal changes to its mixed economy, India grew at an average annual rate of 5.2%. In 1991, prompted by a currency crisis, the government brought in swingeing reforms. Led by Manmohan Singh, then the finance minister, it cut taxes and tariffs and largely dismantled a system of industrial controls (the “licence raj”). Between 1992 and 2002 the annual economic growth rate was 6%. It would have been higher but for a late dip, caused partly by the Asian currency crisis.

Since then India’s economy has taken off with a whoosh. In the past five years it has recorded an average annual growth rate of 8.8%. If it could keep this up, India would be transformed, as China has been. Its $1 trillion economy would double in size in eight-and-a-half years. Poverty would be reduced at a speed previously unimaginable. This has generated huge excitement in India which the government has encouraged. The planning commission’s latest five-year plan, which became operational on April 1st, envisages an average annual growth rate of 9%, rising to 10% from 2012.

Everyone agrees that India’s long-term potential growth rate has leapt, but the size of the jump is hotly disputed. Optimists point to India’s soaring investment rate. During the 1990s this was around 25% of GDP, but since 2003 it has averaged 35%. Encouragingly, this has boosted investment in manufacturing, of which India urgently needs more to create jobs. In the past five years Indian manufacturing has grown at an average annual rate of 9%, rising to 12% last year.

Parsimonious habits
The crowning reason for optimism, however, is the savings rate, which has risen in similar measure. Until recently India’s investment splurge has mostly been covered by domestic savings: as a share of GDP, savings have risen from 28% in 2003-04 to 35.5% last year. This is a China-like level, and explicable by the same demographic change that China has undergone. India’s bulging working-age population gives it a high ratio of earners to elderly dependents. A young population should be sufficient to keep India’s savings rate close to the current level for the next two decades.

This, the “shining India” story in a paragraph, has also caused excitement abroad. Until this year India, like all emerging markets, had seen a surge in foreign investment, but most of it was speculative. In the past two years, however, foreign direct investment has been catching up. In the first quarter of this year inward direct investment was worth $10 billion, more than twice the equivalent figure for last year.

Yet there are some darker sides to this hopeful tale. The first is inflation. At its recent rate of growth the economy was prone to overheat. This became apparent early last year: as credit soared and the current-account deficit widened, inflation jumped to nearly 7%. That was why the RBI began tightening. The subsequent spike in commodity prices contributed even more to India’s inflationary surge.

At the same time, nearing the end of its term, the government has been on a spending spree. Public expenditure has risen by over 20% in each of the past two years. This has returned India’s public finances to their traditional mess, after a temporary improvement thanks to buoyant tax revenues. Economists at Goldman Sachs expect a budget deficit of around 8.4% this year.

If only the spree had been more productive: a massive investment in India’s infrastructure would have been overdue. Instead, the government’s largesse was handed out in the usual wasteful ways—on oil and fertiliser subsidies and public-sector pay increases—and on some high-profile welfare schemes.

Madcap subsidies
India’s subsidy policies are crazy, as all its governments have realised. But none has been able to change them much. For example, the government hands cash, in ever bigger quantities, to manufacturers of nitrogen-based fertilisers. They produce lots of low-cost, poor-quality fertiliser with which Indian farmers poison their fields and themselves. The government’s spending on fertiliser subsidies is expected to run to $23 billion this year. The total subsidy bill is estimated at over 3% of GDP.

Making nitrogenous fertilisers uses a lot of natural gas, which increases India’s reliance on oil to meet its energy needs. India imports 75% of the oil it uses. Alas, it also subsidises petroleum products, including petrol, kerosene and diesel, by fixing the price at which they are sold to consumers. India taxes these products as well, so the subsidy is smaller than it appears. But this still makes the budget finances hostage to the oil price, now mercifully falling.

India’s fiscal problems are nothing new: its deficit has often been around 10%. As it happens, the most recent splurge is well timed: the first tranche of a civil-service pay rise was handed out in October, just as worries about inflation gave way to fears about growth. What is new is India’s realistic hope of sustaining economic growth of 8% a year. Inefficient government spending puts this at risk.

Because the government eats up so much of India’s savings, the country relies unduly on foreign capital to sustain its high investment rate (its current-account deficit recently widened to about 3.5% of GDP). High public spending also contributes to inflation, which limits the RBI’s freedom to cut interest rates. If the current high cost of borrowing deters private investment, the government will have little scope to offer a public alternative. The investment rate will then come down, and growth with it.

Sadly, the prospects of either this government or its successor dismantling the subsidy raj are dim. Perhaps the petrol subsidy, for which there is no obvious justification, may be eased, though not this side of the election. But the more ruinous kerosene subsidy is likely to remain as long as most poor Indians have no access to electricity; no matter that, by an official estimate, half the supply of subsidised kerosene is creamed off by corrupt middlemen.

The government’s profligacy makes it all the more essential that it retains the confidence of private investors. The best way would be to surprise them with some long-awaited reform. Even bullish Indian economists, confident in a high-growth future, say as much. According to Arvind Virmani, the prime minister’s chief economic adviser, the medium-term target of a 9% GDP growth rate “was clearly based on an assumption that we will push ahead with reform…Given the global crisis, it’s important that we accelerate reform if we want to meet the target.”

Asked what reforms are most pressing, Mr Virmani tosses over a book in which he describes them. They include, in order of importance: fiscal reform, including of subsidies; privatisation of public enterprises; opening state-controlled banks to more private ownership; reform of India’s throttling labour laws; and liberalising certain industries, including coal and sugar. Mr Virmani’s book was published in April 1999. Hardly any of its prescriptions, he notes, have been followed: “We have to start acting faster.”

Reformists in the government appreciate this. On October 30th the cabinet approved a draft bill on insurance reform. If passed, it will include raising the current 26% ceiling on foreign ownership of Indian firms to 49%. This is one of seven financial-sector reforms (others cover banking and pensions) that have been awaiting approval for four years because the Communists were obstructing them. The insurance bill was supposed to come before parliament this month, but even if it does, there would not be time for it to be approved under the present government.

Reasons for hope
What reforms the next government might introduce will depend on the make-up of its coalition. It will depend, too, on how serious the slowdown is. Sadly, there seems almost no prospect of another raft of liberal measures. Yet there are some slim reasons for hope.

One is duress. A fiscally straitened government can either cut spending, which would be difficult, or boost revenues. In a slowing economy it might therefore consider selling a few of the state’s many loss-making companies. Another, more tentative, reason for hope is political. In middle-class India, especially, the recent run of high growth has become a source of national pride. So it is reasonable to hope, at least, that more politicians will make sustaining rapid economic growth their highest priority.

The third reason is intellectual. India has, so far, been proved right in opening its financial sector to globalisation only cautiously. But in a more carefully regulated world it should become less reluctant.