Friday, August 17, 2012

Rediscovering the growth magic

Over the last six months there has been an increasing sense of pessimism regarding India’s economic future. Is the growth story over? Was the eight-nine per cent growth a temporary aberration of a few years when the global economy itself was doing so well? Perhaps, there was no real takeoff and hopes for sustained double digit growth rates were the result of unwarranted euphoria. There has been for quite some time now persistent high inflation, high interest rates, rising fiscal and current account deficits and declining growth rates.


To add to the negativity of the domestic perspective, the international environment could not have been bleaker. The advanced economies of the U.S., Europe and Japan are still struggling with the consequences of the 2008 financial crisis. Europe is in a crisis regarding the future of the euro itself. A political consensus on a clear road map for the way forward is still a work in progress with deep differences in both diagnosis and policy prescriptions.

If the pessimists are right then the best case scenario may be to assume that perhaps by 2015, Europe and the global economy would have recovered, India may by then have been able to undertake necessary but difficult ‘reforms’ and then, perhaps, higher growth rates could be hoped for.

But are some underlying trends being missed? When the 2008 global financial crisis hit India, the economy suddenly went into a free fall. The general consensus then was that India would be in for a prolonged period of difficulty, and recovery would occur along with that of the rest of the global economy. India surprised itself and the rest of the world by its extraordinary, swift and robust recovery and that too with a stimulus package that was crafted and implemented as the country went in for a general election. The actual fiscal stimulus was quite modest; less than one per cent of GDP and considerably less than that of most others. What made rapid recovery possible was that it was domestic demand driven.

Domestic demand rose substantially on the back of some earlier political decisions (seen with unease and apprehension by most mainstream economic analysts); the positive wealth effect of the write off of farmers’ loans, the improvement in the terms of trade for farmers through higher support prices, and higher salaries for state employees on the implementation of the Pay Commission’s recommendations. In contrast, in the U.S., the negative wealth effect due to a sharp fall in housing prices as well as stock market was so steep that consumer demand fell sharply. Recovery is still a work in progress.

A combined and well coordinated fiscal and monetary stimulus was feasible as there was policy space. The Reserve Bank of India had been raising interest rates to prevent overheating of the economy and inflation, which had shown upward movement, had come down and so the RBI could lower interest rates significantly. Tax revenues had been growing rapidly with both manufacturing and services growth rates being in double digits in the preceding years and so there was fiscal space. The fiscal stimulus was not grandiose but aimed at creating demand immediately in the coming months across a wide spectrum, ranging from increased expenditure for Bharat Nirman projects to grants for purchase of buses for public transport in cities.

The world suddenly took note of what appeared to be India’s unusual strength, the ability to achieve high growth rates on the basis of domestic demand. Historical experience suggests that inclusiveness has been conducive for growth if growth is not to be export led. This was the essence of the American experience for over 50 years in the 20th century till the 1970s, from the time Ford successfully made and sold its cars to ordinary people who also became industrial workers with growing real wages. Larry Summers, the eminent American economist, in an unusual speech in 2010 referred to the possibility of the World in 2030 acclaiming the success of the Mumbai consensus rather than the Shanghai or the Washington consensus; the strength of the Mumbai consensus being domestic demand driven inclusive growth in a robust democratic framework. This was in contrast to the state driven export led growth paradigm of East Asia, the allusion to the Shanghai consensus, which was no longer feasible due to the emerging difficulties in the West which had no option but to make serious structural adjustments. The Washington consensus of liberalisation, privatisation and deregulation with the faith in the market to deliver the best possible outcomes had crossed its useful shelf life with the global financial crisis in 2008.

Business cycles and recessions have been normal to open free market economies since the advent of industrialisation. Since our transition has been somewhat recent, the reality of “recessions” has yet to sink into our understanding and discourse. If we look at IIP numbers, we were in negative growth territory for some months. The reasonable questions would then be: when to expect recovery, what would be its nature, feeble or robust, and how to try and strengthen it? With tight monetary policy in response to high inflation, excess demand should have been squeezed out of the system by now and this seems to be indicated by core inflation numbers. If this indeed is the case, then recovery should, indeed, be around the corner. Credibly signalling fiscal responsibility would hasten lowering of interest rates by the RBI. Becoming more investor friendly would naturally help in turning market sentiment around.

The sharp depreciation of the Rupee is a real blessing at this juncture. It has, in the course of a few weeks, undone the appreciation of the real exchange rate that had taken place due to the difference between our higher inflation rates and those of our major trading partners. This should address the current account deficit as devaluation is a time tested remedy. What is more important, depreciation of this order should be of great advantage to domestic value addition in manufacturing both for the domestic market as well as for exports; with the open domestic market being more important in the current state of the global economy. India’s reluctance to see the advantages of a competitive exchange rate and to pursue it could be a reflection of the weakness of the political constituency for manufacturing in comparison to that for trade and consumption. Brazil, for instance, has been vocal about the appreciation of its currency due to capital flows. It even attempted measures to moderate this to preserve competitiveness in manufacturing.


The real discussion needs to focus on how to make the recovery robust enough. Given the international situation, it would depend entirely on the success in promoting domestic demand. Without raising the fiscal deficit, the state needs to find innovative ways to drive much larger investment flows into infrastructure to reduce the competitive disadvantage that exists. Mitigating policy and regulatory uncertainty and hence risk is what investors seek rather than big ticket reforms, which would benefit over the medium term rather than in the coming quarters. Going by recent experience, inclusiveness would be critical for higher growth. Inclusiveness is not something unproductive that can be afforded with growth but is essential for it. Bharat Nirman needs to be carried further in terms of 24x7 electricity, an essential requisite of the last century, and broad band, the essential requirement of this century. Bridging the divide between India and Bharat could make the difference between a modest recovery and a surge to plus-nine per cent.

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