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The recent policy measures announced by the Union government do not seem to have convinced foreign investors. Photo: AFP
The recent policy measures announced by the Union government do not seem to have convinced foreign investors. Photo: AFP

Reform or reaction?

Disagreements are no longer about the pace, phasing and sequencing of reforms but about their substance

The recent policy measures announced by the Union government may have managed to stir the Sensex but have done precious little for the overall sentiment or the substance of business.

The measures, aimed at buoying capital and debt markets by increasing the flow of foreign capital, do not seem to have convinced foreign investors. Nor has the promise of rolling back general anti-avoidance rules or GAAR. These measures have even failed to comfort the rating agencies, which are still threatening to downgrade India’s sovereign rating to junk status.

Indeed, the real motivation for, and the reactions to, the so called “reform push"—approval of foreign direct investment (FDI) up to 51% in multi-brand retail, in insurance up to 49% and in pension also up to 49%, changes in the Companies Bill and the Competition Act and amendments to the Forward Contracts Act—have done more damage to India’s long term prospects instead of furthering its cause.

This is because unlike the 1991 reforms and all the subsequent ones, the current measures lack consensus across the political spectrum. If anything, it has brought to the fore the serious political differences on matters of economic policy. It is perhaps for the first time that such severe political opposition has been expressed against reforms.

The reforms of 1991 succeeded and were sustained largely because there was a consensus on the substantive part of the new economic regime towards which a transition was being made. No wonder, these survived half a dozen disparate governments.

It was this consensus on the nature of economic policy cutting across parties that played a crucial role in making them successful. Not only was there continuity but also a great deal of certainty—both for foreign and domestic participants—about the direction of economic policy. Even if there were doubts and concerns about its speed.

This consensus has all of a sudden been shattered by the recent policy pronouncements. It is too high a price to pay for showing that the government has come back to life or even to dispel the widely held notion of policy paralysis.

The disagreements are no longer about the pace, phasing and sequencing of reforms but about their substance. This will considerably reduce the effectiveness of reforms. And as a signalling device, it will lose its power to communicate the intent of the government, be it to the domestic or the foreign investor.

These reform measures lacked conviction but one possible reason why there were carried out was to address an emerging short-term problem on the external account.

With every passing month, the balance of payments has become worse. The latest balance of payments data for April-June 2012 makes it abundantly clear that India is facing stress on its external account. The trade deficit has increased to 10% of gross domestic product (GDP). Even this is an understated number, aided mainly by a whopping 47.5% decline in gold imports on the back of an increase in the import duty.

The net services exports, normally a bright spot for India, have declined by 13%. At the same time, investment income payments (made by Indian entities on their external liabilities) have increased 14.5%. At the same time, FDI has more than halved from $9.3 billion to $4.2 billion. Portfolio investments saw a net outflow of $2 billion compared with an inflow of $2.3 billion for the same period last year.

The net loans availed by banks have declined a whopping 74% from $11.5 billion to $3 billion suggesting a weakening demand for credit. What is worrying is that, at the same time, short-term trade credits have spiked up 74% from $3.1 billion to $5.4 billion, which may suggest liquidity and working capital pressures for Indian entities.

Exchange rate depreciation alone has accounted for a 0.7 percentage point increase in the current account deficit to GDP ratio during April-June 2012.

The only redeeming feature has been the rise in non-resident Indian deposits from $1.2 billion to $6.6 billion, on the back of deregulation of interest rates. However, this may be a temporary effect that may not be sustainable.

Given this scenario, the government seems to have realized the need to keep the rupee strong and stable. And that, more than anything, appears to have driven the recent reforms push.

That the stress on the external balances is worsening is confirmed by the data for September. The trade gap has widened to $18.08 billion from $13.19 billion in September last year. On a month-on-month basis, it is substantially wider than the August deficit of $15.6 billion.

It is this short-term fragility and vulnerability of the external balances more than a well thought out long-term plan—economically as well as politically—of attracting foreign capital to alleviate the constraints that underlie the recent reform push.

Haseeb A. Drabu is an economist, and writes on monetary and macroeconomic matters from the perspective of policy and practice. Comments are welcome at haseeb@livemint.com

To read Haseeb A. Drabu’s earlier columns, go to www.livemint.com/methodandmanner

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