India: unchained tigers will help growth

2004 has been a surprisingly good year. The world economy grew at an estimated 5%, according to the IMF?s September 2004 World Economic Outlook, the highest in three decades. Stock markets went up, as did housing prices. Inflation remained in check. China and the US both continued to drive global growth in different ways. Politically, many things could have gone wrong, and some have, but not enough to derail the economic expansion. One can say quite confidently, however, that 2005 will be worse for the global economy. Maybe not a whole lot worse. IMF chief economist Raghuram Rajan, was recently quoted as predicting better than 4% growth for 2005. However, there are reasons to be less optimistic.

One expert, Fred Bergsten of the Institute for International Economics in Washington, DC, highlights five risks that threaten world economic growth: the United States? federal budget deficit and its current account deficit, international trade protectionism, high oil prices, and an abrupt slowdown in China?s economy. The last three of these are obvious in their negative impact on economic expansion. The impact of the first two bears further discussion. The twin US deficits are not necessarily causally related. Nevertheless, their coincidence does mean that other countries, rather than US citizens, are financing the US government deficit. In a Latin American country, this would be a recipe for disaster. So far, the US has proceeded blithely, growing through high consumption of imported goods, ultimately made possible by foreign borrowing. Interestingly, China has effectively taken on the role of provider of goods and the credit required to purchase them.

My colleague at UC Santa Cruz (and part-time at Deutsche Bank), Michael Dooley thinks this situation is fine, and can last even for a decade, because the Chinese government will want to ensure continued export-led growth. However, the US imbalances are just too large. We can see their effect in the large decline of the dollar against the euro over the past three years. Asian currencies attempt to maintain dollar pegs, so the euro has borne the brunt of the dollar?s adjustment. With US elections over, it is fair to guess that 2005 will see tightening of monetary policy, which has been exceptionally lax in recent years. Real interest rates have some way to rise before they are even neutral, rather than stimulating a growing economy. The US economy is also seeing some job growth, so labour markets will tighten, and this, too, will spur tightening by the US Fed. The US budget deficit will also receive attention, with the Republicans almost surely following a strategy of expenditure cuts rather than tax increases. The likely consequences: slower US growth in 2005, and not a great year for US stocks or house prices.

Add US fiscal and monetary tightening to high oil prices, a Chinese economy that is also being reined in, and continued frictions in international trade, and one can easily see why the new year may not bring as much global economic cheer as the old one. This is the scenario even without any unpleasant political shocks, so one has to be cautious about the global outlook.

What does this all mean for India? A global slowdown must have some negative consequences. If US job growth dries up, protectionist pressures aimed at outsourcing will return. Foreign investment may weaken (especially if foreign CEOs are arrested so cavalierly), making infrastructure improvements that much harder. India?s own fiscal deficit remains a drag on the economy, because government money is poorly spent, and its financial sector still has too many closeted skeletons. What is surprising is how well the Indian economy does, despite its handicaps. It is predicted to chug along, growing at 6% in 2005.Foreign reserves are more than ample.

While policymakers deserve great credit, the unsung heroes of India?s economy have been the Indian entrepreneur and manager. They have created dynamic, globally competitive companies. They proved themselves in the global boom of the 1990s, and in the bust that followed. Yet these tigers remain weighed down by policy chains. Policy initiatives such as more rational labour laws, removal of small scale industry reservations, improvements in the efficiency of financial intermediation (and higher savings) and breaking down internal trade barriers, will all give India?s entrepreneurs and India?s economy, greater ability to weather future global storms in 2005 or beyond. And only unchained tigers will give India growth at East Asian levels.

The author is professor of economics, University of California, Santa Cruz