Mumbai: To plan based on the best-case scenario is to tempt fate, as India’s economic policymakers have learned the hard way.
A federal budget that assumed economic growth of nearly 9% this fiscal year and projected bold deficit cuts was viewed as ambitious when it was released in February. With the benefit of hindsight, it now looks to have been a pipe dream.
Instead, India’s slowdown is poised to worsen as the cumulative impact of 12 interest rate increases in 18 months squeezes demand, with growth set to fall below 7% in coming quarters, some economists predict.
Stubbornly high inflation far exceeding official forecasts has forced the Reserve Bank of India to continue raising rates even as growth slows and developed economies sink deeper into fiscal problems, making India a global outlier and threatening to prolong the duration and depth of its downturn.
The failure of inflation to respond to the RBI’s rate rises exposes the limitations of an economy that, without reforms to stimulate investment in more capacity, is unable to grow at the government’s wished-for double-digits without overheating.
“One of the reasons why India actually requires a period of relatively weak growth is that policy has just been too loose for too long, that the government is trying to achieve the unachievable,” said Credit Suisse economist Robert Prior-Wandesforde, who pegs sustainable growth at 7.5 to 8%.
Before the financial crisis, India’s growth topped 9% for three straight years, fuelling hopes it will someday outpace China, which is on track to grow about 9.5% this year.
Now, the lagged effect of rate rises, combined with worsening global demand that could hurt exports and impede capital inflows, darkens the outlook for Asia’s third-largest economy. The recent tumble in the rupee adds to an already heavy oil import bill and is a new source of upward pressure on prices.
India grew 8.5% in the last fiscal year but slowed to 7.8 and 7.7%, respectively, in the March and June quarters. Because it can take a year or more for policy rates in India to have a real impact, a tightening cycle that began in March 2010 has only recently begun to eat into demand.
“Preferably they would have done all this action earlier than they have done, and if they had acted rather earlier the ultimate peak in rates would have been lower than it’s going to actually be,” said Prior-Wandesforde, who expects growth of just 7.2% for this fiscal year and 7.3% the year after.
The International Monetary Fund recently cut its India growth forecast to 7.8% in 2011 and 7.5% in 2012, from 8.2% and 7.8% in June, respectively.
The price of hope
While governments everywhere like to put a rosy spin on things, that can be dangerous if it drives policymaking.
New Delhi’s aim to cut the fiscal deficit to 4.6% of GDP, set in the run-up to elections in five states, was based on a growth target that looks impossible now.
“The budget is not only an economic forecast ... it is also a political document. It’s also (to) tell the people that there are better things ahead,” said D.H. Pai Panandiker, head of New Delhi-based think tank RPG Foundation.
The RBI’s rate tightening, meanwhile, has been based on inflation targets that proved optimistic. The headline wholesale price index hit a 13-month high of 9.78% for August.
New Delhi’s budget target for more than $8 billion in state company share sales also looks optimistic, with investors in no mood to buy. A $2.5 billion share sale in Oil and Natural Gas Corp was recently put on hold.
Halfway through the fiscal year, the divestment program has raised just $250 million, fuelling market expectations that New Delhi will be forced to exceed its bond issuance plan and overshoot its fiscal deficit target.
While India bit the bullet in June after months of delay to raise diesel prices and ease its subsidy burden, it has not subjected them to market forces the way it has with petrol.
What could ride to India’s rescue is a sustained drop in the global oil price, which would provide relief both on the fiscal and inflationary fronts, although there is nothing Indian policymakers can do to make that happen.
Despite tax collections that are roughly on target, India is running far behind on its fiscal deficit goal, reaching 55% of the budgeted full year total after just four months, compared with about 24% at the same point last year.
Still, officials seem determined somehow to reach or come close to the deficit target, with a finance ministry official saying on Monday that the government maintains the stance that it has no intention of borrowing beyond its goal this year.
In perhaps the most bearish - or realistic - outlook yet from New Delhi during the current economic cycle, Montek Singh Ahluwalia, the influential deputy chairman of the Planning Commission, recently told Reuters that the base case for Indian growth is 7.5-8% in the next couple of years.
While New Delhi spends heavily on rural subsidies that win votes and drive up consumption, it is behind on spending to alleviate pressure on its roads, ports and power supply. India is on track to fall 10-12% short of its $500 billion infrastructure investment goal for the five years to March 2012.
Goldman Sachs expects India’s growth potential to fall to 7.6% in the next fiscal year, from 8% before the financial crisis, due to slowdown in supply side reforms and investment.
Poor infrastructure adds roughly 2% points to inflation in India, while up to 40% of fresh produce rots because of inadequate supply chains. A proposal to allow entry to foreign retailers such as Wal-Mart Stores Inc would ease food inflation but is stalled by political opposition.
Investment that would add industrial capacity has slowed as costs rise and manufacturers worry about demand. Problems with land acquisition and environmental clearances mean mining firms in coal-rich India spend billions to secure supply overseas, while power projects are delayed for lack of fuel.
Not known for speed at the best of times, the Indian government under Prime Minister Manmohan Singh has been all-but paralysed by a spate of corruption scandals that have distracted it from its reform agenda and weakened it politically.
“The problem is not about getting to a bottom,” said Sanjay Mathur, economist at Royal Bank of Scotland in Singapore.
“My worry is that, when you think the bottom, you think that things are going to get better, but no. We’ve had such sluggish policy momentum, reform momentum, that you could be bumping along for a long period of time,” he said.
With little help from New Delhi, RBI chief Duvvuri Subbarao has been left with the lonely task of increasing interest rates, most recently on 16 Sept, in the face of deteriorating conditions at home and globally.
Not everyone thinks he made the right decision.
“The impact of this hike will be felt only after a 2-3 quarter lag, by which time growth and inflation will have slowed considerably, and this may serve to exacerbate the downturn,” wrote Goldman Sachs economist Tushar Poddar.
In the absence of capacity addition, slowdown is exactly what India needs, some argue.
“I think there’s resignation that you have to accept a slower growth rate if you really want inflation to come down,” said Jahangir Aziz, chief India economist at JP Morgan.
“That realisation has come slowly,” he said.