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March 10, 2012

Prospects of a structural slowdown

More than mere turbulence for the Indian economy

The stellar performance of Indian stocks this year (up around 30 percent in US dollar terms, out of which around one-third came from the depreciation of dollar against the rupee) must have motivated Financial Times’ David Pilling to write that India is defying gravity. He pointed to the Indian Supreme Court as having stepped into the governance breach. But India cannot rely forever on ad hoc rescuers. The systemic foundations for an aspiring global power are still sorely missing. If anything, they might have been eroded in the last eight years.

Structural growth slowdown unfolding

The growth rate of the Indian economy had slowed to 6.9 percent in 2011-12, as per government projections. This compares with the growth rate of 8.4 percent in 2010-11. Many predict a quick return to growth rates above 7 percent in the year 2012-13. Such hopes might be premature. Some others wonder if India had entered a slightly more permanent phase of slowdown given the slowdown in the savings rate from over 36 percent to around 32.3 percent. At this level, the savings rate is slightly below the level that prevailed in 2004-05. That puts the potential economic growth rate at around 8 percent, provided the productivity of capital has not gone down in recent years.

Such a possibility cannot be ruled out since most of the states that rely on thermal power are facing huge shortfall in electricity generation due to the non-availability of coal. Further, most of the state utilities are deep in the red because of politicised electricity tariff setting. There is severe under-recovery of costs from each unit of power sold to urban and agricultural users. There is cross-subsidisation from industrial users. However, there is a limit to how long they can bear the cross for inefficient pricing of electric power by the state. More importantly, the state utilities are unable to pay independent power producers for electricity sourced from them. This will lead to further decline in electric power generation. India’s incomplete reforms in the power sector are proving to be a liability. Power generation is open to the private sector while distribution remains captive to political interests. As a result, it is now undermining private sector power generation too.

The other concern is that the decline in the savings rate may not reverse soon. It is due to the combination of lower corporate savings, household savings and government savings. The first two are partially caused by the third. Persistently high and raising government budget deficits have kept inflation high, raising costs for businesses and eroding real incomes for households. Declining savings rates and rising land and power costs have brought down investment while the consumption share of the economy has risen. This consumption– investment balance—too much of the former and too little of the latter—is an important contributor to India’s trade deficit which played a role in the slide in the Indian rupee in the second half of last year. This issue is alive, even if dormant for now.

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Photo: Sharonpe

The fiscal deficit is widely expected to come down in the coming fiscal year 2012-13. Put differently, given the gravity of the situation, many expect the government to act. But that is not a foregone conclusion. A lot depends on the outcome of elections to various state assemblies, results of which will be announced by the first week of March. The fiscal budget for 2012-13 is due to be presented on March 16th by the government. The government may persist with its populist, redistribution and entitlement programmes and may even expand them. Further, since the government has balked at paying market compensation for its borrowings, there has been the inevitable monetisation of deficits. That too has contributed to inflation persistence.

A recent article in Mint points to rising farm loan defaults despite good monsoons and high food prices. The reason: rational expectations. Farmers got a loan waiver from the government some 18 months before the last national elections in 2009. They think they may get another this year anticipating the next national elections to be held before summer 2014. If the state election results are bad for the Congress Party, the farmers might have guessed right again.

In a bankers’ conclave that the newspaper hosted, the chairman of the State Bank of India had this to say: “Agriculture is a bit of an issue. That is because of moral hazard that was created in 2008 when there was a write off of large agriculture loans,” he said, and also suggested that the credit culture in rural India was deteriorating.

The inflation rate declines: will it sustain?

India’s stock markets celebrated the fall of both the headline and the core inflation rates in January. The headline wholesale price inflation dropped to 6.55 percent. As recently as April 2011, it was nearly 11 percent. The core inflation rate—defined as the rise in the prices of manufactured goods excluding food—dropped to 6.5 percent from 7.4 percent the month before. Most of it occurred due to the base effect—coming off from a big jump in the core index in January 2011. Inflation trends may continue to enjoy the tailwind of the high base effect from the first quarter of last year. The trend may not necessarily sustain. The price of crude oil is now beginning to defy gravity given that major central banks have pushed interest rates to the ocean bed and monetary liquidity skyward. The price of the Indian crude oil basket is up more than 11 percent since the beginning of the year.

Nonetheless, the country is primed for its first rate cut in April while it takes another cut in the Cash Reserve Ratio in March for granted. Analysts and the market may get their wish, provided the government keeps its end of the bargain to tighten fiscal policy in its budget for 2012-13 (April to March). The odds are stacked against a meaningful fiscal consolidation programme and in favour of ‘smoke and mirrors’ approach.

Reform at your own peril

Raghuram Rajan has zeroed in on why politician-reformer is a rare species—the environment does not allow him to thrive. The public does not or cannot grasp the costs of acts of omission and commission that are yet to manifest themselves. Hence, any action taken to prevent a calamity or improve things might be viewed with disfavour since it involves upfront costs. Improvements may not happen. At least in such cases, there is a sliver of hope. But actions taken to prevent worse situations are doubly tricky. If the actions succeed and the worst outcomes are avoided, people will have no idea of what they were saved from but they will only remember the costs they paid. No wonder we are predictably irrational. Mr Rajan’s piece confirms a bleak prognosis for tough economic reforms in India.

As noted earlier, India’s imported crude oil basket price is up 11 percent this year. Japan has re-joined the money printing race with vigour. Policy rates in the once-developed nations are plumbing new lows while the central banks launch monetary liquidity into the stratosphere. Add Middle East politics and bombs to the mix, and oil can go a lot higher.

It is futile to expect, at least in the short-term, that politicians would do the right thing or that the public would persuade them to do so. Only crises have that power


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