Half-way into Manmohan Singh’s second term as prime minister, the so-called India Shining story is unravelling. Having weathered the 2008 financial crisis better than almost anyone predicted, projections that the country would soon be growing faster than China, at 10 per cent or more a year, had become the norm. That confidence has come hurtling back to reality with a thump.
Admittedly, GDP is still expanding at around 7 per cent, a rate the developed world can only dream about. But big new investment projects have virtually dried up, the fiscal deficit is heading towards 6 percent of GDP and the rupee was Asia’s worst performing major currency last year while India’s Sensex stock market index fell 25 per cent. What’s more, inflation remains stubbornly high despite 13 interest rate hikes over the past year and a half. Some even joke that the “I” in BRIC, the club of rapidly developing economies, should now be Indonesia rather than India.
Political infighting and inertia bear much of the blame. Dr Singh, who launched the economy on the road to liberalisation when finance minister 20 years ago, has lost the will and the ability to reform. His government’s energy has been sapped by corruption scams. And he has been unable to push through even those reforms that he promised, because coalition partners keep threatening to pull the rug from under his government. How badly will this political paralysis hurt the economy’s immediate prospects? What’s the best way of tackling the endemic corruption? And is India’s long-term growth story still intact? These are the questions addressed in Breakingviews’ two-part Unravelling India series.(Click here for graph)
Wasting a good crisis
In India major reforms tend to follow economic slowdowns. It was a balance of payments crisis in 1991 that kicked off Dr Singh’s original reforms. Yet this time, instead of springing into action, the political system is paralysed. The best it can offer is handouts and subsidies, which will further exacerbate the country’s economic problems.
The failure to enact structural reforms in Dr Singh’s first term as prime minister from 2004-2009, as well as since he was re-elected, is one of the reasons the country’s productive potential has not grown as fast as it might have. Demand, though, has been strong — driven both by the growing middle classes and deficit-financed cash handouts to the rural population. The snag is that, with demand outpacing supply, inflation remained above 9 per cent throughout 2011.
The Reserve Bank of India has tried, only partly successfully, to tackle the inflation by pushing interest rates up to 8.5 per cent. While demand has slowed down, it’s investment that has been hit more than consumption — and that’s an unhealthy mix for the future. For the moment, investment — which was 35 per cent of GDP last year — doesn’t look too bad. But large new investment proposals fell to a five-year low in 2011, according to data from the Centre for Monitoring Indian Economy. Unless investment picks up, the country’s productive potential won’t rise as rapidly as it could, and it will face renewed inflation whenever it tries to press on the accelerator.
The hike in interest rates isn’t the only factor restraining investment. Many new projects, especially anything to do with infrastructure or exploitation of natural resources, require government approval — and the machinery of government is operating at a snail’s pace. That, in turn, is partly because several people have been thrown into jail in connection with a telecoms scam, where radio spectrum was awarded to mobile phone companies at a fraction of its value, costing the state an estimated $39 billion in lost revenue. Officials across government are reluctant to sign off on new projects because they are afraid they may get incarcerated too. Hopefully, the bureaucratic stasis will only last until government transitions to a cleaner way of operating. But, in the meantime, it is gumming up the economy.
Business confidence has also taken a hit. Industry is worried about the paralysis in Delhi. The government’s habit of spending more than it raises in taxes — and then mainly on things that boost consumption rather than infrastructure — is also crowding out the private sector. Business has in recent years tapped foreign sources of capital to help plug the gap. But the euro crisis has made it harder to borrow from abroad. Indeed, some companies such as Reliance Communications and Tata Motors are ruing the day they loaded up with dollar loans only to find that the plunge in the rupee means their debts are bigger in their home currency.
Power is an example of how a cat’s cradle of government policies is messing up a vital sector. The main source of energy is coal, which is abundant in India and made available to generators at about 45 per cent less than global prices. So private-sector groups such as Tata Power, Sterlite and Reliance Power started investing in new coal-fired power stations, financing them mostly with borrowed money. The snag is that new coal-mining projects have been delayed by environmental concerns, and so the power producers don’t have enough cheap local coal. Buying expensive imported coal, on the other hand, is uneconomic because the price at which they are allowed to sell electricity is capped by the state. Some of the power producers look like they will need a debt restructuring. India may soon have insufficient electricity to drive growth.
