Despite a period of slow growth, high inflation, fiscal deficits, external imbalances, political uncertainty, and poor business confidence, India has an opportunity to restore growth by implementing policies that make better use of its considerable assets.
Fiscal year 2013 has been tumultuous for India. For the first time in a decade, India’s economic growth fell below 5 percent, growing 4.6 percent year over year in the first half of FY 2013–2014 relative to last year.1 Unfortunately, growth is not India’s only challenge. The economy is burdened with persistently high inflation, rising fiscal deficit, and excessive imbalance in its current account, exposing internal challenges that are affecting investors’ confidence in the economy’s ability to grow. Political challenges are creating more confusion and skepticism, with India just a few months away from its general government election. Global economic uncertainties are aggravating India’s internal troubles: India was among the worst hit of the emerging economies whose currency, stock, and bond markets experienced extreme volatility this past summer due to the US Federal Reserve’s (Fed’s) tapering signal. Its currency depreciated more than 20 percent, while stock markets fell 10 percent during May–September 2013 because of heavy capital outflows.
Unfortunately, growth is not India’s only challenge.
Economic and political challenges from all fronts are making it difficult for policy makers to promote growth and ensure stability. The question is, how prepared is the economy to face its challenges head-on and bounce back? Will India be able to regain its lost position as one of the fastest-growing nations? India’s ability to overcome its adversities lies in its inherent strengths and potential. India has gone through difficult times before, which makes it resilient and better able to overcome economic challenges. It is no surprise, then, that it is one of the few major emerging economies to make a strong comeback after the Fed announced that it was deferring tapering.2
Economy muddled with challenges
The growth in Q2 FY 2013–2014 improved slightly, to 4.8 percent, relative to the previous quarter’s low growth. This improvement was due to stronger growth in the agricultural and construction sectors, but domestic activities in most of the real sectors continue to underperform, as seen in figure 1. Growth in the industrial sector remains sluggish due to poor growth in the manufacturing, mining, and quarrying sectors, while growth in the services sector is also showing signs of weaknesses. Industrial sector growth has been hit by poor growth in consumer durables and basic goods, which account for 54 percent of India’s industrial products, while the capital goods sector has been highly volatile. The only relief is that a favorable monsoon has improved the scope for a good agricultural output, which will probably continue to boost the economy’s growth in the coming quarters as well. Real growth has been falling continually, and according to the IMF, which recently revised down its GDP forecast for India, the growth outlook is not very positive.
According to the latest figures, wholesale price inflation (WPI) touched 7 percent in October, while consumer price inflation (CPI) continued to remain in double digits at 11.6 percent (see figure 2). Inflation is expected to rise further, as suggested by a survey conducted by the Reserve Bank of India (RBI).3 According to the survey, 92.5 percent of respondents expect prices to increase in the next year.4 The meteoric rise of food prices is the biggest reason for the rise in prices in India, which is likely to ease, owing to better agricultural output. The RBI’s newly elected governor Raghuram Rajan has clearly signaled in the last few monetary policy statements that he will focus on price stability, which implies that policy rates are likely to remain high. The industrial sector is already reeling from the high cost of capital and low availability in a tight liquidity situation, and high rates will only hurt growth further.
The rising fiscal and current account imbalances have been among the greatest macroeconomic worries for India (see figure 3). India’s fiscal gap widened sharply in the first six months of FY 2013–2014, and was estimated to be 76 percent of the budget estimate and approximately 8.3 percent of GDP in the first half of FY 2013–2014. This implies that the government has to spend less in the run-up to national elections or risk missing its stated aim of cutting the budget deficit to 4.8 percent—with the latter seeming more probable.
