India’s economic growth is testing new lows with every passing quarter. The economy grew at its slowest pace in more than four years during the first quarter of fiscal year (FY)1 2013–2014, and unfortunately, this may not be the bottom. Domestic economic activities are showing signs of weakness, exposing internal challenges that could compromise the economy’s ability to grow. At the same time, global macroeconomic uncertainties are aggravating India’s internal troubles. The US Federal Reserve’s (Fed’s) announced intention to taper its purchasing program sooner than expected on May 22, 2013 led to a series of events that adversely impacted India’s equity market, currency, and capital account balance. Thanks to the recent Fed announcement to continue its pace of buying Treasuries and mortgages securities at the current rate, India’s equity market could breathe a sigh of relief. However, optimism due to reduced Fed policy uncertainty was short-lived. Two days after the Fed’s announcement, the Reserve Bank of India (RBI) delivered an unexpectedly hawkish statement to raise the policy rate (the repo rate) by 25 basis points to control high inflation in the economy.
The RBI’s policy announcement is a gentle reminder that India has few reasons to cheer and many reasons to be concerned. A mere hint by the Fed to taper its bond purchases unnerved investors and aggravated India’s recent economic woes. Sooner or later, the Fed will eventually reduce its unsustainable extraordinary monetary policy. Is India prepared to fight its way out of its domestic economic challenges, which will likely be exacerbated by global policy uncertainties?
Domestic economic activities are showing signs of weakness, exposing internal challenges that could compromise the economy’s ability to grow.
Fundamental domestic challenges
India’s economic performance has been weaker than expected, resulting in a downward revision of the country’s growth forecast for FY 2013–2014. Slower growth, high inflation, and rising fiscal and trade deficit are posing significant challenges to its troubled economy.
Growth: India’s GDP grew at a disappointing rate of 4.4 percent year over year2 in Q1 FY 2013–2014; poor growth is attributed to a broad-based slowdown in domestic demand. Private consumption expenditure, which has been on a downward trend, grew at a mere 1.6 percent. Growth in gross fixed capital formation turned negative to −1.2 percent despite the efforts of the Cabinet Committee on Investment, which was instituted by the government this year to fast-track and reduce bottlenecks of key projects. Modest GDP growth was helped by a 10.5 percent rise in government expenditure in Q1 FY 2013–2014.
Sector-specific contribution to growth remained modest in Q1 FY 2013–2014. An early and good monsoon had a huge positive impact on sowing activity and helped boost agricultural output, but poor growth in the services and manufacturing sectors weighed upon total growth in the first quarter. Growth in industrial production declined by 4.5 percent in Q1 FY 2013–2014; all its constituent sub-sectors, barring consumer non-durables, experienced a contraction. In the first quarter of the fiscal year, the index of mining, manufacturing, and electricity registered growth of −4.6 percent, −1.2 percent, and 3.5 percent, respectively. Industrial production experienced an unexpected rebound in July due to positive growth in capital goods. However, the overall pace of expansion was anemic. Growth in consumer durables has remained negative for four consecutive months this fiscal year, which implies that overall consumption spending is weak and may pose significant risk to the sustainability of growth in the capital goods sector.
Both consumer and business sentiments on economic conditions have been experiencing a decline. What is worrisome is that none of the survey participants3 were optimistic about the economic developments for the next six months during the time these surveys were conducted.
Growth outlook: Most of the leading indicators point to weak growth in Q2, while sentiments are waning. By July, India’s government ran up a fiscal deficit of 62.8 percent of the budget target deficit. If the government is committed to limiting its fiscal deficit to its target of 4.8 percent of GDP this fiscal year, government spending will not contribute to growth for the rest of the FY14. In such a scenario, the above trends suggest that growth may remain stagnant or even decline in the current quarter, while the economy may expand by 4.5–5.3 percent in FY 2013–2014.
Inflation: For India, the economic challenge doesn’t end with falling growth; stability of growth has also been in question for the last few years. India has one of the highest consumer price inflation (CPI) rates among all emerging nations. It averaged around 10.2 percent in FY 2012–2013. Inflation—including headline and consumer prices—fell briefly for three consecutive months until May 2013 due to a fall in international oil and gold prices. The fall reversed in June, and CPI (IW)4 averaged 11.2 percent in June–August 2013. The pickup was primarily due to food inflation, while fuel and non-food inflation declined.
Inflation outlook: A good monsoon this year may ease pressure on food prices, which will likely help reduce CPI. But a hike in administered fuel prices by the government to reduce the fuel-subsidy bill, the depreciating rupee, and supply-side shortages will keep inflationary pressures high. A survey by the RBI5 indicates that the inflation expectation for the next three months is very high, and around 71 percent of respondents expect prices to rise faster than the current rate.
Fiscal balance and debt: India’s fiscal balance, which measures the government’s ability to manage its finances, is already showing signs of deterioration. After registering a deficit of 4.9 percent of GDP in FY 2012–2013, there are indications that fiscal deficit might widen further this fiscal year. In the first four months of FY 2013–2014, India’s deficit already reached 62.8 percent of the budgetary provision for the full year, and expenditure on major subsidies reached 51. 3 percent.
