It is fast becoming fashionable to scoff at India’s growth prospects. After the March quarter gross domestic product (GDP) numbers gave everybody a nasty surprise, economists have been busy revising their growth forecasts downwards. A competitive devaluation of Indian GDP prognostications is currently under way. Morgan Stanley has broken ahead of the pack, slashing its real GDP growth prediction for FY13 to 5.8%.
There are strong reasons for the popularity of this new game. The hopes that the Reserve Bank of India would quickly reduce interest rates, thereby imparting a much-needed boost to investment, have been dashed. Growth has fallen much more than expected, while mastering inflation is proving to be more difficult than envisaged. Add erratic government policies, a large current account deficit, a drying up of capital inflows, a political logjam and a world economy in imminent danger of slipping into a double dip, and you start to wonder how things could possibly get worse. Oh wait, that list seems to have left out El Nino.
So how did the Indian economy notch up growth rates of 9% plus during 2005-08? After all, we had a United Progressive Alliance (UPA) government at that time and that too supported by the Left. No reforms worth the name were carried out. The difference was the global economy had very high growth rates in that period. According to International Monetary Fund (IMF) database, the global economy grew 5.2% in 2006 and 5.4% in 2007. The database dates from 1980 and these are the highest ever rates of growth achieved by the world economy since then. It’s no wonder then that India’s growth rates too were exceptional, never mind the policy paralysis at that time.
But we also know the growth rate of the world economy at that time was based on an explosion of debt, a trend that we now know, with the wonderful benefit of hindsight, to be unsustainable. Was there a similar increase in debt in India too? The accompanying chart shows the ratio of bank credit to GDP at current prices. In 1990-91, this was 22.6%. By the end of that decade, in 1999-2000, it had moved up to 25.2%, a paltry increase. India being a developing country, it’s reasonable to expect this ratio to improve gradually, as more and more people and businesses are able to avail bank credit.
But during the next four years, between 1999-2000 and 2003-04, the bank credit-to-GDP ratio went up to 34.2%, or an increase of 9 percentage points in four years. Mortgages and consumer credit increased dramatically, as households discovered the benefits of leverage. What’s more, the credit-to-GDP ratio moved up spectacularly in the next few years. Between 2003-04 and 2007-08 this ratio increased from 34.2% to 51.3%, an increase of 17.1 percentage points in four years. In short, debt levels went up sharply during the period, although India’s bank credit-to-GDP ratio is still low compared with most countries.
This explosion in credit was aided and abetted by low interest rates. Interest rates on bank deposits of tenure between one and three years were in the double digits all through the 1990s, coming down to 8.5-9.5% in 1999-2000. They went down to a low of 4-5.25% in 2003-04 before starting to inch up again. But they remained relatively low compared with the 1990s, and in 2007-08, interest rates on one-year bank deposits were between 8.25 and 8.75%, lower than they are now. Even if interest rates come down, it may not be possible to see the kind of sharp rise in borrowing that led to such a strong rise in the credit-to-GDP ratio as we had seen earlier and that led to such high growth in the economy.
There was every reason for credit growth to increase rapidly during the boom years. Large inflows of capital allowed firms to raise equity cheaply from the markets and, once they had the equity capital, raising loans from banks were easy. The money helped entrepreneurs increase production and hire more people. People started spending and borrowing more and companies made bigger profits, enabling the government to get more in taxes and lower the deficit. That in turn led to lower government borrowing, which allowed interest rates to remain low. In sum, it was a virtuous circle, the exact opposite of what is happening today.
The received wisdom has been that it was the strength and potential of the Indian economy that attracted foreign investors. Instead, what if it was the large capital inflows that set the stage for high growth in the Indian economy? India’s economic growth is closely tied to risk appetite in the global economy.
For the virtuous cycle to start operating once again, what is needed is a revival of capital flows to our markets. But that is only likely to happen, on a sustained basis, when the world economy gets back on track. There are no signs of that occurring soon. And without foreign fund flows, how will the cost of capital come down and how will growth go back to 8% plus? Hence, the pessimism. True, a favourable outcome from the Greek elections could lead to a temporary revival of risk appetite, but let’s not forget that German Chancellor Angela Merkel said a solution to the European mess could take years. She should know.
Manas Chakravarty looks at trends and issues in the financial markets. Comment at email@example.com
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