The current account deficit also widened in Q1 FY 2013–2014 relative to the previous quarter, and it remains close to its historically high levels. The good news is that it is likely to ease, going by recent signs of correction in the trade account deficit (see figure 4). Policy measures by the RBI to curb gold imports and factors such as slowing domestic demand and lower oil prices due to reduced external risks have helped contain import bill growth. At the same time, exports have grown faster in the first half of the current fiscal year relative to FY 2012–2013 due to currency depreciation and improved global demand. Remittance flows to India have surged as the country’s overseas population took advantage of the weaker domestic currency.
The high current account deficit is one of the biggest reasons for the increased vulnerability in the capital outflow witnessed in recent months. Net portfolio investment accounts for the majority of capital flow in the economy, of which 98 percent is foreign institutional investment (see figure 5). Due to the inherent nature of institutional investments, capital flows in India are highly vulnerable to global liquidity and international investors’ sentiments. On the other hand, the proportion of direct capital investment is a mere fraction of GDP, which implies a very small proportion of the capital account is being invested in production and building long-term assets.
The recent capital outflow resulted in a sharp depreciation in India’s currency—22.5 percent—this year. The Indian rupee hit a record low on August 28, 2013, although it has recovered some of its lost ground since then. However, as long as the current account and proportion of foreign institutional investments in total capital flow are high, the currency will remain vulnerable to external shocks; any events similar to the Fed’s hint of tapering, or actual tapering by the Fed, can upset the currency’s stability.
Impact on sentiments
Poor growth and economic challenges are affecting consumer and business sentiments. According to an RBI survey, consumer confidence diminished in September, with around 60 percent of respondents expecting that economic conditions will worsen.5 The consumer confidence measured by the current situation index declined due to the worsening perception of household circumstances, income, spending, and employment (see figure 6). On the other hand, the industrial outlook for the overall business situation is at its lowest level since 2005 due to the pessimistic assessment of and expectations for exports, imports, and the overall financial situation. The Business Expectation Index fell below the threshold level of 100 to 97.3 for the first time since 2008, indicating that businesses are highly pessimistic about the economic outlook and investment prospects.6 Rising interest rates and the perceived rise in external finance costs are impacting investment decisions, while the perception of profit margins continues to remain negative. All these factors have led to poor production and employment outlooks.
Simple strategies with greater benefits
Though overwhelming, these challenges must be fixed if India wants strong and stable growth. Some must be addressed immediately, while others require more focused attention and structural intervention.
The immediate tasks
For the most part, resolving India’s slowing growth, high inflation, and widening fiscal and current account deficits requires immediate initiatives beyond the measures already taken. These include promptly removing bottlenecks to the existing infrastructure and manufacturing investments, improving the allocation of subsidies, and curbing external deficits by improving export competitiveness and reducing imports. Measures should be taken to curb gold imports by imposing restrictions and promoting alternate investment options among retail investors. In addition, fuel imports should be contained by removing subsidies on fuel products and encouraging the use of alternate and environmentally friendly sources of energy. Monetary and fiscal policies should be coordinated so that if monetary actions provide the first line of defense, they are followed by immediate and credible government action. The government needs to communicate its policies effectively to contain the current account deficit and inflation, as well as focus on quick implementation of reforms without watering down the reform process.
Strategies for the long run
With the rising population and a growing market potential, improved infrastructure and connectivity are a must. While large infrastructure projects are being undertaken currently, the quality and scale is not enough considering the size of the population. Despite reforms being introduced, India’s system of acquiring land and allocating natural resources remains suboptimal, and bureaucracy and corruption prevent new laws from being functional. While the government has recently created institutions to accelerate decision making and implement transparent processes, the effort in this direction has to be more assertive.
One important concern is that a large proportion of India’s national income comes from the information technology and software industry, while contributions from the manufacturing and services sectors remain low. India cannot sustain growth if its growth model continues to focus on only a few sectors that employ a small part of the population. A majority of India’s population lives in rural areas and does not have access to basic health facilities and primary education. To ensure stable, sustainable, and equitable growth, the country needs to employ its growing population, which means that it has to develop its manufacturing and services sector to diversify its growth model.