Outstanding public debt, which accounts for approximately 43 percent of GDP, increased by 5 percent quarter over quarter in Q1 FY 2013–2014. While India holds 91 percent of its total outstanding debt internally, the share of external debt is rapidly increasing, and the country holds a majority of this debt in foreign currency. At the same time, the share of total outstanding government debt held by foreign institutional investors (FIIs) is trending upward. The share increased from 0.9 percent to 1.8 percent since March 2012 and contributed to the government’s increased vulnerability to market speculations. This is also evident from the fact that 10-year government bond yields rose by 1.4 percent from May to August 2013, primarily triggered by selling pressure from FIIs on fears of tapering quantitative easing in the United States and a possible war in Syria.
While India holds 91 percent of its total outstanding debt internally, the share of external debt is rapidly increasing, and the country holds a majority of this debt in foreign currency.
Fiscal outlook: To prevent the deficit from surpassing its target of 4.8 percent this fiscal year, the government needs to cut discretionary spending and restructure deficits for the next eight months. That said, a recent initiative to pass the food security bill and an impending election in less than eight months indicate that the country’s budgetary target will be very challenging, if not impossible, to achieve. If the fiscal deficit widens beyond 5 percent of GDP in FY 2013–2014, which is probable, it could adversely impact investors’ sentiments, raise debt liability, and increase government bond yields. A high debt burden will limit the government’s fiscal flexibility and its ability to respond to future shocks, as well as restrain investment in India’s social and physical infrastructure.
External account: India’s external sector imbalance persisted above sustainable levels in Q1 FY 2013–2014 after a record high current account deficit of 4.8 percent in 2012–2013. The trade deficit of 10.1 percent of GDP in FY 2012–2013 widened to 11.5 percent of GDP in the first quarter due to deteriorating export performance and increasing imports of gold and crude oil products, including petroleum, oil, and lubricants.
The announcement by the US Federal Reserve Bank to taper its quantitative easing and tensions over Syria led to a sharp capital outflow from most of the emerging nations, including India. Net portfolio investment turned negative in June and July as FIIs withdrew $13.2 billion from the Indian market in these two months. India’s currency, which has been under pressure for more than two years, fell 23 percent against the US dollar during April–August 2013. The currency, however, gained back some ground in the next two months.
By August, high trade imbalance, currency depreciation, and rapid capital outflows depleted India’s foreign exchange reserve by 7 percent since the start of this fiscal year (see figure 1).
Trade outlook: India’s currency is expected to remain weak in the coming months. Exports are expected to benefit from a weaker currency, which is evident from the first two months’ data in Q2, but it is unlikely that growth will be sustained. Relatively high inflation, high cost of imported raw materials for production, tax structures, and infrastructural deficits are expected to raise the costs of production and, hence, compromise the advantage of a depreciating currency.
Figure 2 briefly summarizes the risks to India’s economy. It is evident that both real and the financial economies are facing challenges, and the outlook is not very encouraging either.
The countering monetary policy actions
The RBI promptly instituted several measures after May6 to contain the exchange rate volatility and current account deficit. The objectives of these measures were to contain gold imports, check speculation in the currency market, and tighten liquidity in the economy. Prompt as they were, these monetary measures failed to contain the fall in currency, and a significant funds were withdrawn by FIIs as the Fed’s September policy meeting closed in.
Raghuram Rajan, who took over as the new governor of RBI on September 4, 2013, announced plans in his introductory speech to emphasize currency stability, strengthen the bank’s monetary policy framework, and generate financial development and inclusion. He highlighted improving competition between banks by granting new licenses to banks and increasing participation of foreign banks. Besides, he stressed greater independence of banks in decision making, encouraged banks to clean up balance sheets, reduced the requirements of banks to invest in government securities, and improved efficiency in priority sector lending requirements. His speech was well received by the market, and subsequently, the pressure on currency eased. Within two weeks of taking over, he has already implemented full liberalization of bank branching; other measures are underway.
RBI’s hawkish move: In his first policy announcement on September 20, 2013, Rajan surprised the market by taking a bold step by hiking the repo rate by 25 basis points and focusing primarily on containing rising inflation. At the same time, he also announced scaling back some of the emergency measures that were taken recently to prevent currency depreciation (mentioned above) to ease liquidity. His policy review clearly indicates that while the key concerns would be inflation and currency stability, RBI will closely monitor economic conditions and may undertake mid-course corrections and adjustments outside usual policy dates, if required. His actions to correct the national balance sheet and growth agenda are expected to improve investors’ confidence.
However, if viewed dispassionately in the current economic scenario, India needs more than just monetary policy to correct its course. There has to be more action to manage fiscal accounts, and Rajan cannot turn the tide alone.
