Uncomfortably high inflation, external headwinds, and an uncertain policy environment are adding downside risk to India’s economy, which is operating below its potential.
All of a sudden, the cogs of government policy have been set in motion. While the government’s reform agenda momentarily raised hopes, the implementation of the reforms remains uncertain. The economy, however, is not out of the woods yet. Weak industrial production, an erratic and delayed monsoon, muted global demand, and policy uncertainty cloud India’s economic outlook. Meanwhile, inflation remains elevated, and the government’s woes arising from a high fiscal and current account deficits continue to constrain the economy. Growth projections have been lowered several times, and analysts predict that India will grow at less than 6 percent during the 2012–2013 fiscal year.
A step forward, but will the government retract?
The government decided to allow foreign players to invest up to 51 percent in multi-brand retail. This announcement opens up India’s retail sector for multinational retail giants, but there are some restrictions. Retail stores can be set up only in cities with a population of more than 1 million. The minimum investment must be $100 million, and at least 50 percent of the investment must be in back-end infrastructure within three years. Moreover, state governments will have the right to decide whether or not they will allow foreign direct investment (FDI) in the retail sector in their respective states.
The decision to allow FDI in retail can potentially eliminate several inefficiencies that mar India’s retail sector. However, the political consequences of the decision have already cropped up. The government faced significant political backlash from the opposition parties as well as its allies. One of the government’s allies has already withdrawn its support from the ruling coalition. While the government is unlikely to collapse on the back of this decision, the implementation of the FDI policy is unlikely to be smooth. The central government is unlikely to backtrack on its policy stance because state governments make the final decisions about whether or not to allow retailers into the country. But, as of this writing, only 10 states have decided to allow FDI in multi-brand retail. The success of multinational organizations that enter India’s retail space may depend on how they and the government are able to assuage the fears of those who are likely to be affected by their presence. Given India’s huge consumer base and a rising middle class, global retail companies are excited about their growth prospects. However, retail outlets have faced the ire of angry mobs in the past, and multinational retailers will likely tread cautiously amid uncertainty.
Another policy decision that met stiff political opposition was the reduction of subsidies on diesel and cooking gas. The government decided to restrict supply of subsidized cooking gas to six cylinders per household in a year and increase the price of diesel by 5 rupees per liter, which led to political resistance. All major political parties also participated in a day-long strike soon after the reforms were announced. Furthermore, the National Federation of LPG Distributors of India has threatened to go on a strike against the government’s multiple-rate policy on cooking gas cylinders. Some state governments have intervened by increasing the limit on subsidized cylinders to nine, while others have waived state taxes on the sale of diesel. The backlash against the subsidy reform is just beginning, and political parties and trader unions are demanding a rollback of these reforms. The ensuing outcome is difficult to predict.
The government’s subsidy bill rose substantially, owing to a decline in the value of the rupee and elevated prices of petroleum products. While the subsidy drawdown is unlikely to solve India’s fiscal woes, it is considered to be a step in the right direction. India’s high-deficit problem raises the interest rates for domestic borrowing, which impacts private investment; it also restricts the monetary policy options of the central bank because deficits are usually financed by borrowing funds from the central bank.
Given India’s huge consumer base and a rising middle class, global retail companies are excited about their growth prospects.
Meanwhile, the finance ministry approved 49 percent FDI in the insurance and pension sector, up from the current ceiling of 26 percent. However, the bill is yet to be approved by the parliament. In addition, the government has proposed allowing foreign minority stakes in the aviation, electricity trading, and broadcasting industries. Finally, the government will also divest its equity ownership in some state-owned corporations. It may be relatively easier to implement these reforms as they are unlikely to face significant political roadblocks.
Limited options, limited action
In April 2012, the Reserve Bank of India (RBI) aggressively cut its policy rate by 50 basis points. In its mid-quarter review in June, it did not opt for further policy easing. While the domestic economy remained fairly sluggish between June and September, global macroeconomic weaknesses did not subside either. Industry participants anticipated that the RBI would cut interest rates and prop up India’s negative investment climate. However, in its policy meeting in September, the RBI maintained its monetary stance and kept the policy repo rate unchanged at 8 percent. However, the cash reserve ratio (CRR) was lowered by 25 basis points to 4.5 percent. The CRR cut is likely to inject primary liquidity in the banking system to the tune of $3.1 billion and would likely have a larger cumulative impact on the economy through the money multiplier.
Through its current policy stance, the RBI has reiterated that containment of inflation remains its primary focus. Driven by a rise in food prices, consumer price inflation came in at 10.3 percent in August 2012. Food prices for consumers accelerated to 12.0 percent in August from 11.5 percent in July. Meanwhile, revised CPI data for July remained at 9.9 percent. Vegetable prices witnessed the highest increase at over 20 percent during August. Currently, inflation is well beyond the central bank’s comfort level. In addition, a weak monsoon is expected to have a significant impact on grain production, and farm output may experience a contraction this year. As such, food price inflation is likely to persist. However, abundant rainfall in the latter half of the monsoon season will likely ensure adequate irrigation for the winter crop.
Finally, the government’s recent policy announcements regarding an upward revision in diesel prices and a partial curtailment in subsidy on cooking gas are likely to put upward pressure on inflation in the short term. However, over the medium term, these initiatives are expected to help the central bank to manage inflation and strengthen India’s macroeconomic fundamentals. The central bank may adopt an easier monetary policy if inflation declines to manageable levels.
Twin deficit, twin challenge
Some of India’s macroeconomic challenges stem from its twin deficit problem. Government expenditures exceed revenues, resulting in a fiscal deficit, and the country imports more than it exports, leading to a current-account deficit. Persistent current account deficits put pressure on the exchange rate, and additional government borrowing increases the borrowing cost for other market participants, thus crowding out private investment.
In the 2012–2013 fiscal year, the government expects the fiscal deficit to be restricted to 5.1 percent of GDP. However, that target seems ambitions and is likely to be missed. Subsidies on oil and other petroleum products, fertilizers, and expenses on social welfare programs will make it extremely difficult to contain the fiscal deficit. Furthermore, any decision to deregulate diesel prices further or cut subsidies is likely to face political hurdles. In the absence of additional fiscal reforms, the central government’s deficit will likely range between 5.6 and 5.9 percent of GDP. Combined with the deficit of the state governments, the overall deficit could be as high as 9 percent of GDP.
Moreover, ambiguity pertaining to the government’s policy around taxation of foreign capital flows led to a huge exodus of foreign funds from India. This put additional pressure on the exchange rate and exposed importers to currency risk. The Reserve Bank of India’s timely intervention stemmed the decline and bolstered investor confidence. As a result, the rupee has appreciated in recent months, after witnessing a steep drop between February and June this year. However, if India’s economic prospects do not improve or investors flee to safer assets as the European crisis deepens, the rupee could experience some volatility.
India’s economy is operating below its potential, and a return to pre-crisis levels of growth is unlikely in the near future. Given the global economic uncertainty and India’s domestic macroeconomic challenges, the downside risks to the economy outweigh the upside. In an already-inflationary environment, a weak monsoon is likely to push food prices even higher, which may dampen domestic consumption. Furthermore, a weak performance in the agricultural sector does not bode well for the economy. Finally, India will remain vulnerable to the geopolitical tensions in the Middle East, which may lead to a spike in global oil prices. While the government’s reform plan is a welcome sign, it may be too early to celebrate.