India: A long, winding road to growth

India: A long, winding road to growth

India: A long, winding road to growth

Global Economic Outlook Q3 2013

India’s economic growth is slowing down more than expected, and, given the country’s current economic challenges, there is not much room for maneuvering fiscal and monetary policies.

GEO Q3 IndiaThe Indian growth story is turning out to be unique and perplexing. The economy is facing new challenges, while old ones persist. The question is how the economy will grow amid so many hurdles. The path to recovery is similar to Indian roads—full of pot holes, which not only slow down progress but also make maneuvering difficult.

Disappointing growth and outlook

After a disappointing growth of 5 percent in the calendar year 2012, the lowest growth reported in a decade, 2013 started with a weak recovery of 4.8 percent year over year in Q1 2013 compared to the previous quarter, primarily due to weak domestic demand. Private final consumption expenditure growth, which has experienced a sharp decline since Q2 2012 (figure 1), was a mere 3.8 percent in Q1 2013 due to poor consumer sentiments. Private capital formation declined as well due to the high cost of financing, infrastructure bottlenecks, poor investor sentiment, and weak domestic and global demand. However, it was government expenditure that declined the most in the past two quarters, owing to the expenditure reforms initiated in September 2012. Expenditure grew marginally by 0.6 percent in Q1 2013.

Figure 1. Disappointing growth due to poor domestic demand is evidence of fiscal drag

The latest monthly data on industrial production and PMI manufacturing indicate very modest growth in the FY Q1 2013. According to the April data, capital goods output rose 1 percent year over year, and the manufacturing sector grew 2.8 percent year over year. On the other hand, the mining sector contracted 3 percent year over year.

India’s economic growth is slowing down more than expected. The International Monetary Fund’s recent downward revision of growth in 2013 from 5.9 percent to 5.7 percent signals that the economy now needs stronger government policies and more reforms. However, the government’s hands are tied, given the challenges that the economy is currently facing, and there is not much room for maneuvering fiscal and monetary policies.

The fall in external demand for exports (both merchandise and services) and the rise in fuel and gold imports resulted in a record-high current account deficit in 2012.

Inflation is a concern

Despite the low growth, inflation has continued to remain high, with consumer price inflation (CPI) hovering above 10 percent year over year for most of 2013. Supply constraints, particularly in food and infrastructure, the resulting food price rise, and high dependence on fuel imports have kept inflationary pressures high. The past few months have seen some respite in inflation due to a fall in food and international crude oil prices. As shown in figure 2, wholesale price inflation (WPI) has come down from 7.3 percent in February to 4.7 percent in May, while CPI (which has been higher than WPI) has declined to about 10 percent in April. However, the fall may soon reverse due to a reduction in fuel subsidy (leading to a rise in administered prices), persistent supply-side shortages (due to infrastructure bottlenecks), and the recent depreciation of the Indian rupee. The success of the monsoon in the next three months will also be an important determinant of inflation.

Figure 2. Inflation has eased down lately, though inflationary pressures remain high

The challenge of twin deficits

The government’s strategy of fiscal consolidation has repeatedly gone off course since 2008 due to a series of unfavorable developments. Faced with prospects of a sovereign rate cut and the crowding out of private investments in the economy, the government has undertaken a series of reforms, including fuel subsidies and rail fares, starting in September 2012. While cuts in expenditure due to the reforms have helped the government report better-than-expected fiscal performance, as suggested by the recent revisions (4.9 percent of GDP in FY 2012–13) shown in figure 3, the deficit is still wide enough to weigh on investors’ confidence. The FY 2013–14 budget emphasizes measures to control the deficit further, with a target of 4.8 percent. Further, fiscal consolidation by the government, if it happens, may impact expense quality and result in necessary expenditure being deferred, adversely impacting long-term growth prospects.

Figure 3. The fiscal and current account deficits

On the other hand, the current account deficit in FY 2012–13 was the largest ever. The fall in external demand for exports (both merchandise and services) and the rise in fuel and gold imports resulted in a record-high current account deficit in 2012. Thanks to the recent fall in international crude oil and gold prices, the preliminary estimate of trade deficit in Q4 of FY 2012-13 came down to 3.6 percent of GDP, compared to a historical high of 6.7 percent in the previous quarter. This helped contain the current-account deficit to 4.8 percent of GDP in the past FY, lower than the earlier estimate of 5 percent.

However, the past three months data indicate that the trade deficit has bounced back to high levels in the first quarter of FY 2013–14. The fall in gold prices has only served to reinforce Indian consumers’ appetite for purchasing gold as a hedge against inflation and uncertain equity returns. This has boosted demand for gold imports. A fast-depreciating currency has also led to an increase in the import bill for fuel, partly shaving off the advantage of a fall in international crude oil prices. Higher chemical and fertilizer imports too have increased in May. On the other hand, growth in exports remains sluggish due to poor external demand. In other words, there is strong evidence that suggests that the trade deficit is likely to widen in the short term, posing by far the biggest risk to the deteriorating current account deficit.

