Jun 26, 2008

The Darkening Sky

How things change in three months. Back in early March India's economic growth was still barreling along at around 9 per cent. Headline inflation data (for late February) still indicated a "comfortable" 5 per cent rate. The finance minister, fresh from presenting a populist budget, was confidently projecting the continuation of a ŝ per cent batting average" on growth. The sub-prime credit crunch in industrial countries seemed to have little direct fallout for India and the indirect effects through slower OECD growth were as yet distant. True, international oil prices had broken the talismanic $100/bbl level but concern in India was muted, mainly because domestic prices were held unchanged and the fiscal burden of massive implicit subsidies was masked by the double ploys of hammering oil company profits and issuing oil bonds. True, some economists had carped about a fiscally lax budget (including unfunded subsidies for oil, fertilizers and food), lack of reform and the damage to the credit culture from the farm loan waiver. But hey, who listens to economists? The overall mood remained quite buoyant.
Three months later things look much less rosy. The indicators of slowing growth proliferate in the daily papers. The government and RBI are in a small minority in expecting growth in 2008/9 to attain 8.5 to 9 per cent. The great majority of independent analysts expect the outcome to be in the 7 to 8 per cent range, with a growing number favoring the lower side of this band. Equity markets have tanked and stock prices are in doldrums. The really nasty surprise has come from inflation. Headline inflation has shot up since March and stood at a very uncomfortable 11 per cent in early June. Although a whole slew of fiscal, monetary and administrative measures have been deployed by the authorities, there is little respite in sight. The price spike has been concentrated in commodities, especially food, metals, fertilizers and oil products (either uncontrolled or because of rare upward revisions in controlled prices of petrol, diesel, kerosene and LPG). Yes, the primary source of this inflationary surge has been external, but that provides little consolation to people buying goods and services.
The other great dampener to economic spirits has been the growing realisation that the fiscal situation has suddenly turned quite dire. The February budget's estimate of a central government deficit of 2.5 per cent of GDP for 2008/9 appears laughably optimistic. As fuel, fertilizer and food prices soared since March and the corresponding "issue" or user prices were kept unchanged by the government, the estimates of implicit subsidies on these items rose steeply: over 3 per cent of GDP on fuel; nearly 2 per cent on fertilizers and perhaps 1 per cent on food. Even allowing for revenue increases on higher rupee bases, a true (implicit subsidy inclusive) central fiscal deficit of around 6 to 7 per cent of GDP seemed very likely. Together with State fiscal deficits in the order of 2 to 3 per cent of GDP, the combined true fiscal deficit is clearly going to be in the range of 9 to 10 per cent of GDP. Keeping these true deficits off the budget books through devices such as oil bonds and arrears owed to public entities in food and fertilizer in no way dilutes their adverse economic consequences. Nor does it fool knowledgeable observers. By April and May more and more analysts and investment banks were routinely reporting such high deficits, making a mockery of the budget estimate and (more importantly) pointing to a correspondingly heavier public sector borrowing burden on the market for loanable funds and hardening interest rates.
The drivers behind the burgeoning fiscal deficit have been the surging international prices of oil, fertilizers and food. The same factors are causing the yawning deficits in foreign trade and the current account of the balance of payments. If world oil prices average around $ 130/bbl in 2008/9, India's commodity trade deficit is likely to be in the order of 10 per cent of GDP and the current account deficit close to 4 percent of GDP. (Very roughly, every $2/bbl change in the average world oil price means a 0.1 percent of GDP change in the current account deficit). Unsurprisingly, the five year old problem of external capital surge seems to have disappeared, with the current account deficit widening and FIIs withdrawing over $ 5 billion from Indian capital markets in the first five months of 2008. Suddenly, it seems more like 1987-90, with reforms stalled, fiscal and balance of payment deficits ballooning and political uncertainty on the rise.
Actually, of course, things are not nearly as bad as the late 1980s for three important reasons. First, the RBI holds more than $300 billion of foreign exchange reserves as insurance against temporary liquidity crunches on external account. A couple of years of balance of payments strain could be absorbed easily without undue turmoil in external trade and payments. Second, the Indian private sector is in far better shape today than 20 years ago on all the usual yardsticks of productivity, profitability, balance sheet strength and dynamism. In theory, at least, it is much better placed to ride out temporary stresses in the economic environment. Third, the latest official data indicate that aggregate investment in the economy was 41 percent of GDP in 2007/8. It would be quite unlikely to drop by more than 6 or 7 per cent of GDP even if the economy goes through a couple of weak years. That suggests aggregate investment levels will probably not fall below 34-35 per cent of GDP, which, in turn, makes economic growth below 7 percent a year somewhat unlikely. However, given the massive scale of the implicit subsidies noted above, a deterioration in public savings of 4 to 5 per cent of GDP is quite possible, associated with a drop in investment and a widening of the investment-savings gap.
The trajectory of corporate investment and savings (which have risen sharply in recent years) is much more uncertain. The exceptionally difficult short-term challenge for monetary policy will be to contain the current, strong inflationary tendencies and expectations without inflicting undue damage to private investment. We know that in 2008/9 the investment-savings gap may need to widen by perhaps 2 per cent of GDP to accommodate the higher current account deficit. The question is at what level (of total savings and investment) will the equilibration occur. Beyond the short-run, fiscal policy (including price increases of fuel, fertilizer and food) must shoulder the primary responsibility for reducing macro imbalances.
Seven months ago (BS, November 22, 2007) I wrote "the UPA's legacy for sustaining rapid and inclusive growth in future years leaves a lot to be desired". Since then, the government's continued and prolonged failure to gradually adjust domestic oil prices to international realities has spawned a massive fiscal deficit and significantly worsened this government's already dubious economic legacy.
The author is Honorary Professor at ICRIER and former Chief Economic Adviser to Government of India. The views expressed are personal

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