The Election Year Challenge

Does the Government have a strategy to sort India’s economy out?

Will the release of the annual Economic Survey and Union Budget, the season for contemplating the state of the economy is upon us. The year 2012-13 has seen some serious hurdles arising that have pulled down India’s growth rate to as low as 5.0 per cent. This is far worse than in 2008-09, when the economy had faltered in the immediate aftermath of the global financial crisis but solutions were at hand to revive the economy. A good dose of fiscal and monetary stimulus was able to achieve its objective, as seen in the acceleration of investment and growth in the next two years. What happened thereafter came as a bit of a surprise to most economy watchers. Nobody, and least of all the Government, had expected another downturn so soon after the first one had been dealt with so successfully.

How was the global economy doing at this time? Although the US recession had officially ended in June 2009, the American economy had not fully recovered, with unemployment still high. Meanwhile, Europe was facing its own challenges as sovereign risks in peripheral countries began to be highlighted. Still, India had always had strong domestic drivers of growth and these external developments should not have had a huge impact. It seems that a number of domestic bottlenecks emerged at this time that pulled the economy’s pace down quite severely. First, the investment pipeline dried up as clearance of projects and acquisition of land were unduly delayed. Second, the stimulus itself had created inflationary pressures that forced the RBI to quickly tighten monetary policy. Third, volatility in financial markets, including a steep currency depreciation, threw business plans askew.

To return the economy to a higher growth path, each of these conditions will need to change. The critical question is whether these changes will happen quickly enough so that signs of a recovery are discernible in the coming year. Here, we need to factor in what impact the impending General Election of 2014 will have on the economy. Mostly, around the world, elections create a sense of uncertainty that becomes a constraining factor in making business decisions. In the US, for example, any decision on the ‘fiscal cliff’ its government was headed for had to wait till elections were over. In India, elections are often associated with governments taking populist decisions and political parties stepping up their spending, which gives a short-term boost to the economy.

Financial markets are often a useful barometer of near-term expectations for the economy. The Indian stock market has been rising intermittently on hopes that the economic cycle has bottomed out and that policy action by the Government and RBI will foster a recovery. But with few convincing signs of a recovery on the ground, these bouts of optimism have not lasted long enough. Investors also continue to worry about the stability of the present government and the nature of the coalition that will come to power after the polls.

Does the government have some strategy for dealing with the troubles faced by the economy? After all, it would not like to leave it in a mess when elections are declared a little over a year from now. I believe it does, and has identified the right problems. In order to kickstart the investment process, it has set up the Cabinet Committee on Investments with a mandate to clear delayed projects over a size of Rs 1,000 crore. However, given the labyrinthine that the Government is, this one-stop shop for clearances may not be able to deliver. What the Government is also looking at is the creation of large manufacturing zones where investors will be provided good-quality physical infrastructure and a conducive business environment.

Second, the Finance Ministry has made its aim to achieve fiscal consolidation quite apparent. It began cutting fuel subsidies a few months ago by raising diesel prices and limiting the availability of subsidised LPG cylinders, without worrying too much about the political fallout. It was able to lower the fiscal deficit from 5.8 per cent of GDP in 2011-12 to 5.2 per cent in 2012-13, and hopes to further reduce it to 4.8 per cent in the coming year. If this is indeed achieved, it may provide a big boost to the economy by enabling the RBI to further lower interest rates. Of course, the Government should not indiscriminately axe spending or raise taxes in its eagerness to reduce the deficit. Reductions in capital spending or aggressive tax demands on the corporate sector could hurt a recovery instead of fostering one.

Finally, the Centre displays a realisation that the country needs to consistently attract foreign capital flows to fund its current account deficit. In 2011-12, capital inflows fell short of its financing need by over $12 billion. As a result, India’s foreign exchange reserves declined by $10 billion and the rupee depreciated by about 15 per cent against the US dollar. In 2012-13, this deficit is likely to be even wider. While foreign capital inflows have been strong so far, they are subject to huge risks, and any change in global sentiment towards emerging markets could reverse their direction. It would therefore be better to rely on foreign direct investment (FDI), which is stable, rather than portfolio investment, which can withdraw without warning. To encourage the former, the Government has increased FDI limits in several sectors including retail and civil aviation. However, these policies will take time to bear results and will not act as a quick fix.

Even after so much policy action, the outlook for 2013 remains highly uncertain. Without hazarding a definitive view, I will lay out what is often called the base case. This, the most likely outcome in my view, is that of a moderate improvement in the economy. With fiscal consolidation taking place and the RBI moving further into an easing cycle, interest rates should moderate and investments should pick up, especially with the Government playing a more facilitative role. The global economy should also have a stabilising effect, with no further negative impulses from the external environment. The current account deficit should start narrowing: both oil and gold imports should moderate, oil as a result of the ongoing domestic price correction and gold as it becomes unaffordable. And foreign capital inflows should be adequate to fund that deficit.

Of course, one cannot be sanguine about this scenario unfolding, as there are many risks to this outlook. One major concern is that if investments pick up even moderately, interest rates could start hardening, as it would increase the gap between savings and investments. There has been a significant shift in the portfolio of assets held by Indian households. Given the decline in inflation-adjusted returns on financial assets, investors have turned to gold and real estate for better returns. The problem with increased demand for gold is that it cannot easily be intermediated by the formal financial system and thus turned into productive investments. Instead, the decline in funds available to the banking system constrains a reduction in interest rates despite softening growth and demand for credit.

The answer to this dilemma lies in altering the behaviour of investors by offering them financial instruments with better returns. In his Budget speech, the Finance Minister mentioned the prospect of offering inflation-indexed bonds, and, in a report, the RBI has suggested ways to monetise idle stocks of gold. Proposed measures include the introduction of gold bonds and gold deposit schemes with tax incentives that will encourage gold holders to deposit their gold holdings with banks. These proposals need to be implemented quickly, as high demand for gold—almost all of it imported—continues to strain the country’s balance of payments. India has been fortunate to receive excess capital inflows over the past few months, but external developments could turn financial flows extremely volatile. With foreign exchange reserves now adequate to cover just six-and-a-half months of imports, the urgency of limiting imports is apparent.

Ultimately, of course, policymakers need to focus on controlling inflation to fix India’s macroeconomic imbalances. A moderation in inflationary pressure will enable the RBI to ease monetary policy, restore purchasing power to consumers and dampen excessive demand for gold. For the past three years, wholesale price inflation has been stubbornly high, but has shown signs of moderating in recent months. Consumer price inflation continues to rise due to this index’s higher weightage of food items. Inflation in food articles has been particularly hard to contain, indicating an urgent need to reform the agricultural sector so that prices do not keep spiralling. Perhaps the Centre needs to rethink its foodgrain procurement policy of minimum support prices that are increased year after year. This acts as a disincentive for farmers to diversify production to items that have no guaranteed prices. Perishables such as fruits and vegetables as well as animal products have been especially subject to a steep price rise.

Food-related infrastructure and the access of farmers to the market, which is tightly regulated through state-level APMC Acts, need to improve. Private sector involvement in creating market linkages can bring about better supply chain management. Improvements in rural infrastructure and livelihoods should marry well with election year economics, given that the vast majority of our people live in rural areas. The 2014 General Election would be a real test of the hypothesis that India’s polity has matured to a stage where economic development, rather than handout-oriented populism, wins votes.

About The Author

Bidisha Ganguly