Home / Opinion / The Indian economy is in a deep mess

The Indian economy continues to face strong headwinds. A quick look at some of the data published by the International Monetary Fund (IMF) in its latest report on the global economy brings out very clearly that India is perhaps the most vulnerable among its peers. Consider these three data points:

Exhibit one: IMF has indicated that it now expects most major emerging markets to grow at a slower rate in 2013 than what it had earlier predicted in July. The reduction in the Indian growth forecast is by far the steepest: 1.8 percentage points, or more than three times the average reduction in emerging markets as a whole.

Exhibit two: The sharp slowdown has been accompanied by some of the highest rates of consumer price inflation among emerging economies, and about twice the average rate for emerging Asia. There is a similar story on the external front, with India having one of the biggest current account deficits. This unusual combination of a sharp slowdown and macroeconomic imbalances is a definite cause for concern. The previous slowdown during fiscal 2003 was accompanied by low inflation and a current account surplus.

Exhibit three: The potential growth in the BRICS club—Brazil, Russia, India, China and South Africa—has fallen since the crisis. Potential growth is the rate at which an economy can expand with stable inflation. India’s potential growth rate has fallen by 1.6 percentage points since 2011, according to IMF calculations—from 7.3% to 5.7%. None of the other BRICS economies have seen such a steep fall in their potential growth rates. It appears that nearly half of the Indian growth slowdown since 2011 is accounted for by a reduction in potential growth while the other half is from cyclical factors.

All these are worrisome indicators, and need to be heeded by all those who have been taken in by a new sense of optimism over the past few weeks. The prospect of a good harvest will undoubtedly provide a boost to domestic demand and the rupee depreciation could boost exports. But the noxious combination of slowing growth, double-digit consumer inflation and a record current account deficit is a quick indication that at least part of the economic slowdown is structural rather than cyclical. The new IMF estimates of our growth potential only provide heft to this sort of reasoning.

All calculations of the potential growth rate—be they using statistical techniques such as the popular Hodrick-Prescott filter or by estimating production functions—are at best approximations. There are other estimates that seem less glum that those released by IMF on Tuesday. But just about every serious econometric study shows that there is more to the Indian growth slowdown than just temporary cyclical factors, whatever government economists may claim.

The core problem continues to be the collapse in investment activity over the past couple of years, especially new capacity creation by the corporate sector. It is well known that the potential output is inextricably linked to the investment rate in an economy. What is even worse is that the supply-side freeze has been accompanied by a persistent stimulus to demand that has stoked high inflation. Neither the fiscal nor the monetary stimulus introduced at the onset of the global financial crisis was withdrawn on time, which meant that demand was pushed up while the supply side was rigid. It should be no surprise that India has been walloped by high inflation.

It is too early to write off the India story. India continues to have a high savings rate that can provide the resources when the investment cycle turns. The Indian economy began its acceleration in 1980, and growth has averaged around 6.5% over the past 33 years, over several economic cycles. There is no reason to believe that such a growth momentum cannot be regained in the coming years, but it is unfortunate that a great opportunity to raise the sustainable growth rate even further has been missed. Much of the failure can be explained by the lack of adequate economic reforms since 2004 and the fiscal profligacy we have seen since 2008.

In short, the Manmohan Singh government will leave behind a set of economic problems that cannot be explained away as cyclical snags that will soon go away. The new numbers from IMF only underline this harsh reality.

What does India need to do to end its structural economic problems? Tell us at views@livemint.com

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