All this is happening when the global economy is slowing and the euro crisis is raging. India isn’t as much exposed to trade as, say, China is. But its reliance on foreign capital makes it vulnerable to any seizing up in financial markets such as the one which followed Lehman Brothers’ bankruptcy. What’s more, if the euro did explode, the government’s own deficit means it wouldn’t have many ways of cushioning the blow.
In fact, the government’s only significant liberalisation move — a relatively modest plan to open up the country’s retail sector to foreign investment — has fallen flat on its face. Just days after announcing the move in November, which would not only have brought in foreign money from the likes of Tesco and Wal-Mart but also helped modernise the supply chain and curb inflation, Dr Singh had to shelve the plan. The reason? Mamata Banerjee, the powerful chief minister of West Bengal, and on whose support Dr Singh’s government relies, refused to back it. She also incidentally torpedoed an anti-corruption bill in the dying days of 2011.
Instead of reform, the government’s main proposal has been for a new food security bill which involves giving about 800 million out of the country’s 1.2 billion people access to virtually free rice, wheat and coarse grains. There’s nothing wrong with a plan to curb malnutrition. After all, India has worse rates of child undernourishment than sub-Saharan Africa. But the new plan is badly targeted, covering two-thirds of the population. It may double the cost of food subsidies, taking them to 2 per cent of GDP, at a time when the deficit is already too high. The scheme also looks like a fertile new ground for corruption. What’s more, the government’s need to acquire huge quantities of grain will push up food inflation. It’s hardly surprising that many observers think the main motivation for the plan isn’t to combat malnutrition but to buy votes ahead of the 2014 general election.
It’s not at all clear that the 79-year-old Dr Singh really believes in what the government is doing. But he is hemmed in from two sides. One is his fractious coalition partners; the Congress Party has only 206 out of 543 seats in the Lok Sabha. The other is Sonia Gandhi, the standard-bearer of the Nehru-Gandhi dynasty who runs the Congress Party. She is considered to be less of a reformer and more of an old-fashioned socialist. A common quip in New Delhi is that Ms Gandhi has power without responsibility; whereas Dr Singh has responsibility without power.
Amidst all this gloom, industrialists and political pundits cling to the hope that things could get brighter in the spring. Part of the hope derives from the fact that inflation is at last falling. It is expected to come down to between 6 and 7 per cent by the end of 2012, according to UBS estimates. Though that’s still high, it should allow the central bank to ease interest rates a bit which, in turn, could encourage business to invest.
But the bigger hope hangs on elections in five key states in March. If Congress does well, it could reassert itself. There’s a particular focus on Uttar Pradesh (UP), the largest state with over 200 million people. Congress is not in a position to win this state. But it may be able to form a coalition in UP with the local Samajwadi Party (SP). As a quid pro quo, the SP may then be prepared to support Congress in New Delhi, allowing it to dispense with Mamata Banerjee as an ally. Because the Congress and the SP would each have a hold on the other, such a coalition might be more stable than the current one.
In this rosy scenario, Dr Singh would then be free to re-launch his reform agenda. He’d bring back the plans for opening up the retail sector to foreign investment and combating corruption; he’d push through draft bills on mining and land acquisition; he’d get the machinery of government moving again; and he’d rein in the fiscal deficit. The main way of doing the latter would be to curb fuel subsidies, which cost the government 3.5 per cent of GDP according to the OECD. Such a move, which was heavily hinted at by Dr Singh in his New Year’s address, would help pay for the new food subsidies.
All this would be great if it happens. But it does rely on the state elections going the way Congress wants, as well as the government deciding that it really wants to push through another dose of reforms which would be unpopular and involve overriding vested interests. And, of course, it depends on Dr Singh or another reformer being prime minister — which, given Ms Gandhi remains the power behind the throne, cannot be guaranteed.