Since the end of 2001, the US Federal Reserve (Fed) and the Bank of Japan in particular as well as a few other central banks had flooded the global economy with enough liquidity to cause speculative bubbles throughout the world. The much-talked-about housing boom in the US and some European economies such as Spain, Ireland and the UK (and their subsequent bust), the proliferation of high-risk and leveraged instruments in the financial markets (and the subsequent deleveraging), the emergence of massive carry trade positions in the Japanese yen and Swiss franc (and their swift and brutal unwinding in due course of time), superspike in commodity and food prices (and their sharp fall due to demand destruction), an overheating Chinese economy (and now expectations of a massive fall in growth) etc., were all manifestations of the global lax monetary policy and its ill effects, engineered by then Fed governor Alan Greenspan and his trusted aide Ben Bernanke.
Given the inevitability of a nasty global recession in 2009, the macroeconomic headwinds have now turned against the Indian economy as well. And economic forecasters are busy cutting their gross domestic product (GDP) growth forecasts. A secular 9-10% GDP growth envisaged by the government and the Planning Commission for years to come now looks like an elusive dream and has been replaced by a more modest growth target of around 7% for the current fiscal year.
Illustration: Jayachandran / Mint
The unfortunate news is that fiscal 2010 is likely to see an even lower growth rate, the aggressive interest rate cuts by the Reserve Bank of India notwithstanding.
Why? The answer lies in what economists call the savings-investment identity of an open macroeconomy. Savings consist of three elements: private savings (both household and corporate), government savings and foreign savings (the current account deficit or capital account surplus). Investment can be classified in two categories: government and private investment. Foreign savings in the form of a current account deficit (CAD) or capital account surplus (CAS) make up for the shortfall in the domestic savings needed to fund investment in the country. In the presence of a high fiscal deficit (negative balance between government savings and investment) and inadequate domestic private savings to fund the entire private investment, CAS or CAD played a crucial role in filling the savings gap and propelling the Indian economy into a high-growth trajectory in the last five years.
But, unfortunately, most of this CAS, which consisted of short-term capital, or so-called “hot money”, has currently reversed course from emerging market economies due to risk aversion and deleveraging. Therefore, CAS which had seen a stellar rise from $25 billion in FY06 to $108 billion in FY08 may fall to single digit in FY09 or FY10 if the current bout of capital outflows continue from the country. A shrinking CAS implies that there will be less foreign savings available to fund private investment at home. Therefore, domestic savings have to increase at a higher rate to make up for the investment requirements in the Indian economy if private investment growth has to be maintained at the same rate in the absence of adequate foreign savings.
But in all practicalities, there is very little scope for domestic savings to increase or even remain stable in the next year. First, the government dissavings or fiscal deficit is likely to deteriorate further in FY10, given the lagged impact of various subsidies and sops that have been announced this year, coupled with an expected slower tax collection on the back of a growth slowdown. Second, private savings are also likely to fall as corporate profitability reduces on the margin and as household savings reduce due to lower pay or job cuts in certain sectors. In such a scenario of falling foreign as well as domestic savings and a high fiscal deficit, the private investment has to adjust downward sharply (due to the crowding-out effect as well as lower capacity expansion) to maintain the savings-investment identity. To be sure, the year-on-year growth of the gross fixed capital formation component in the GDP has already fallen to a single-digit growth of 9% in the first quarter of FY09 from a double-digit average of 16% in the last five years.
As savings fall and private investment adjusts downward, the overall growth of the economy is likely to be hit substantially in FY10. In all likelihood, real GDP growth in FY10 is expected to fall at least 1 percentage point below the average trend growth of 7% recorded between FY99 and FY08. One possible way to counteract this negative effect is to cut corporate as well as income taxes and also aggressively cut wasteful government expenditure (instead of a fiscal boost, as discussed in the recent Group of Twenty summit) in order to prop up private savings and investment. This can also have an indirect positive impact of boosting the image of India as a reform-friendly country and help to encourage foreign capital flows back into the country. Failing to do so will lead to the inevitable severe growth slowdown in FY10 that economists and policymakers are currently losing sleep over.
Kaushik Das is an economist with Kotak Mahindra Bank. These are his personal views. Comment at firstname.lastname@example.org