The Indian economy experienced a downpour of economic events in June, coinciding with the heavy early-monsoon rains, making the clouds of economic uncertainty murkier. Economic activities have been showing signs of weaknesses; events during May–June exposed new challenges to the growth outlook. The US Federal Reserve’s indication in late May that it was tapering its purchasing program sooner than expected led to a series of events that adversely impacted India’s equity market, currency, and capital account balance. While a better-than-average and well-distributed monsoon in the following months brought some relief to planted crops across India, the challenges intensified for the Indian economy.
Heading toward an unsustainable situation
The last time we visited the Indian economic outlook in July, the economy was showing a few signs of improvement.1 Fiscal and current account deficits were revised down for fiscal year (FY) 2012–13 from their earlier estimates, and inflation had been trending down.2 However, we had expressed doubts about the sustainability of these improvements. The global economic scenario was rapidly changing, and we expected that these changes would unequivocally increase domestic economic uncertainties. The recent data releases indicate that our doubts were correct.
The GDP grew at a disappointing rate of 4.4 percent year over year in Q1 of FY 2013–14. The growth fell primarily because of poor growth in the services and manufacturing sectors. After declining for three consecutive months, headline inflation, which is measured by the wholesale price index, reversed in June and rose to 5.8 percent in July 2013. Consumer price inflation too moved back to double-digit growth of 10.3 percent year over year in June. This increase was primarily due to food inflation, while fuel and non-food inflation declined. The trade deficit rose 9.3 percent year over year in Q1 of FY 2013–14 and is estimated to have widened to 11.5 percent of GDP in Q1 of FY 2013 due to deteriorating export performance and increasing gold imports.
Growth in industrial production declined by 3.5 percent year over year in June, and all its constituent subsectors, barring consumer nondurables, experienced a contraction. The indices of mining, manufacturing, and electricity registered respective growth of -4.5 percent, -1.2 percent, and 3.5 percent in Q1 of FY 2013–14. Contraction in the manufacturing and mining sectors since April 2013 reflects deteriorating investment conditions in the production sector. Although the manufacturing PMI improved modestly in June, the pace of expansion was anemic. Most lead indicators point to continuing headwinds for manufacturing and services sector activity.
The rising market expectations of the United States reducing its purchase of Treasury equivalents before the end of 2013 led to a rise in interest rates and rapid appreciation of the US dollar. As a result, the domestic exchange market came under stress. Internal economic uncertainties—such as a rising trade deficit, slower economic activity, uncertain government policies, and poor perception of the government’s ability to manage its account among institutional investors—led to huge outflows of portfolio investment, particularly from the debt segment. The business and consumer confidence index continued to remain low in Q1 of FY 2013–14. The Indian currency, which has been under pressure for more than two years, nosedived 23 percent against the US dollar during April–August 2013. By the end of August, the equity market had fallen by nearly 4.5 percent since the beginning of FY 2013–14.
Perhaps India now needs more than just monetary policy to correct its course.
Monetary policy action
The Reserve Bank of India (RBI) promptly instituted several measures post May to contain the exchange rate volatility and current account deficit. The objectives of these measures were to contain gold imports, check speculations in the currency market, and tighten liquidity in the economy. These measures are likely to be repealed once the exchange rate stabilizes. As prompt as they were, these monetary measures have failed to contain the fall in currency—an indication that investors are probably losing faith in the Indian growth story. This is also evident from the significant amount of funds being withdrawn by foreign institutional investors during the last couple of months.
Raghuram Rajan, who took over as the new governor of the RBI on September 4, 2013, announced his plans in his inaugural speech: stabilizing the currency, strengthening the monetary policy framework, and generating financial development and inclusion. He highlighted how competition among banks will be improved by granting new licenses to banks and increasing the participation of foreign banks. Additionally, he stressed increasing the independence of banks in decision making, reducing the requirements of banks to invest in government securities, and improving efficiency in priority-sector lending requirements.
At the time of this writing, while the governor is yet to elaborate on the policy stance that is to be announced on September 20, 2013, market participants have received his message positively. However, given the current economic scenario, implementing these actions will not be easy for the new governor. Perhaps India now needs more than just monetary policy to correct its course.
Analyzing public policies
The government has the most important role in reviving economic growth, initiating meaningful reforms, and checking the fiscal balance. It has undertaken some reforms in the last two months to revive foreign direct investment and has also worked on speeding the approval process. Several important bills have been passed during this session of parliament to improve the investment climate: the company bill, aiming to enhance transparency in company operations; the food security bill, aiming to ensure nutritional security and thus improve living standards for the poor; and the land acquisition bill, aiming to ensure fair compensation to farmers. 3
However, the effectiveness of the government in undertaking reforms has been widely criticized. At the same time, the passing of some bills is widely debated, with the food security and land acquisition bills considered populist reform measures to appease voters with national government elections less than a year away. It is feared that some of these bills will raise the cost of business and delay investments. Additionally, the food security bill is expected to increase the government’s expense on subsidies, which may impede containing deficits to 4.8 percent of GDP this fiscal year.
Are we looking at another crisis like that of 1991?
While the economic situation looks gloomy due to the sharply falling currency, rising current account deficit, and investors’ recent questioning of India’s growth prospects, our answer to the question above is no. India’s currency predicament is similar to that of many other emerging economies experiencing a similar sell-off by foreign investors. The exchange rate is now market-determined, and India still has comfortable foreign exchange reserves, with over six months’ import cover. Moreover, the banking system is healthy and transparent. Falling growth is undoubtedly a concern, but India’s growth is still stronger than that of other emerging economies.
India is suffering from “a crisis of confidence,” which requires effective government actions to correct the external and fiscal balance. The government needs to effectively communicate its policies to contain the current account deficit and inflation. The bottlenecks to infrastructure and manufacturing investment must be addressed and removed promptly, which in turn will boost investment sentiments. But with elections just few months away, there is little the government can do. Most likely, there will be no change in the mood of investors, and growth will remain stagnant until after the elections.
- Rumki Majumdar, “India,” Asia Pacific Economic Outlook, July 2013, http://dupress.com/articles/asia-pacific-economic-outlook-july-2013-india.
- The fiscal year in India begins on April 1 of the year referred.
- The last bill has been passed by the lower house but is yet to be passed by the upper house.