For the most part, resolving India’s slowing growth, high inflation, and widening fiscal and current account deficits requires immediate initiatives beyond the measures already taken.
One important solution lies in encouraging small-scale industries, which have been generating employment and promoting balanced regional development. India’s industrial policy resolution has, from time to time, encouraged the growth of small-scale industries. However, to foster growth, the country must now focus on technologies that are flexible and can be adopted to different mass production processes, as well as improve productivity in manufacturing, agriculture, and agro-based industries.
India can learn a great deal from policies in other countries. For instance, Japan recently put in place a policy to end subsidies to some sections of farmers, which is expected to help consolidate farming, boost productivity, expand production, and reduce food prices.7 This policy is likely to free a considerable amount of unproductive agricultural land for better alternate use, thus reducing land prices in urban areas, which is a big concern in India as well. At the same time, the government of Japan is also providing protection to farmers through import tariffs and other measures. India can benefit a great deal from implementing, with necessary adaptations, some features of Japan’s policy.
Building on its strength
A country’s most important resource is its people, and India has this resource in abundance. India’s young and diverse population, with a quickly growing middle-income group, provides the economy with a big potential market, as well as productive resources to serve this market. If this population is tapped effectively, India has the ability to develop a self-sustaining growth model and reduce its dependence on the global market. The availability of quality education, labor reforms, and financial inclusion can help the economy reap the advantages of a growing population.
India’s healthy financial and banking sector is its other strength. This sector has shown immense resilience in the face of the global financial crisis, and the RBI has played an important role in preserving financial stability through a unique combination of monetary policies and macro-prudential regulations. While the banking sector has experienced an increase in bad loans in recent years, it is not cause for concern yet. However, with rising global policy uncertainties and India’s strong linkage to the global financial system, India should keep a close check on liquidity and the stability of the banking system. Appropriate measures such as increased competition and supervision can improve banks’ efficiency and access to markets, as well as contain the contagion risk of any global financial crises.
India’s finances are relatively stronger than its peers. The country’s overall public debt to GDP has been declining since 2006 and is currently 66 percent of GDP, of which only 46 percent is held by the central government. Moreover, the debt is denominated in rupees and has an average maturity of more than nine years. India’s external debt burden is also low, with only 5.2 percent of the debt being short term. India’s strong foreign currency reserve implies that its sovereign risk rating is stable, and the economy has the ability to borrow without a significant rise in risk premium. However, India should improve its fiscal balance to improve investors’ perceptions of sovereign risks.
There is no doubt that the Indian economy is challenged. However, if the economy can strengthen its inherent potency and plan effectively to close the gap between the potential and actual, India can get out of the trough and back on to its high-growth path.
EndnotesView all endnotes
- Hereafter, all growth percentages mentioned in the article are measured as year over year unless otherwise specified.
- Refer to “Are emerging markets losing their brand appeal?” in this edition of Global Economic Outlook.
- Reserve Bank of India, “Inflation Expectations Survey of Households, round 3,” September 2013, http:// rbidocs.rbi.org.in/rdocs/Publications/PDFs/05IEHR281013.pdf.
- The RBI’s Inflation Expectations Survey of Households for the July–September 2013 quarter (33rd round) captures the inflation expectations of 4,960 urban households across 16 cities for both the following three months as well as the following year.
- The consumer confidence survey is conducted by the RBI, and the business sentiment survey is conducted by Federation of Indian Chambers of Commerce and Industry. Both the surveys were last published in June 2013; also see Reserve Bank of India, Industrial outlook survey: Q2: 2013–2014 (round 68), October 28, 2013, http://rbidocs.rbi.org.in/rdocs/Publications/PDFs/03IOS281013.pdf.
- An index below the threshold of 100 signifies contraction.
- Economist, “Rice farming in Japan: Political staple,” November 30, 2013, http://www.economist.com/news/finance-and-economics/21590947-government-abolishes-previously-sacrosanct-agricultural-subsidies-political.