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Business News/ Opinion / Online Views/  Indian economy is not yet out of the woods

Indian economy is not yet out of the woods

A market and currency rally shouldn’t be confused with a growth revival

Illustration by Shyamal Banerjee/Mint (Illustration by Shyamal Banerjee/Mint)Premium
Illustration by Shyamal Banerjee/Mint
(Illustration by Shyamal Banerjee/Mint)

An impressive stock market rally, a smart recovery by the rupee, the lowest trade deficit in four months, a slender improvement in industrial output, some hints of weakening consumer inflation: Is the Indian economy finally on the mend?

There has been a distinct buzz of optimism over the past two weeks as if the dramatic events of July and August are but distant memories. Much of the recent optimism is premature. It is quite likely that India will end the fiscal year with a lower current account deficit as well as more muted inflation, but a vigorous resurgence in economic growth is nowhere on the horizon.

Let us consider inflation first. The large negative output gap that has opened up—because the Indian economy is growing below its potential—will necessarily be disinflationary. The past few months have already seen a sharp fall in wholesale price inflation. Consumer prices continue to gallop as close to double-digit rates, however. The prospect of a bumper year for farm output will hopefully put a lid on food prices. So inflation should continue to gradually cool down unless a war in West Asia sends global oil prices sky high.

There could be some welcome relief on the external front as well. The current account deficit is still the biggest single threat to economic stability. A combination of two factors—administrative measures to restrict gold imports as well as a push to exports because of a weaker rupee—will likely help control the current account deficit. The government says it will keep the current account deficit to $70 billion compared with private sector estimates of $85 billion. Even the government target is at least $20 billion higher than what can be considered safe in a volatile world (or around 2.5% of a $2 trillion economy). It is thus quite likely that the Reserve Bank of India will have to draw down its foreign exchange reserves to partly fund the external gap.

The bigger challenge will be reviving growth, which is now about four percentage points below its peak during the boom years. A good monsoon will likely provide a boost to rural demand, though it remains to be seen how the positive effect on farm incomes from higher output is balanced by a negative effect from lower farm prices.

It is worth remembering that the government has already committed itself to far more modest procurement price increases than in the past decade. However, the net effect of a good agricultural year is bound to be generally positive for the Indian economy. The other boost to growth could come from higher exports, if the recent revival is any indication.

Rural demand and foreign demand could, thus, act as buffers for the Indian economy in what continues to be a difficult year.

Yet, a sustainable growth revival requires a decisive turn in the investment cycle. In particular, corporate investment has to get back on track. There are no signs as yet that this is happening.

The government is trying out administrative measures to quickly clear large projects. The public sector units are also being pressurized to use the massive cash hoards they are sitting on.

But these measures will offer only temporary relief. The bigger problem is the vitiated business climate thanks to five years of ridiculous policy decisions. Deteriorating corporate financials are also a growing challenge.

India does not have adequate space for any stimulus right now. The fiscal deficit is already too high, and a fiscal stimulus will push India closer to a ratings downgrade. Monetary stimulus should also be ruled out given the high levels of consumer inflation as well as hardening interest rates in other countries. Narrowing the gap with global inflation at this juncture could lead to further capital flight from the local bond market.

The ongoing situation brings back memories of the state of the Indian economy at the turn of the century. The Asian crisis of 1997 had pulled down economic growth, yet inflation was high and India continued to have a large current account gap. It was only by 2002—or four years after the Asian crisis ended—that inflation was moderate and the current account was in surplus. Fiscal correction had also begun in earnest.

The upshot: The economy stabilized well before it was ready for its splendid growth acceleration between 2003 and 2008. Like it or not, that will likely be the timetable this time around as well: economic stabilization followed by a growth revival.

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Published: 15 Sep 2013, 06:26 PM IST
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