Over the past couple of decades, India's private sector has grown substantially in size and scope, our markets have become more globally interconnected, but our politics has become more fragmented. We are still struggling to craft and administer sound economic policy in this radically changed environment.
The fragmentation of politics and the pressures of coalition management have contributed to a near-secular rise in budgetary social expenditures and spending on subsidies since 1991, leaving little fiscal space for government-led capital investment. The reality is that private corporate investment has become more vital than ever to drive sustained gross domestic product (GDP) growth.
Globalisation has accentuated the volatility of markets. We cannot reverse this trend. The ebb and flow of external capital has to be anticipated and managed much more proactively now more than ever before.
The much celebrated growth of private entrepreneurial activity has made lobbying pressures even more intense than under the Licence Raj. This is a feature of the policymaking environment that is here to stay and we must develop institutional strategies to resist regulatory capture even as we seek to encourage robust private investment.
Nowhere around the world do markets and their participants have patience for politics. Markets are amoral and apolitical. They like strong, decisive leadership. They generally do not cope well with uncertainty, nor do they like to be regulated. We know that at least, over short periods of time, markets can behave quite irrationally. In a globally connected world, capital and currency markets, in particular, tend to overshoot. Yet they can wield great power and have humbled many a politician who has ignored them.
That said, politicians do have the power to discipline markets, but they typically only exercise it when it is politically expedient to do so. For all the years that financial engineering was helping to give high-risk poorer households ubiquitous access to sub-prime mortgages, the political establishment in the US was quite complicit with the Wall Street agenda of financial deregulation. It is only after the financial crisis that Capitol Hill changed its tune. Since then, riding a groundswell of Main Street opposition to Wall Street, legislators have greatly increased the regulatory burden on the financial system and have been quite successful in forcing American banks to recapitalise their balance sheets.
The relationship between markets and politics is an uneasy one. Mutual trust and confidence - which are hard to build but easy to lose - are critical to the effective functioning of a market-oriented democracy. We must understand, however, that the burden of managing this relationship lies with politicians, not with the market. It is the policymakers' responsibility to build market confidence by finding the right balance between nurturing and regulating market forces. Don't nurture markets enough through disciplined economic policy and efficient administration, they will revolt. Don't regulate them properly - which is to say firmly, transparently and predictably - and they will take advantage. This is the challenge of economic policymaking in the market-oriented democracy that is India today, a task that is much more delicate than the one we faced 20 years ago.
The United Progressive Alliance (UPA)'s answer to these challenges was the pursuit of inclusive growth, the idea being to let markets and private enterprise drive growth and build core physical infrastructure, leaving the government to worry about education, health, rural development and the protection of those left behind. Things went well for UPA-I. India saw strong growth with impressive gains in poverty reduction. Then came the global financial crisis of 2008. The government responded with a vigorously expansionary package of fiscal and monetary policies. This substantially protected us from the fallout of the crisis and helped propel UPA to a second term, but also provided a chance for the party's traditional suspicion of markets to resurface. The hubris that came from easy access to capital in a post-crisis world awash with liquidity made things worse.
Some of us at the time had warned that India's road to affluence was not preordained, but such cautionary advice was drowned in the din of the Davos wallahs' and Delhi chatteratis' celebrations of a resilient India's inevitable rise*. Confident perhaps that capital had nowhere else to go, UPA-II's political establishment became increasingly strident about curtailing the perceived excesses of the market. Environmental concerns and concerns over land acquisition gained political currency. The uneven and unpredictable administrative application of this changing policy stance took a toll on investor confidence.
Meanwhile, an overconfident private sector did not do itself any favours through aggressive bid manipulation of infrastructure projects and other antics. Allegations of crony capitalism forced the Comptroller and Auditor General and courts to intervene, leading to administrative paralysis. Old anti-market instincts of the bureaucracy re-emerged, the Vodafone tax saga being one of the more high-profile results. An increasingly confrontational government made no apologies for heavy-handed re-regulation of the telecom industry or for the shortfall of domestic coal promised to private power generation projects set up at a huge cost. Intentionally or not, the government managed to convey to the investment community, both domestic and foreign, that it could not be trusted to stand by its assurances, commitments or even contractual obligations. Very soon the honeymoon between government and corporate India was over and trust between the government and markets was ruptured. There followed a sharp decline in private corporate investment and consequently downward pressure on GDP growth.
In parallel, instability within the UPA-II coalition drove the Congress party to try and shore up political support within its traditional power base. A systematic shift of the terms of trade in favour of agriculture was engineered through sharp and frequent increases in minimum support prices and through much heralded government schemes aimed at the rural poor. Although these interventions did arguably help sustain the pace of poverty reduction in the period 2008-12, they contributed to a deterioration in the quality of government spending, undermined fiscal consolidation and fuelled consumer price index inflation. We understand in retrospect that the Reserve Bank of India probably failed to act aggressively and early enough to nip the latter in the bud. Gold became the preferred inflation hedge for Indian savers. Household financial savings plummeted even faster than the decline in the investment to GDP ratio, widening our current account deficit to dangerously high levels. The coup de grace came with the US Federal Reserve's announcement of the imminent end to the liquidity injecting quantitative easing 3 policy. The ensuing retreat of foreign capital from emerging markets has hit the Indian rupee particularly hard.
We are where we are today because we have not done a good job either of nurturing and regulating market forces or of managing the growing political pressures for populist policy making. If we continue in this direction, we will not be able to revive growth nor be able to deliver inclusion. To return to a path of politically and economically sustainable growth we must learn to craft policies that restore the fine balance between the power of market forces and the demands of politics.
The author is executive chairman, IDFC.
*See "The Road to Affluence", Financial Express, June 25, 2009.
The first part of this article appeared on September 16. This concludes the two-part series