India's Vicious Downward Cycle

Posted March 6, 2009 

India’s economic growth is now trending downward, but not everything can be ascribed to the global financial crisis. The present cycle of economic reforms in India dates to 1991. These reforms were triggered by an external balance of payments crisis in 1990-91. In a federal country, not all reforms are under the purview of the central government; some are state subjects. To the extent the central government is involved, it has often been argued that the absence of a crisis led to complacency and reforms stagnated. This has been even more the case since 2003, when India moved to a higher growth trajectory.

Now, ironically, with the arrival of a truly global financial crisis, that complacency has given way to a backlash against free-trade and deregulation, the very reforms the country needs. Yet even before the financial crisis hit, last year’s food and fuel crises dampened some of India’s enthusiasm for globalization and liberalization. There were, for instance, bans on exports of rice, wheat, maize, edible oils, sugar and even cement and steel, with export duties eventually replacing quantitative restrictions in some instances. Higher global crude prices meant domestic prices of petroleum products were consciously insulated from transmission and the administered price mechanism (APM) continued. But India wasn’t an outlier in adopting such knee-jerk reactions, since other countries also introduced similar policies.

Moreover, the left-leaning United Progressive Alliance formed a coalition government in 2004, and across a variety of sectors (education, health, pharmaceuticals, steel, cement, chemicals, fertilizers, public sector, pensions, insurance, foreign-direct investment), government decisions tended to favor regulatory controls and state intervention rather than reliance on the market. This is partly ascribed to communist parties being part of the UPA government, but resistance to reforms is more endemic.

So, even before the Wall Street-triggered financial crisis hit India last September, growth had begun to slow. Between 1992 and 2002, the annual average rate of real GDP growth was between 6% and 6.5%. Largely because of a drop in interest rates in 2002, growth increased to 8.5% in 2003-04; 7.5% in 2004-05; 9.4% in 2005-06; 9.6% in 2006-07 and then dropped to 9.0% in 2007-08. The trend rate of growth was jacked up to around 8.5% and this led to complacency in the mind of the government that nothing more needed to be done on the reforms front. Then, an increase in inflation persuaded the UPA government to hike interest rates—this shaved off around 1% from the base-line growth of 8.5%, and global shock shaved off another 1%.

Initially, the most common reaction to the global shock was denial: This was “only” a financial-sector crisis; Indian banks were not that exposed to U.S. assets; financial-sector regulation in India was better than in the U.S.; there wasn’t complete capital-account convertibility; the fact that India hadn’t liberalized the financial sector completely was a cushion, and so on. As with the East Asian financial crisis in 1997-98, the Wall Street crisis has been interpreted both as a caveat to market-based reforms and a red flag to crossborder financial sector liberalization.

In the initial aftermath of the crisis, the decoupling argument—that growth in India was no longer dependant on growth in the U.S. or other developed Western economies—kept surfacing, though people were never very explicit about what decoupling truly meant. Indeed, medium-term growth trajectories in emerging Asia seem to have broken away from medium-term growth trajectories in developed countries and that’s evidence of decoupling in one sense. However, the decoupling argument is simply not true in a cyclical sense. Not only is the financial sector not decoupled from the real sector, India is not as insulated from the global economy as one tends to think, even if the export/GDP ratio may not be as high as China’s.

India’s export-to-GDP ratio is 14%, if one only includes goods; and 21%, if one also includes services. Since 2002-03, exports of goods alone have grown by at least 20% in dollar terms every year, crossing 30% in 2004-05. Exports have been a major driving force behind both manufacturing and GDP growth. Manufactured exports account for around 70% of the goods export basket, with petroleum products contributing another 15%. For 2008-09, exports of goods were originally expected to grow at 30% in dollar terms, touching an absolute figure of $200 billion.

But since October 2008, export growth has been negative for four successive months, January 2009 being the last month for which export figures are available. Though there will still be some export growth in 2008-09, thanks to a decent performance till September 2008, the decline in the third quarter (a quarter in which exports are typically concentrated) has been more than 10% and in January 2009, by more than 20%. In other words, one major driver of GDP growth—exports—has virtually disappeared, and prospects of global growth recovering are uncertain. The Planning Commission took stock of assorted models and arrived at the conclusion that the global crisis shaves of anything between 1.5% and 2.5% from base-line growth. If the base-line growth is assumed to be 8.5%, Indian GDP growth therefore drops to between 6% and 7%.
What about employment? Indian employment data aren’t very satisfactory and don’t allow one to obtain clear estimates of employment in export sectors. However, the Commerce Ministry undertook a survey in 2004-05 and arrived at a figure that the export sector (again meaning goods alone) provides direct employment to around 8.5 million and indirect employment to around 1.5 million.

Many export sectors, like textiles and garments, leather, handicrafts and gems and jewelry, are labor intensive and production is often based on migrant labor. Since the slowdown in October 2008, reports have surfaced about consequent job losses—ranging between one million (a Commerce Ministry figure) and 10 million (a nongovernment Federation of Indian Export Organizations figure). There have also been reports of reverse migration from advanced states such as Gujarat to rural areas in backward states such as Bihar.

