The economy is in the doldrums. Dark clouds seem to be floating in from every direction and gathering over the Indian economy. The prospect of achieving anything even remotely close to a double digit rate of growth is practically zero. The current account deficit threatens to reach unmanageable limits. The external outlook for the economy is just as gloomy with the balance of payments deficit growing bigger and bigger over time — the trade deficit has increased by over 50 per cent during the previous year.
We have just been informed that the index of industrial production declined by 3.5 per cent in March — compared to a growth of over 7 per cent a year ago. The decline was driven by a staggering 21 per cent fall in the capital goods sector. Unfortunately, no other sector registered a compensating increase in output. Even the consumer sector was virtually stagnant during the month. The dismal March figure comes after the IIP recorded a modest rise in February. This is just one indication of the volatility affecting the economy.
Unfortunately, such volatility has very negative consequences for future growth. Entrepreneurs hate uncertainty. They would much rather settle for a relatively low level of sustained growth rather than a 10 per cent rate of growth in one period followed by a 3-4 per cent decline in the next period. Such volatility forces them to postpone fresh investment, which in turn has an impact on future growth.
Of course, it does not help matters that no entrepreneur can realistically look forward to any help from the current government. For a long time now, all the energy of the government has been expended on simple survival. It has been announcing one policy initiative only to withdraw it when a coalition partner (read Trinamul Congress) threatens to leave the coalition and bring down the government. In fact, it is conceivable that the government may not survive till 2014 — Mamata Banerjee seems to have said as much recently. At any rate, no one expects the government to be able to implement any new reforms. Even a step such as reducing the fuel subsidy cannot be taken although this does not require any legislation.
It is more or less certain that the government will not be able to meet the fiscal targets that were announced in the budget. The slowdown in the economy will ensure that revenue collections will fall far short of budget estimates. The inability to curb subsidies will imply that actual expenditures will exceed targeted levels. The finance minister had hoped to keep the fiscal deficit to around 3 per cent of gross domestic product — this now seems a distant dream. The failure to meet fiscal targets will in turn reduce the government’s ability to implement expansionary policies in order to stimulate the economy. There may also be an upward pressure on prices. One of the deputy governors of the Reserve Bank of India has said as much while explaining why a further reduction in interest rates is unlikely in the immediate future.
Not surprisingly, this record has attracted a lot of criticism. Of particular significance is the rating agency, Standard and Poor’s, cutting its outlook on India’s long-term debt to negative. The Standard and Poor’s credit rating for India is the lowest investment grade rating. Although it has not changed this rating at this time, it has issued a warning that there is a fair chance that it might downgrade this to “junk status” over the course of the next year or two if the current account deficit continues to deteriorate and the economy continues to stagnate. Other international rating agencies have not been as damning as Standard and Poor’s. But, the continued drift may well force them to share the views of Standard and Poor’s.
India cannot afford to take the views and judgments of these rating agencies lightly for the simple reason that they affect inward flows of foreign exchange. We need rather large amounts of foreign direct investment in order to modernize our rickety infrastructure — the domestic economy simply does not have the capacity to generate adequate finances. Obviously, foreign investors will think more than twice before they take the plunge and invest in an economy which threatens to approach “junk status”. As it is, short-term inflows in the form of portfolio investment have virtually dried up. The Indian stock market is one of the worst-performing markets among the emerging economies, and so, foreign institutional investors have kept away from India. Of course, the lack of foreign inflows into the stock market exacerbates the problem — the sensex keeps drifting downwards in the absence of fresh inflows of funds. This is quite a far cry from the situation not so long ago when India was the favourite destination for all foreign portfolio managers.
Not surprisingly, the growing trade deficit coupled with the lack of portfolio investment into the country has weakened the external value of the rupee. The rupee has been falling against the dollar and other foreign currencies week after week, and is crossing the historic low of Rs 54 to the dollar. The RBI has probably intervened in the foreign exchange market by selling dollars in order to stem the fall of the rupee. (I write “probably” because the RBI does not, for understandable reasons, conduct these interventions publicly.) But there is a limit to the extent to which the RBI can succeed in its efforts. Inevitably, market forces will determine the value of the rupee.
Much depends on expectations. If Indian exporters expect the rupee to slide even further, then they will postpone their remittances of export earnings back to India since every dollar earned is expected to be worth more in rupees. Of course, such expectations have a self-fulfilling nature since the decision to postpone remittances exacerbates the short-term foreign exchange shortage and so results in a further fall in the rupee. Perhaps the only very thin silver lining is that the continuing European recession has meant a reduction in demand for oil. This, in turn, has caused oil prices to fall, albeit slightly. There has been a corresponding reduction in the size of India’s import bill. India continues to have a comfortable stock of foreign exchange reserves. Notwithstanding this, fears have been expressed that we are dangerously close to the situation prevailing in 1991 when both the current account deficit and external trade deficit became unduly large.
All this leads me to think that an early election may not be such a bad thing after all. If we are lucky, a fresh election may result in a stable realignment of political parties. If this happens, then a new government can direct its energies to wards the tackling of the many serious problems plaguing the economy. Otherwise, we may well see two more years of drift which will leave the new government in 2014 with a herculean task.