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Shankar Acharya: New threats to growth

Developments during 2010 have spawned new threats to sustained rapid growth

Gdp  |  Cad  |  Adarsh Housing Society

Shankar Acharya  |  New Delhi 

Everyone knows about the “old” threats to sustained rapid growth in India, including poor infrastructure, dysfunctional labour markets, competitive populism, the weak record of human resource development, painfully slow reforms and the reduced dynamism of industrial countries, post-crisis. Despite these genuine handicaps, the resilience and recovery of the Indian economy in the face of the global financial and economic crisis was quite remarkable. At its trough in 2008-09, growth only slowed to 6.7 per cent, recovered to 7.4 per cent in 2009-10 and surged to nearly 9 per cent in the first half of 2010-11, with almost all forecasters now expecting full year growth at or above 8.5 per cent. The latest official estimates indicate that gross domestic investment stayed buoyant at 35 per cent of in the first half of 2010-11, holding out the prospect of continued strong growth in 2011-12. And it has now become conventional wisdom to expect 8 per cent plus growth rates for the next decade or two as globalisation, “catch up” and favourable demographics continue to propel the Indian economy forward.

All this is true. But developments during 2010 have spawned new threats to sustained rapid growth. First, there is the return of the “twin deficits” problem after almost two decades during which one of them, the current account deficit (CAD) in the balance of payments, was muted. Second, the latter half of 2010 has seen the resurgence worldwide of energy and food inflation. Third, the proliferation of major scams and scandals (telecom 2G spectrum allocation, the Commonwealth Games, the Adarsh Housing Society, the Radia tapes and so on) has further weakened the government’s ability to take and execute decisions in all areas, including economic. Fourth, an activist environment ministry has sharpened the conflict between development and the environment, including through a number of high profile retrospective challenges to major investment projects. Last, but not least, economic reforms appear to have stalled completely. Some of these merit elaboration.

Return of twin deficits
The twin deficits of the late 1980s precipitated the external payments crisis of 1991. Since then the has hovered around 1 per cent of GDP, with a three-year foray into positive territory in the early noughties. In the five years prior to the global crisis, 2003-08, the averaged less than 0.5 per cent (Table). The collapse of world trade during 2008-09 saw the rise sharply to 2.4 per cent of and further to 2.9 per cent in 2009-10. Despite the restoration of (new) normalcy and the recovery of exports, the CAD has risen disconcertingly higher to 3.7 per cent of in the first half of 2010-11, prompting RBI to voice significant concerns in its December 2010 Financial Stability Report: “The current account deficit is widening while capital flows continue to be dominated by volatile components. External sector ratios have deteriorated…”. The central bank omitted pointing out that the problem has been aggravated by its own 18-month old, unannounced (non-transparent?) switch to a policy of minimal currency market intervention, despite an unprecedentedly steep appreciation of the rupee in real terms. While CADs in the range of 3-4 per cent of GDP can probably be managed for a couple of years, they are unlikely to be sustainable indefinitely, given the predominantly domestic orientation of the India economy. And what can’t be sustained, won’t be! Something will give and it could well be growth.

Unlike the CAD, we have been used to high fiscal deficits since the mid-1980s. Interestingly, the most successful period of fiscal consolidation occurred during the five years 2003-08, which saw the combined (Centre and states) fiscal deficit reduce by more than half, down to 4 per cent of GDP by 2007-08 (see Figure). It is no coincidence that those were five years of low interest rates, an unprecedented increase in savings and investment, record high growth and low inflation. The populist burst of 2008-09 took the deficit back up to 8.5 per cent of GDP that year and even higher to 10 per cent in 2009-10. Given the global recession, such fiscal profligacy helped cushion India’s economic slowdown in the crisis. But the case for renewed consolidation had grown strong by late 2009 and the government announced a gentle three-year path for deficit reduction in the Budget for 2010-11. In fact, the budgeted, modest deficit reduction for the current year is likely to be met only because spectrum auction revenues have been three times higher than budgeted (an extra 1 per cent of GDP). And the revenue deficit (roughly equal to government dissavings) is unlikely to drop significantly below the high level of 2009-10. Absent such enormous one-off bonanzas, further deficit reduction next year (and beyond) will be difficult in the face of expanding entitlement programmes and higher subsidies, implying that interest rates are likely to remain high and act as a dampener to investment and growth. (Click for grapfical view)

Energy and food inflation
For several months now, rising oil prices have been putting pressure on India’s external payments, the government budget and the finances of the oil companies, which are obliged to sell most distillates (including diesel, kerosene and LPG) at subsidised prices. Even the recent freeing up of petrol prices is at risk. International institutions (such as the IMF and IEA) indicate that international oil prices are expected to harden further. Food inflation has spiked upwards in the last two months, thanks to a global surge in food prices and the unreformed structural weaknesses of Indian agriculture and marketing/distribution systems. All this threatens the already high levels of general inflation and is expected to trigger further policy interest rate increases by RBI. Higher interest rates will weaken investment and growth.

Other impediments to investment
The numerous scams and scandals that have dominated news media in the recent months have brought Parliament to a standstill and drained the limited capacity of an already weak government. As if this were not enough, a number of high profile rulings by the environment ministry have halted several major mining projects (notably in Orissa) and the Lavasa township project in Maharashtra, while raising significant issues with respect to India’s most successful private port, Mundhra, in Gujarat. From an investment/development perspective, the questioning of large, completed projects sends a seriously negative signal to investors at home and abroad. “Animal spirits” are bound to be damped, to the detriment of investment and growth.

Such setbacks would matter less if economic reforms were proceeding smoothly and helping increase the productivity of available resources. Unfortunately, reforms have been on a slow train since 2004. Now, with Parliament stalled and government in a defensive mode on a variety of scams, the train seems to have been shunted to a siding. The political landscape does not augur well for an early resuscitation of economic reforms. The recent history and dim prospects for the induction of the long-heralded Goods and Services Tax are a good example. This continued hiatus in reforms will inevitably take its toll on medium-term growth performance.

So, while it may be comforting to read in reputed foreign publications about India’s “transformative growth” to becoming the world’s third-largest economy by 2020 or 2025, the actual strengthening of anti-growth forces during 2010 raises some serious doubts about the nation’s long-term economic trajectory.

The author is honorary professor at ICRIER and former chief economic adviser to the Government of India. The views expressed are personal

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First Published: Thu, January 13 2011. 00:42 IST