Reforms fall short
The Indian government has undertaken reforms in the last few months in an attempt to revive foreign direct investment: raising the limits on foreign investments in sectors that include insurance and defense, a cap raised to 100 percent in telecommunication, and relaxing investment norms in multi-brand retail to give more clarity and space to investors. Several other important bills were passed during the monsoon session of parliament: the company bill to enhance transparency in company operations, the food security bill to ensure nutritional security and thus improve living standards for the poor, and the land acquisition bill to ensure fair compensation to farmers.
Nonetheless, the government’s effectiveness in undertaking reforms has been widely criticized. Frequent protests by members of parliament over various issues disrupted the reform process. In addition, the government’s efforts to undertake meaningful reforms have been followed by disappointing implementation. In the past, reforms have been repeatedly watered down, which continues to frustrate the business fraternity and impact investor sentiments.
Furthermore, recent bills pertaining to food security and land acquisition have been criticized as populist reform measures to appease voters before the approaching election. It is feared that such bills could raise the cost of business and delay investments. Additionally, the food security bill is expected to increase government spending on subsidies, which could make it harder to contain the country’s deficit to 4.8 percent of GDP this fiscal year. Political uncertainty, poor progress in reforms, and signs of widening fiscal deficit suggest that the Indian government may not be prepared to respond to unexpected shocks that could arise from domestic as well as global uncertainties.
India still has time to correct its course
The US Fed’s monetary policy uncertainty and speculations by institutional investors have certainly aggravated India’s recent economic woes, but high current account and fiscal deficits are probably the biggest reasons for the diminishing confidence on India’s slowing growth. High trade imbalance, currency depreciation, and rapid capital outflows are depleting India’s foreign exchange reserve, while high fiscal imbalance and a rising debt burden are making India less attractive in the eyes of its investors. The postponement of tapering by the Fed gives India some time and opportunity to correct its course. There are three strategic priorities that could help India improve its economic performance:
- Restore investors’ confidence. India is suffering from a crisis of confidence, so restoring the confidence of the global business community should be the top priority. Monetary actions can provide the first line of defense, but India needs immediate and credible action to correct its external and fiscal balance. The government needs to effectively communicate its policies to contain its current account deficit and inflation. It also needs to rapidly implement reforms without watering down the process. Policies should focus on strategies that improve export competitiveness by taking advantage of the depreciating currency. At the same time, measures should be taken to curb gold and fuel imports by imposing restrictions, removing subsidies on fuel products, and encouraging the use of alternate and environment-friendly sources of energy. Rising food inflation can be tackled by addressing inefficiency in public distribution systems and supply- side shortages.
- Address structural weaknesses. In India, structural weaknesses are hindering long-term growth prospects. The bottlenecks in infrastructure and manufacturing investments have to be addressed and promptly removed. Tax issues concerning some of the industries need to be resolved while public investment in sectors like coal, power, roads, and railways needs to find a place on the fast track. The Cabinet Committee on Investments (CCI), which has been set up to fast-track key projects, should be closely monitored by the government as well as the business sector to maximize its effectiveness.
- Ensure stability in the financial system. Policy actions in advanced economies will continue to pose risks to India’s financial and banking systems; they need to be prepared for spells of high volatility and uncertainty. Deteriorating asset quality and liquidity in the market, which primarily contributes to the instability of the banking system, have to be closely monitored. In addition, measures should be taken to improve the efficiency of banks by increasing competition and access to markets with proper supervision.
While India’s current vulnerability to external uncertainty is similar to most of the other emerging economies, fundamental domestic challenges to growth are making the country’s economy extremely susceptible to external shocks. A recent fall in the world ranking on the global competitive index7 places India below most of its competing emerging nations, and India cannot afford to neglect that. Impending elections cannot be an excuse for policy paralysis, and if India delays its actions until the elections in May 2014, it might lose an opportunity to improve its economic situation and the confidence of its investors.
- Fiscal year in India begins on April 1 of the year referred.
- Hereafter, all growth percentages mentioned in the article are measured as year over year unless otherwise specified.
- The consumer confidence survey is conducted by the Reserve Bank of India (RBI) and the business sentiment survey is conducted by the Federation of Indian Chambers of Commerce and Industry (FICCI). Both the surveys were last published in June 2013.
- IW refers to Industrial Worker and refers to retail prices of fixed basket of goods and services being consumed by the target group—an average working class family. http://labourbureau.nic.in/Special%20Art%20CPI%20IW%20NS%202006.pdf
- The Inflation Expectations Survey of Households for the April–June 2013 quarter (32nd round) captures the inflation expectations of 4,960 urban households across 16 cities for the next three-months as well as the next year.
- These measures were made to counter the impact of Fed’s first announcement of tapering monetary stimulus on May 22, 2013 and contain market volatility.
- The Global Competitive Index published by IMF ranks India 60, its lowest ranking so far, and places it 31 ranks below China. India is now placed below China, Thailand, Indonesia, Turkey, South Africa, Mexico, and Brazil and is barely above Russia.