Reform or Regress

Written by KG Narendranath | Updated: Dec 31 2011, 05:34am hrs
Around this time last year, India seemed to be re-entering the high-growth phase. With 8.9% GDP growth (now revised to 8.6%) in the first half of 2010-11, many thought the economy was more or less back on the perch from where it slipped owing in part to the financial meltdown contagion. But that was not to be. The situation and its perception changed dramatically in a year, so much so that when finance minister Pranab Mukherjee said earlier this week the economy would revert to the high growth trajectory soon, few believed him.

In Economic Survey 2010-11, the government had confidently predicted 9% (+/-0.25%) growth for 2011-12. (Indias real GDP had grown at an annual rate of close to 9% during 2003-08, falling to 6.8% in 2008-09 but picking up resiliently to 8% in 2009-10 and 8.5% in 2010-11). The survey referred to savings and investments that showed positive momentum to justify its forecast but listed among possible downsides a somewhat tenuous situation regarding the global economy. According to its authors, the other factors that could impact its accuracy were a (probable) sharp deterioration in weather conditions and a (possible) disproportionate spike in crude price.

A year later, it is clear the global situation has turned out to be worse than expected. Goldman Sachs has cut its 2012 global growth prediction to 3.2%, adding the euro zone economy would shrink 0.5%. Crude has averaged around $110 per barrel so far against $85 last year.

Thanks to favourable weather and a relative pick-up in agricultural investment during 2005-10 (when the investment growth stood at 12.5%), farm output grew at 3.9% and 3.2% in the first and second quarters, respectively. For the sector that has been a laggard for long negative growth of 0.1% in 2008-09 and a near flat growth of 0.4% in the drought year 2009-10 those were rather good figures, especially since they came on the previous years somewhat high base.

Grain output, the key ingredient of farm GDP, is poised to break last years record 241.5 million tonnes the crop year ending June 2012 will produce 245 million tonnes. So, if the survey forecast of 9% now looks woefully off the mark (the finance ministry has scaled down its forecast to 7.5%, +/-0.25% in its mid-year analysis), the farm sector is little to blame. The sector, anyway, accounts for under 15% of GDP.

The issue is the general slowdown in investment and the inability of private consumption (consumer demand grew just 5.9% in the second quarter) to replace government expenditure (fiscal stimulus focused on spurring consumption). More precisely, there is a need to bolster the productive capacity of the economy through reforms. The economy could already be growing above its capacity, which would explain the persistent high inflation, rather than temporary supply constraints. (Headline inflation was above 9% in 21 out of the past 22 months, despite monetary tightening since March that took the repo rate to 8.5%).

Forget the monsoon failure of 2009, inflationary pressures had been building right from 2006-07 due to the widening demand-supply gap for food (thanks to a 7.5% rise in per capita income in the boom period of 2003-08). The real reason for the stickiness of high food inflation (which fell to a six-year low of 0.42% for the week ended December 17 after running high for several months) is the fall in productive capacity in agriculture, which has seen no worthwhile reform for years. So the farm sector holds potential to grow and raise its share in GDP if a market-oriented pricing mechanism is brought in.

Goldman Sachs says the current slowdown has been concentrated in industry (read manufacturing and mining). Indias industrial output shrank 5.1% in October owing to a fall in production in manufacturing, mining and capital goods. This worrying piece of data came on top of the dismal 6.9% GDP growth for Q2 (which saw a 2.9% contraction in mining and sharp decline in manufacturing growth to 2.7%).

The Economic Survey writers said investment was recovering but, in hindsight, their statement was made in haste. Growth in gross fixed capital formation (GFCF) had recovered to 8.6% in 2010-11 from 1.5% in 2008-09, but it was still below the pre-crisis level of around 15%. The recovery (which some say was nothing but delayed release of investments committed in a cycle that was about to end but was disrupted by the global crisis) could not be sustained in the absence of necessary policy action/facilitation and weakened sentiments of both domestic and foreign investors.

That investors are little convinced in India is apparent from a 0.6% fall in GFCF in July-September a growth of 7.9% in the previous quarter. Increasingly unsure of the Indian economy's prospects, foreign investors pulled out in a big way, despite the uncertain global scenario that left them with few choices.

Nine months into the fiscal, FII investments in equities remain evened out against record purchase of $29 billion in 2010. The Sensex has lost over 35% in dollar terms in 2011, contributing to the shrinking of the countrys market cap to below $1 trillion from $1.6 trillion a year ago. This has brought to the markets the dubious distinction of being the underdog among peers. This contrasts with last years situation when India was among the best-performing markets.

The rupee has plunged 15% since October owing to net capital outflows. While a dip in exports has been more evident from October, a sharp spike in oil and gold & silver imports (43% and 55%, respectively, in April-November) has strained the current account. The deficit on the account will likely see an unprecedented expansion in the October-December quarter at $20 billion or about 40% of the deficit projected for the whole fiscal and could be 3-3.5% of the GDP for the full year, a level not seen since 1990-91.

The situation would look even more grim if one looks at the aggregate year-on-year bank credit growth which moderated to about 17% from 22% at the start of the fiscal. Crisil forecasts credit growth to remain at 17% by March 2012).

The countrys fiscal deficit in April-November is pegged at R3.53 lakh crore or 86% of the full-year target, with the current run rate of tax revenues being 7.3% against the Budget estimate of 17.9% and that of expenditure being 10.2% against the budgeted 3.4%. Citigroup India estimates fiscal deficit at 5.1-5.8% of GDP against the budgeted 4.6%.

The economy needs reforms in several areas labour market, pricing mechanism for farm goods, water, electricity, fertilisers and revamp of the public distribution system to raise its productive capacity. The growth this year could be significantly below the latest official estimate. Unless necessary reforms are carried out, the economy will likely slip into a phase of moderate expansion of 5-6% for several years, as was seen after 1994-97.