The Indian economy is caught between low growth and stubbornly high inflation. Last month, the International Monetary Fund (IMF) revised the year-over-year GDP growth forecast of India to 5.7 percent for 2013, down from its January estimate of 5.9 percent. The IMF attributed structural factors as the primary reasons for the poor performance, rather than the cyclical factors cited by the government last month. Additionally, the IMF expects consumer-price inflation to remain at around 10 percent in 2013 due to a rise in food and fuel prices. Lately, there have been signs of easing inflationary pressures. The wholesale-price inflation has steadily decreased since late 2012, while consumer-price inflation went below 10 percent this May, as the economy operates below capacity. However, the government’s attempt to reduce the fuel subsidy bill by raising administered fuel prices will likely reverse the fall in inflation in the remaining part of the year.
The policy dilemma
The situation for India is unique because both fiscal and monetary policies have had limited flexibility to bail out the economy. High fiscal and current-account deficits restrict the government’s ability to undertake proactive stimulus programs to boost the economy. The level of domestic inflation remains higher than the Reserve Bank of India’s (RBI’s) comfort level, which limits the RBI’s ability to ease monetary policy further. Despite such pressures, the RBI is expected to reduce the policy rates, though marginally, in order to boost economic activity in the country.
High twin deficits may limit government actions
Fiscal deficit is expected to be 5.3 percent of GDP in 2012–2013, while the current account recorded the largest-ever deficit of 6.7 percent of GDP in the third quarter of 2012–2013. The government’s strategy of fiscal consolidation has repeatedly gone off course since 2008 due to a series of unfavorable developments. Since last September, the government has taken bold measures to cut down fuel subsidies to prop up public finance, helping the government to restrict the fiscal deficit within the revised target of 5.1 percent of GDP. However, with general elections being just a year away, progress in this direction will be limited and even likely reverse.
On the other hand, the fall in external demand for exports and the rise in import bills due to an increase in fuel prices and gold resulted in a record-high current-account deficit. The March data shows some improvement in the current-account balance due to a rise in merchandise exports and recent moderation in commodity prices, especially in international oil and gold prices. However, it is the capital-account growth that can play an important role in swinging the balance of payments to a surplus. Recent government reforms in the retail and aviation sectors and the establishment of a ministerial panel to fast-track industrial projects may improve investment sentiments and capital inflows. However, more than 40 percent of the capital flow in 2012–2013 has been institutional in nature, and the risk of a reversal of capital flows is very high.
Last month, the International Monetary Fund revised the year-over-year GDP growth forecast of India to 5.7 percent for 2013, down from its January estimate of 5.9 percent.
Easy monetary policies may not help after all
The combination of low growth, high inflation, and high current-account deficit has induced the RBI to manage liquidity through the calibrated use of various monetary policy instruments. The government’s recent fiscal consolidation has provided some space to the RBI to ease monetary policy in order to support growth. The RBI has cut interest rates thrice this calendar year and undertaken durable liquidity injections through outright purchases of government securities as a part of open-market operations. However, despite policy easing, interbank liquidity conditions tightened, especially since November 2012, mainly due to large and persistent buildups in government cash balances and strong currency demand. Credit demand has remained low due to sluggish domestic demand as well deterioration of banking asset quality. In addition, poor investment growth and an expected low rate of returns from investment are likely to limit the impact of easing monetary policy.
The problem lies elsewhere
The issues in India are structural, with supply factors (such as labor-market bottlenecks and poor infrastructure) and domestic policy factors (such as policy uncertainty and regulatory obstacles) contributing to the fall in investments. The pace of reforms is slow as governance concerns and delay in approvals continue to weigh on business confidence.
It will be difficult to sustain growth without a revival of investment growth in the economy. As long as inflation, especially consumer-price inflation, remains high, growth in consumption demand will be gradual, in turn keeping investments low. On the brighter side, growth in the Indian economy is expected to bottom out as the IMF expects that the government’s recent reform measures, improving external demand, and a better monsoon season will likely boost economic activity. However, the pace will likely remain gradual until the next elections as uncertain policies fail to address the core structural problems.