India at a watershed as it confronts the spectre of stagflation
The Brics economies are all experiencing difficult growing pains, but India is probably most at risk of being left behind, afflicted by slowing growth and a raft of legacy structural problems it failed to tackle in the good times.
Long-hailed as a growth-superstar, India has staged a remarkable fall from economic grace during the past year.
Growth in the year to March was just 5%, compared with the 9% average annual growth rate in the 10 years prior.
Growth engines are sputtering. The warning signs of stagflation – slowing growth, rising inflation and stubbornly high unemployment – are all around, with even the head of the PM’s economic advisory council sounding the alarm.
In common with other emerging markets, India’s currency has plunged against the US dollar on fears related to the tapering of QE, making its large current-account deficit more costly to sustain.
Borrowing costs have surged in response to recent government efforts to prop up the currency by restricting liquidity in the rupee money market. The rupee was changing hands at 59 to the dollar in a recent trade.
Turkey, Brazil and Indonesia have raised rates to try to counter outflows of capital, while India has kept its overnight repo rate at 7.25%.
Together with government bond investors reallocating their holdings, this has helped push the yield on 10-year debt to 8.1%. Foreign investors in government bonds have withdrawn $6.5 billion since the middle of May, according to the Securities and Exchange Board of India, but equities have not seen a similar sell-off, so far.
Factory output and exports are down but consumer price inflation remains stubbornly high at 9.9% in June, up from 9.3% in May – meaning negative real rates for depositors and bondholders.
The government acknowledges what needs to be done to get the economy back on track but appears to be unable or unwilling to push through sufficient change, even as the economic picture is rapidly deteriorating, say analysts left disappointed by the stalled reformist agenda of the government of prime minister Manmohan Singh.
Investment growth has stalled as businesses frustrated by a lack of progress on reforming the country’s notorious bureaucracy, freeing up the supply of land and power shortages, abandon expansion plans. Liberalization of the key state-run coal mining and electricity distribution sectors is going nowhere.
Foreign direct investment (FDI) is down around 21% to $36.9 billion in the year to March. In July, the government proposed extending a relaxation of FDI restrictions announced last year raising foreign investment limits on the telecoms and insurance sectors, and lifting the ceiling for foreign portfolio investors by $5 billion to $30 billion.
Last year’s measures cleared the way for foreign airlines and supermarkets to enter the market but all but one have availed themselves of the opportunity due to lingering concerns about inadequate infrastructure and red tape.
The UAE’s Etihad Airways is the lone exception, but its bid to purchase a 24% stake in India’s Jet Airways for $349 million has already become tangled in a complex bureaucratic web. Steel giants ArcelorMittal and Posco recently cancelled projects worth $12 billion due to problems gaining land and mining permits.
“The main reason for the sharp step-down we’ve seen in the potential growth rate is lack of investment as a result of excessive public spending in unproductive areas,” says Shweta Singh, emerging markets economist at Lombard Street Research.
“This has crowded out investments leading to higher inflation bringing down the non-accelerating inflation rate of growth. The inflation problem was worsened by the poor policy responses from the central bank when the economy was growing above trend, leading into growth problems later on – what we call India’s stagflationary scenario.
“The policymakers woke up pretty late but they have been undertaking reforms so we’ve seen a lot of progress on fiscal consolidation and the central bank has been easing.
“The reason we’re still looking at significant capital outflows is that India has one of the highest current-account deficits amongst emerging markets. What makes matters worse is that it also has a big public deficit and this very large twin deficit explains to a great extent why the rupee has been performing so badly.”
Singh says the most potent channel of recent – pro-cyclical – central bank tightening will be to suck out domestic demand, putting pressure on the current-account deficit. However, curtailing domestic demand when growth is weak will hurt foreign investment in equities that are more in sync with the economy’s growth prospects.
“The way out is to reduce public expenditure, particularly in non-productive subsidies, so as to bring in private investment because until the investment rate picks up, there is no way there will be a pick-up in the potential growth rate,” Singh adds.
The two key components of the current-account deficit are oil and gold – both priced in dollars – posing additional financing risk for the deficit, given the depreciation of the rupee.
The government has deregulated petrol prices and more than doubled the import tax on gold in a bid to tighten imports.
However, high gold imports are a consequence of cultural practice as well as the paucity of domestic investment opportunities, with investors choosing to put their money in gold as a hedge against both inflation and currency shocks.
Capital Economics’ chief Asia economist Mark Williams says the government spent the past eight years focusing much more on welfare measures – food subsidies and other make-work schemes – while neglecting structural reform, and the legacy of that is that GDP growth has slowed.
“There was a lot of hubris about three or four years ago with people talking about the economy reaching double-digit growth rates,” says Williams. “But instead the government has been forced into embracing reform because of the weakness of growth.
“One problem is that it’s a coalition government and state governments hold a lot of power. The government in Delhi can’t simply decree reforms and expect them to be passed and implemented across the country.
“With elections coming up next year, that’s going to make it difficult to have a wholehearted push for reform at the moment. So we can expect some improvement in the regulatory environment in areas like opening up to investment, but it’s going to be slow.”
Lombard Street Research and Capital Economics’ growth forecasts for the next 24 months are 5.5% to 6%.
Williams concludes: “Growth is going to be disappointing in the near term – in principle, India should be able to generate much faster growth.
“There has been a bit of a sea change with the pro-reform finance minister Chidambaram and the long-term prospects are still pretty good, partly because it is by far the poorest of any of the Bric economies. Its poverty gives it a good starting point from which to grow.”
There might be a broader policy conclusion: the Congress-led coalition in recent years has banked on public investment to power the seemingly virtuous growth cycle – domestic consumption fuelling investment via surplus savings, while arguing this strategy will generate enough revenues to soak up the deficit in the medium term.
However, events during the past two years have exposed the downside risks to this gamble, adding fuel to the conservative economists’ argument: the government should focus on supply-side reforms, consolidate the fiscal position and give the central bank more flexibility to fight inflation.