We are faced with a declining investment-to-GDP ratio thanks to a sharp fall in private fixed asset creation. Gross fixed capital formation is down from its peak of 34.5% of GDP in 2008 to 30.6% last quarter. This is, by far, the most important reason why GDP growth continues to decelerate, and may become even more sluggish in the coming quarters.
But growth is not our only challenge. Our savings ratio has been declining at an even faster pace than the investment-to-GDP ratio. Consequently, the current account deficit, which is nothing but the savings/investment gap, has been widening from the already elevated level of minus 4.5% of GDP in March 2012 to an estimated minus 6% in January 2013. Even in a liquidity-surplus global economy we cannot be sanguine about this. If fickle FII investors lose faith in the resilience of the Indian economy and/or should US growth surprise on the upside, we could see a rapid withdrawal of international capital from Indian markets, triggering a change in exchange rate expectations that RBI would find difficult to tackle. Financing a deteriorating external balance in a slowing economy is a tricky business. At the moment, we are flirting with potentially-serious macro instability.
To make matters worse, CPI inflation continues to rise despite an incipient moderation in WPI inflation. In fact, the gap between CPI and WPI inflation has widened significantly, implying that real interest rates are negative for households who contribute the largest share of bank deposits, and very high for corporates that are the most dependent on banks for their borrowing. As a consequence, households are deploying their savings into gold and other real assets instead of bank deposits, and corporates are turning to cheaper non-bank sources of debt financing. As I have argued elsewhere, this weakens the transmission mechanism of monetary policy. Under current circumstances, not only would cutting interest rates not translate into a strong growth response, it could make our external accounts even weaker by further fuelling gold imports and making India less attractive for yield-seeking foreign capital. Gold imports, year to date, are a whopping $37 billion, similar to last year.
What is to be done Here are a few suggestions. The immediate focus must be on reducing the risk of instability stemming from the deteriorating external accounts. For this, the goal must be to reverse the decline in domestic savings through aggressive fiscal consolidation. It is no longer enough to meet the 5.3% fiscal deficit target for this year. The Budget must signal a credible path to 4.8% next year. Given the timetable for national elections, it will not be easy to overcome market scepticism, but it is essential that Mr Chidambaram prevails. A temporary surcharge on income tax, particularly for the higher income brackets, and a cut in allocations to ministries with a poor utilisation record may not be a bad idea. But an aggressive technology-based plan to improve tax compliance, and a reduction in total spending on subsidies must be his highest priorities. For the latter to pass political muster, a lot will depend on more effective targeting through direct cash transfers.
Second, the problem of food inflation must be tackled aggressively to break the back of CPI inflation. There should be a moratorium on any further increases in administered prices of food. Our burgeoning stock of rice and wheat should be run down by selling some into the open market both domestically as well as internationally. This would drive the market price of foodgrains down, bolster our export earnings, and help reduce the food subsidy bill, while protecting the urban and rural poor. The case can and must be made that this is also smart electoral strategy.
Given the compromised effectiveness of monetary policy, the finance minister must also carry the burden of reviving investment for now. He must build the National Investment Fund by earmarking disinvestment proceeds for public spending on infrastructure development instead of using these funds to plug the revenue deficit. He must not raise corporate taxes or tinker with the corporate incentive structure at this time. The government of India should, in mission mode, launch an aggressive improve the ease of doing business campaign as a follow up to the creation of the Cabinet Committee on Investments. Most importantly, the problems of the power sector, particularly as relates to the availability of coal, gas and the cash situation of state electricity boards, must be addressed on a war footing. Given the rising risk aversion of domestic banks, the time is right to widen the definition of priority sector lending to include financing for certain types of infrastructure projects. Without a revival in infrastructure spending we will not return to an 8-9% growth rate.
Finally, and only once we have evidence that the external accounts are stabilising, the above measures must be complemented with aggressive monetary easing.
It is a tough road ahead. We must be clear-headed and coordinated about the sequencing of policy actions and determined to execute expeditiously. Perhaps the most important task of the finance minister is to communicate to all that business as usual is not an option.
The author is vice-chairman & managing director of IDFC