While teaching a module about India’s economy, in January 2006, I stated that there is ample reason to be a “petro-pessimist about Incredible India”. This was while discussing the administered pricing mechanism for energy with its damaging combination of controlled retail petrol prices with rising crude prices, then $60 a barrel. Whenever the occasion arises, I repeat that phrase.
At that time, being a pessimist was to risk inviting ridicule. The second Bric (Brazil, Russia, India, China) report from the prestigious investment bank Goldman Sachs in January 2007 predicted that, before 2050, India’s GDP (gross domestic product) would surpass that of the US, far more bullish than its earlier 2004 predictions. (One should ask, even if this were to happen, how does it matter, but ignore this.) The Sensex was soaring, the economy was booming, and India had become one of the main darlings of foreign investors.
(Illustration by: Jayachandran / Mint)
Three months later, in Lille, France, I was picking up clothes from the dry-cleaner, an immigrant from Algeria. I was rather zapped when he told me, “Indian economy very good, GDP growth very high”. This was merely after finding out that I am from India, without knowing that I am a macroeconomist. Clearly, India’s economic performance was genuinely global news. Oui, my French almost ends there!
That contrarian pessimism is now spreading. As fuel prices get hiked, Incredible India is being revealed to be somewhat indigent India. It is time to evaluate our external borrowing policies.
Even last summer, opinion at home about India’s growth prospects was very optimistic. However, the London Economist ran a survey of emerging markets in August and gave India the lowest rating. All Asian currencies were rising due to capital inflows, but most of them had huge current account surpluses. (The current account with some adjustments is the difference between exports and imports.) India was the odd one out. The rupee had been rising due to capital inflows in excess of the current account deficit, the balance going into forex reserves with the Reserve Bank of India mopping up dollars. The obvious policy—tighten up on the capital inflows that had led to the rupee rise.
The Economist’s bad rating of India attracted a lot of flak. Someone characterized the Economist survey as “the crudest form of mercantilism”. Mercantilism is the old doctrine that a current account surplus, leading to accumulation of gold in the past, is good. Hence, a current account deficit (and its flip side, foreign borrowing to pay for it) is bad.
It is certainly the case that a current account deficit is not necessarily bad. It can be the sign of a healthy economy that is borrowing to finance economic activity, infrastructure and its growth. Australia has run huge current account deficits for decades, now about 6% of GDP, but has done well.
However, India is not in the same league as Australia. A more relevant comparison would be Indonesia, which introduced full capital convertibility in the late 1970s under the influence of the “Berkeley boys”. However, domestic policies were not sound, with retail price controls on oil. Over time, Indonesia, the crude oil exporter, became an importer. Capital inflows with heavily distorted domestic sectors, such as agriculture and energy, are a lethal combination. Indonesia suffered the most during the Asian crisis.
When evaluating a country’s economic fundamentals, far too much attention is paid to the fiscal deficit. A major activity of the International Monetary Fund (IMF) is to get countries to reduce their deficits. IMF imposes conditionalities for lending tied to fiscal deficit reduction. This does help to cut the deficit and improve the economy, as was the case for India in the early phase of reforms.
However, the link between the size of the fiscal deficit and subsequent economic performance is not very strong. The adverse economic impact of price controls in crucial commodities such as oil is much stronger.
Policymakers and many well-regarded economists in India have not paid enough attention to the harmful impact of petrol price controls on India’s sustainable GDP growth rate and long-term inflation outlook. They have been too optimistic about GDP growth, and not pessimistic enough about inflation.
Such excess optimism by itself cannot do much damage. However, the efforts to attract capital by broadcasting India as a great place to invest have long-run adverse consequences. Assured by statements by leading policymakers during Invest India meets abroad, and without knowing how weak the fundamentals are, foreign investors pump in money, further gaining by a rising rupee in the short run. It would be informative to do a survey of foreign investors during 2004-2006 and find out how many of them knew about India’s growing “oil pool deficit”, let alone had an estimate of its magnitude.
The view that capital account convertibility imposes discipline on the economy is not precise enough. We need to distinguish between inflows and outflows. Allowing Indians to hold overseas assets (outflows) does impose discipline—if bad policies are followed here, domestic residents can vote with their bank accounts. But, allowing more borrowing (inflows) often has the opposite effect—it allows indiscipline. Even if the official fiscal deficit is manageable, external borrowing has enabled India to live beyond its means and continue with retail fuel price controls, thus prolonging the economic damage. Ending critical retail price controls should be a precondition for liberal external borrowing.
Vivek Moorthy is a professor at IIM Bangalore. Comment at firstname.lastname@example.org