India has a better chance of growing independent of the West than any other country in Asia.
The Chinese word for crisis is a combination of the words for danger and opportunity, and both apply to India at this juncture. If we do not get our act together on the economic reform front, the economy has a real danger of slipping into a multi-year slowdown. On the other hand, the global economic meltdown is also a real opportunity for India to differentiate itself from the export-driven Asian growth model.
The danger is apparent: Despite five years of 8.5 per cent economic growth and buoyant tax revenues, our fiscal situation is precarious. We will have a combined fiscal deficit of nearly 12 per cent of GDP in 2009,the highest on record. The government’s own estimates suggest that this will only drop to 10-10.5 per cent in 2010, despite assuming benign commodity prices. God forbid if commodities spike again, in which case 2010 may be even worse.
Why worry about the fiscal at a time like this, you may ask? Isn’t the whole world going overboard in spending, why then should we be left behind?
The problem is that such a high fiscal deficit makes us vulnerable and dependent on foreign capital flows to sustain our growth and infrastructure investment. Our deficit is also far more structural in nature, and such huge spending gives very little stimulus, if any, to the suffering sectors of the economy.
The much-heralded surge in savings in India from 27-28 per cent in 2003 to 35 per cent last year, was largely brought about because of the improvement in corporate savings which almost doubled (as a percentage of GDP) and a reversal from dis-saving to saving by the government sector — in the initial years of the UPA government the fisc was in control. We did not actually get much improvement in household savings. With the deterioration in the fiscal situation, the government will be back in a dis-saving mode, and even on the corporate front, savings will be less than half of last year’s as profits cave in. Thus from a savings rate of 35 per cent, we will be lucky to hit 27-28 per cent in the coming year, and therefore investment rates will drop from 37-38 per cent to something under 30 per cent. This will be a real drag on growth and capital formation.
With such a huge fiscal deterioration, we will also have a crowding-out problem, with the net GoI borrowing requirement for this year crossing Rs 300,000 crore (even after netting off the MSS bonds). In a year when corporate credit demand is weak, this type of borrowing requirement may get filled with domestic savings, but as soon as economic activity picks up, domestic savings will not be able to meet the growth needs of corporate India as well as finance, surging government expenditure. There is no way that interest rates can be kept at reasonable levels if we need to finance a 12 per cent fiscal deficit and finance 8 per cent GDP growth in the absence of large foreign inflows of capital. Large chunks of corporate India moved their financing offshore in recent years, most of which will now come back onshore for refinancing. If interest rates spike, it again constrains growth,investment and corporate profitability.
The other issue is of course our infrastructure deficit. The government has tried to take the route of PPP to attract private capital to supplement its own lack of resources. With such a large fiscal deficit, there is no money available to put into infrastructure, and now very little risk capital available globally to come in and fill the breach. We still have policy issues in many areas of infrastructure which has prevented PPP from taking off, but independent of these policy disputes, there is no way that the country can attract anywhere near the hoped-for private capital flows to meet the plan targets. In the absence of infrastructure investment, how will growth sustain?
The reality is that a huge fiscal deficit makes India very dependent on private foreign capital flows to finance our corporate sector and infrastructure. In the absence of strong capital inflows we will be unable to advance at the rates of growth the country now expects.
At a time when we are very dependent on capital inflows, the global environment has turned very hostile to risk capital. There is system-wide de-leveraging ongoing in the global financial system, and equity and debt flows are constrained. Very few sources of long-term capital have liquidity currently or, alternatively, wish to take risk. As banking systems across the OECD head for quasi-nationalisation, capital will tend to get pulled back into the home country.
We have to recognise that India has no God-given right to receive billions in capital; we have to make our policy framework attractive to capital, and build confidence in global financial investors that the country means business. We have to be able to convince long-term investors that we can take the hard economic decisions which are needed to sustain our long-term growth. We will have to compete for the limited capital which is available with many other attractive emerging markets. Global investors have to once again get excited about our structural growth rates and ignore the macro-vulnerabilities. I sometimes think we are too complacent, we feel investors have to be in India: While partly true for FDI, there is no such compulsion for financial capital. No investor has to be in India. Investors will only go where they see returns.
The only way to tackle the structural fiscal deficit issue is either to aggressively target our expenditure and subsidies or undertake significant disinvestment and creatively sell government assets like spectrum. In the absence of these moves we will be stuck with a double-digit deficit, high interest rates, poor infrastructure and a potential sovereign credit downgrade. We could easily spin into a negative loop, with the poor fiscal causing a credit downgrade, which would further spook investors, reduce capital inflows, lower growth, spike rates —and the cycle would feed on itself.
However, lest I sound too pessimistic, all is not lost. If the new government moves ahead decisively to tackle the fiscal and delivers on second generation reforms in areas of education, labour policy, financial system etc, then we can regain investor confidence and claim our rightful share of global capital flows.
India is actually very well-positioned for the new post-US consumption world. We are a large economy with very little dependence on exports. Consumption is about 65 per cent of the economy, our demographics suggest it will remain strong. Our banking system is solvent. Capital investment will lead to huge productivity gains. We have good entrepreneurs and as the government share of the economy falls, there are huge growth opportunities in the domestic market. We do not need a growth model change like in China, which has to move away from exports/capital investment and towards consumption as its growth driver.
India should actually attract a lot of investor interest in today’s world, where the less globalised an economy, the better is its outlook. If our government can deliver on second generation reforms and tackle our structural deficit issues then we can be the toast of the investment world. Ironically, the more effective we are in reducing our dependence on foreign capital inflows, the more likely we are to attract these same flows.
India is unique in that our fate lies to a large extent in our own hands. There is enough slack in the system that good policy can make a huge difference to productivity and growth. If we deliver economic reform and strong economic policymaking, we can grow rapidly and attract investor attention. We are not as dependent on a US bail-out or recovery as most of Asia. We have a better chance of being able to grow independent of the West than any other country in Asia.
We once again have a chance to really stand out and differentiate ourselves. Will we take this opportunity?