Emerging external and domestic challenges

One recent challenge that India has been facing is the reversal of capital inflows in the past few months. In the past, foreign investors have brought capital into the Indian stock market due to high global liquidity, interest rate differentials between advanced and emerging nations, and better growth prospects relative to the advanced economies. However, lower-than-expected growth, macroeconomic imbalances that include fiscal and current account deficits, poor investment conditions and corporate earnings, and a volatile currency have led to a reversal of the trend. Institutional investors are turning into net sellers in the Indian equity market. The market expectation of an improvement in the US economy and the hint of a possible exit by the US Federal Reserve this year have also contributed to the reversal of capital inflows. In a recent monetary policy review meeting, the Reserve Bank of India (RBI) expressed apprehension of a sudden stop and reversal of capital inflows from emerging markets, including India.1

Foreign direct investments picked up in the calendar year Q3 2013 after the government’s announcement of reforms in the retail and the aviation sectors and the establishment of a ministerial panel to fast-track industrial projects. These factors helped improve investors’ confidence and thus capital inflows. However, the growth in direct investments has lately been slowing due to government inefficiencies, the regulatory burden, and a lack of competition in the economy.

The steep currency depreciation in the past few months has been another cause of concern, in particular, the risk it poses to the current account deficit. The currency depreciated more than 14 percent against the US dollar in 2012 (figure 4), primarily due to the widening of the current account and fiscal deficits. The fall had briefly reversed until April 2013. However, in the past three months, the currency steeply depreciated, about 10 percent, due to a combination of domestic and global factors, a widening trade deficit, and the sudden reversal of capital inflows (due to growth concerns and the possibility of the US Federal Reserve’s exit from the monetary policy stimulus program). While policy makers have emphasized that the recent currency weakening is temporary, there are significant downside risks to the further weakening of the currency in the coming year.

Figure 4. Currency volatility and movement in foreign exchange reserves

The reversal of capital inflows and widening of the trade deficit have led to a sharp fall in the foreign exchange reserves in FY 2013–14. While India’s position is still comfortable, with an import cover of more than six months, under circumstances of unexpected external uncertainties, further weakening of the currency, and increased capital outflows, reserves may fall below sustainable levels.

Also, the persistent fall in capital goods production and poor industrial activity reflect depressed investment conditions in the economy. A sustained revival of growth requires a continuous growth of investment in the economy. However, investments have remained subdued due to poor business profitability, a slowdown in private consumption demand, poor governance and regulatory hurdles, and tighter credit conditions. On the other hand, unwillingness to lend to businesses stems from fears of erosion of asset quality, deteriorating cash-flow situations of borrowers, and heightened risk premiums.

Policies amid challenges

The combination of the previously mentioned challenges has severely restricted the flexibility of both monetary and fiscal policies in the economy. High fiscal and current account deficits restrict the government’s ability to undertake proactive government stimulus programs to boost the economy. The recent austerity measures to consolidate the fiscal position have led to a fall in government expenditure and resulted in a fiscal drag on growth, as evident in the past two quarters.

On the other hand, widening current account deficits, currency depreciation, and inflationary pressures limit the RBI’s ability to ease monetary policy. The industrial sector has been pushing for further monetary easing, which will likely encourage the fresh investments necessary to pull the economy out of the slowdown. However, the RBI prefers to wait until it sees sufficient evidence of further declines in CPI and inflation expectations, as well as currency stability. The RBI kept interest rates unchanged in its June meeting, after cutting rates thrice in its previous policy reviews. The cash reserve ratio has been held steady since the February policy meet to keep a check on liquidity.

Exploring more options to boost investments

Short-term risks to global financial stability have come down considerably compared to the past year. However, the uncertainty in the international environment still remains. The need of the hour is to boost investment in the economy, which in turn will likely help improve the labor market and consumer confidence. The issues in India are more structural, where supply factors (such as labor market bottlenecks), poor infrastructure, and domestic policy factors (such as policy uncertainty and regulatory obstacles) have contributed to the fall in investments. These issues cannot be addressed merely by monetary and fiscal policies.

The pace of reforms is slow as governance concerns and delay in approvals continue to weigh on business confidence. There is a need for some institutional mechanism that removes bottlenecks to stalled projects, especially in key sectors such as coal, power, steel, and roads. Policy efforts should bring enduring improvements in productivity and competitiveness to the economy. At the same time, the efficiency of the Indian banking system has to be improved, with a focus on managing systemic risks to banks emanating from the external environment, as well as on recent domestic macroeconomic risks.

The government is considering further opening up the Indian economy, including raising the cap on foreign investment in rupee-denominated government debt by up to $5 billion, reducing taxes on such investments, easing access to foreign funds for Indian companies, and reducing curbs on foreign investment in sensitive sectors such as defense, telecommunications, and media. India’s finance minister has been pushing for more foreign investments in the country. Nevertheless, the pace of reforms will likely remain gradual. India holds elections in May 2014, and, until the next elections, the probability of significant reforms being announced is low.


View all endnotes
  1. Reserve Bank of India, “Mid-Quarter Monetary Policy Review: June 2013” <>


Dr. Rumki Majumdar

Dr. Rumki Majumdar is a manager at Deloitte Research, Deloitte Services LP

Global Economic Outlook, Q3 2013: India
Cover Image by Jessica McCourt