On trade policy proper, five issues need flagging: First, there is understandable resistance to protectionism surfacing through stimulus packages in the U.S. and France. Second, there have been increasing instances of Indian exports of generic pharmaceutical products being seized on grounds of patent infringement in Europe, a dispute that may end up in the WTO. Third, in January 2009, India imposed a six-month ban on toy imports from China, without specifically citing health hazards. This too may end up in the WTO. Fourth, reports have appeared about India planning to slow on free-trade agreements. Fifth, there has been a package to provide export incentives, through removing export duties and bans, extending terms for export credit and easing procedures on reimbursement of domestic indirect taxes on exports and deemed exports.

What about FDI? FDI inflows in 2007-08 were $32.4 billion and between April and November 2008, inflows were $23.3 billion. After the external sector crisis, there seems to a slight slowing down of FDI inflows, though not to the same extent as foreign institutional investments. In a recent move, on the same date as the interim budget, though FDI equity limits haven’t been hiked, there has been a simplification of rules and procedures.

As for forging an effective fiscal policy, parliamentary elections are due soon. Consequently, a full-fledged budget for 2009-10 wasn’t presented on Feb. 16, 2009. Instead, there was an interim budget which targeted a nominal GDP growth of 11% for 2009-10. With a GDP deflator of 4%, this implies real growth of 7%. Outside the government, most projections are of growth of around 6% in 2009-10, with 5% in the first half, though there is also consensus that growth should begin to recover by the third quarter of 2009-10. Outside the export sector, a recent Labour Ministry survey suggested five million jobs have been lost. To ensure broad-based income and consumption growth and that there is support for reforms, something like 7% growth (with 15 million new jobs a year) has almost become a minimum acceptable threshold, especially because expectations have increased.

The interim budget spoke of two fiscal stimuli in December 2008 and January 2009. There is the central government’s Fiscal Responsibility and Budget Management Act, with mirror pieces of legislation at the level of the states. The FRBM Act requires a revenue deficit of 0% by 2009-10 and a fiscal deficit that is 3% of GDP. This is in line with fiscal reform undertaken in India since 1991. The tax-reform agenda involves low rates, a broadening of the base, standardization and unification and removal of exemptions, reducing compliance costs.

In greater or lesser degree, every government since 1991 has attempted to follow this agenda, and state-level sales tax has been unified through what in India is referred to as vat. However, this isn’t yet a complete value-added tax, since other direct taxes remain and a unified goods and service tax (GST) was supposed to be in place from 2010. In 2007-08, the central government’s tax/GDP increased to 12.5% of GDP as a result of broadening of the base and reduction of compliance costs. With state-level and other local body taxes added, the combined tax/GDP ratio is now around 18%.

Unfortunately, under the UPA government, even before the external sector crisis hit India, public finances went haywire. There was sleight of hand in the budget numbers for 2008-09. In an attempt to make figures look respectable, items (debt relief for farmers, Sixth Pay Commission, National Rural Employment Guarantee) weren’t completely budgeted for. This means the scope for an additional fiscal stimulus is limited. The two additional fiscal packages announced in December 2008 and January 2009 involved indirect tax reductions and increases in public expenditure. The 2009-10 interim budget proposes a revenue deficit that is 4% of GDP and a fiscal deficit of 5.5%. Outside the government, it is widely believed that these targets will be missed.

The 13th Finance Commission will submit its recommendations in October 2009 and these are likely to lead to a greater state share in the tax pool. That will also make management of the central government’s finances difficult. Had fiscal reform and consolidation been introduced by the UPA government in high growth years, the fiscal space would have existed. But dysfunctional government expenditure squandered that opportunity away and low growth affects both Central and State tax revenue adversely, since the base of indirect taxes is narrow in India, in common with many other developing countries. The simple fiscal story is that there wasn’t room for the government to do much, the fiscal house is in a mess, but the worst on the growth front seems to be over.

This leaves monetary policy. Over a period of time, the Reserve Bank of India has eased monetary policy in an attempt to increase liquidity. However, there are still problems with the monetary-policy transmission mechanism, which in any case, involves a time-lag of around eight months: First, RBI’s exchange-rate intervention sucks liquidity out of the system. Second, government borrowing exerts upward pressure on interest rates, as do high guaranteed rates of interest on some government instruments. And at 12.75% to 13.25%, prime lending rates are still high, reflecting a premium risk-averse banks have loaded on. Moreover, an emphasis on reducing nonperforming assets and high guaranteed returns on safe government paper, spliced with additional risk aversion resulting from the financial crisis, have made banks reluctant to lend. Finally, on the demand side, in view of lack of interest in investments, there doesn’t seem to be a great demand for bank lending, beyond working-capital needs. Inflation is now well under control, and therefore further monetary-policy loosening is certain.

For now, India has settled for a growth rate of around 6% in 2009-10 and 7% in 2009-10. Since fiscal-policy options are limited, the emphasis is on monetary policy. With the time-frame for global recovery uncertain, the new growth trajectory has been slashed from 9% to 7% for a few years. Growth of 7% may not be bad compared to what other countries in the world are facing, but many expectations are based on 9%. That’s the challenge for the present government and indeed the new one. Required reforms, and not just fiscal ones, are easier to push when the going is good and not when there is a downward cycle. However, if growth drops significantly, the incoming government will face a different kind of crisis and that may well be good for the cause of reforms.

Bibek Debroy a is professor at the Centre for Policy Research and International Management Institute, New Delhi.