February 4, 2011

The UPA’s triple whammy

Rising fiscal deficit, rising current account deficit and high inflation do not bode well for the Indian economy


Photo: Olivier/OliBac/Flickr

The UPA government has an excuse now—India is suffering from the magazine curse, ever since the Economist put India on the cover three months ago.

The cover story talked of how India’s growth would soon outpace that of China’s. That prediction has been endangered by the UPA government—at least in the near future—simply because it decided to actively contribute to realising that goal through government spending.

Nonetheless, it is hard to find cautious fund and investment managers in India. Despite acknowledgement of serious problems, the overwhelming consensus is that the current demographic dividend will ensure double-digit economic growth, and this will in turn wash away all other sins such as fiscal deficit, lack of economic reforms, economic inefficiency, high and rising cost of living and suchlike. But this view is beginning to sound less and less convincing as high inflation returns. Actually, inflation never went away. The government is pointing to global factors for rising food prices. It may be true up to a point. However, as Omkar Goswami points out in Businessworld, the absence of a productivity revolution in India over the years has a lot to do with it:

Agricultural productivity is pathetic, the supply chain is mired in the late 19th century, and wastage is beyond belief. Nothing has been done in the past decade to raise farm productivity, improve transport and storage, reduce the layers of needless intermediaries and effectively improve food supply. Our food manufacturing sector is equally poor. Please visit rice husking plants, oil mills and sugar factories and you will know what I mean. And the politics of farmer protection translates to idiosyncratic—often knee jerk—policies regarding food imports.

The result of the lack of economic reforms, lack of productivity improvement, and an active pursuit of growth through government spending has been persistently high inflation. In fact, Amol Agrawal, an economist who blogs at Mostly Economics and writes for Pragati, provides a contrast to the four positive pillars of economic stability and growth erected by Luiz Inácio Lula da Silva, Brazil’s former president, with that of the UPA government led by the acclaimed Manmohan Singh. Mr Agrawal notes that the four pillars of the UPA government have been fiscal deficit, talking, inflation and social waste.

If a government actively pursues high economic growth, it ensures two things: it usually pursues it at the expense of future growth and it fails to work on the factors that would, on their own, underpin growth. Economic growth in itself not a desirable policy goal. Government policy should focus on what it can achieve. It can and should lay the building blocks that would bring about high and sustainable economic growth.

A reluctant central bank entrenches inflation expectations
The Reserve Bank of India (RBI) has been caught by surprise by the persistence of high inflation rates in India. While it has arguably done the most in Asia to normalise interest rates, its efforts fall well short of what was needed, given the absence of a supply response. Critics usually question the rationale behind raising rates when the problem is one of inadequate supply. Some argue that productive investments need lower and not higher interest rates.

Unfortunately, low interest rates are frittered away in speculative investments all over the world. There is nothing like higher interest rates to focus the mind. India’s high real rate of interest in the mid-1990s, engineered by then RBI governor C Rangarajan, pushed the Indian corporate sector to trim its balance-sheet. It entered the new millennium in ultimate battle-readiness with low leverage and high potential. It is no surprise that until recently, Indian corporations reported one of the highest returns on equity in Asia.

This time around, however, RBI has failed to respond adequately to rapid inflation. Real rates remain negative and that has stoked speculative investing in stocks and real estate. Indian real estate is arguably in a bigger bubble than Chinese real estate. One saving grace, as a fellow economist noted, India’s real estate bubble is not due to rampant credit growth as in the case of China. The supply side response for structural inflation is desirable but its absence is no excuse not to apply demand-restraining pressures. To be sure, higher interest rates would lower economic growth. But that is what the high inflation rates signal in any case—that the economy is not yet capable of the high economic growth rate that the country is aspiring for. It should not be too difficult for policymakers to acknowledge that more work is needed before the country can enjoy sustainable high growth rates.

Economists at the Standard Chartered Bank suggest that India is unlikely to sacrifice growth for controlling inflation. They may be right. The UPA government’s failure to acknowledge and act on the growth constraints would, in the end, leave India with an undesirable equilibrium—lower growth and higher inflation.

One of the explanations proffered for the RBI’s reluctance to raise rates is that it was not keen to raise the debt-servicing burden on the Indian government that has abandoned its commitments under the Fiscal Responsibility and Budget Management Act. Unsurprisingly, this has not led to any fiscal consolidation but more fiscal laxity.

Fiscal spending and inflation—joined at the hip
India’s fiscal and inflation woes go together. John Hussman, a fund manager, has always argued that expansionary fiscal policy has been the more reliable cause of high inflation than monetary expansion. Furthermore, India has an inflation problem because the government appears to have no stomach for long-duration and overdue supply reforms that would raise the economy’s speed limit. A high rate of inflation is seen as an acceptable price to pay for achieving high growth.

High growth, in turn, is expected to provide the resources required for the government’s explicit redistributive agenda. However, inflation negates redistribution as it is a bigger burden on the poor than on the rich. In developing countries, food and energy constitute the bulk of the consumption basket of the poor and there is little scope for diversification out of these two.

To offset the high cost of inflation, the government has resorted to indexing the wages paid out of the National Rural Employment Guarantee Programme (NREGA) to inflation. This is going to be fiscally costly. Then, there is the pending food security bill. Ensuring food security for the poor is laudable. But, in its proposed form, it is nothing but another version of Public Distribution System which ensures subsidised grains and other foodstuff for urban middle class while much of it is pilfered.

Meanwhile, there is no clear timeline for the implementation of the Goods and Services Tax (GST). The government has postponed—many times at that—its cabinet meeting to raise the price of diesel, fearing its impact on inflation. The price of crude oil is rising relentlessly towards the 100 dollars-per-barrel level. The consequence is that it will increase the fiscal burden, since every dollar rise in the price of crude oil adds to the government’s subsidy burden.

In other words, India faces the triple whammy: Rising fiscal deficit, rising current account deficit and high inflation. In the course of 2011, we might conclude that Shankar Acharya was guilty of understatement when he said:
So, while it may be comforting to read in reputed foreign publications about India’s ‘transformative growth’ to becoming the world’s third-largest economy by 2020 or 2025, the actual strengthening of anti-growth forces during 2010 raises some serious doubts about the nation’s long-term economic trajectory.

V Anantha Nageswaran is fellow for geoeconomics at the Takshashila Institution and blogs at The Gold Standard

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