This exclusive monthly article series, courtesy Al Mulla International Exchange Company, is devoted to Indian macroeconomic policies against the backdrop of an increasingly integrated global economy. These articles would be oriented towards addressing the concerns of overseas institutions/individuals with interest in the Indian economy. As a curtain raiser, this first article in the series, which will appear over two weeks, provides an overview of the Indian economy as it has evolved over the years.
Long-Term Evolution of Indian Macroeconomic Policies: A Broad Brush Approach
India has all along been a ‘Continental Economy’ with limited interface with the global economy. World War II brought about stringent Exchange Controls and the advent of the ‘Command Economy’, wherein the role of the government became predominant. With the advent of Planning in 1951, and more particularly the Second Plan (1956-61), the emphasis was on developing heavy industry and ‘import substitution’ became the watchword. With the continuing stringency in availability of foreign exchange, macroeconomic policy was preoccupied with management of scarce foreign exchange. The command economy was all pervasive and virtually all economic activity was subject to the rigours of the licence/permit regime.
As an attempt was made to increase the growth rate from 3-4 percent to 5-6 percent, it became necessary to increase investments in the infrastructure which had a long gestation lag. Hence, higher growth rates required a more than proportionate increase in investments which in turn required higher savings.
Although 1990-91 is considered as a watershed, as it heralded a strong tilt towards liberalisation, it bears mentioning that in the 1980s considerable efforts were made to rationalise controls and prepare the ground for a move away from the stringent controls regime.
In the pursuit for higher growth rates, particularly after 1997, the policy was to make investments more attractive and this resulted in a preference for lower interest rates and strong fiscal incentives for investments. As a consequence, there was a slowdown in savings. Investments as a percentage of nominal GDP peaked at 38.1 percent in 2007-08 while savings were 36.8 percent. In 2012-13 investments fell to 35.0 percent while savings fell to 30.2 percent. The gap between investments and savings rose from 1.3 percent in 2007-08 to 4.8 percent. Shorn of the jargon, the macroeconomic identity is that the gap between investment and savings is the balance of payments current account deficit (CAD).
Global Slowdown and Indian Macroeconomic Performance
When the global financial crisis emerged in 2007-08 it was felt that the Emerging Market Economies (EMEs) would be unaffected by the global crisis, but it was soon realised that the EMEs would also experience a slowdown. Moreover, the EMEs had serious domestic problems of their own which would require considerable adjustment.
Global growth in 2013 is expected to be sluggish at 3.1 percent, the same as in the previous year. The growth of the developed countries is expected to be about 1.2 percent while EMEs would grow at around 5.0 percent. The expected bounce back in the developed countries has been belied but with somewhat marginally better performance in the US, Japan and the UK but distinct recession in the Euro area. In the recent period the much hyped tapering of the US Federal Reserve Bank’s Quantitative Easing did not take place in September 2013 and when it does eventuate it will be more gradual than envisaged earlier. The EMEs need to recognise that interest rates in the developed countries would, sooner or later, rise. While the tapering of the easing has been postponed, India and the other EMEs have a short window of opportunity to prepare themselves for the unwinding of the US Quantitative Easing.
Recent Indian Macroeconomic Developments
In India, after an average GDP growth of 8.8 percent during 2005-06 to 2008-09, there was a sharp decline from 9.3 percent in 2010-11 to 5.0 percent in 2012-13. In 2013-14, the growth rate is projected at 5.3 percent (The Prime Minister’s Economic Advisory Council, Economic Outlook for 2013-14, released in September 2013, provides an excellent overview of the problems, prospects and policy directions.) While private estimates are that the growth rate in 2013-14 could be lower than the official projections it needs to be recognised that notwithstanding sluggish industrial growth, agricultural output would pick up and, as such, the overall growth rate could be, at least, 5.0 percent.
Inflation in India has accelerated in recent years. From a position where India was one of the EMEs with low inflation rates it is now one of the countries with relatively high inflation rates. The Wholesale Price Index (WPI), at the end of March 2013, on a year-on-year basis showed an increase of 5.7 percent. The Consumer Price Index (CPI) inflation has been elevated at 9-10 percent. The world over it is the CPI which is used as a measure of inflation. Although the CPI is also monitored in India, overall economic policy excessively focuses on the WPI. This approach is flawed and distorts overall policy.
10. The Central government’s budget deficit is projected in 2013-14 at 4.8 percent of GDP but of this the Revenue Deficit is 3.3 percent. Taking into account the States deficit, the combined deficit could be of the order of 7.5 percent of GDP in 2013-14; such a large deficit is a drag on the economy. Given the burgeoning food and fuel subsidies, political economy considerations are unlikely to permit any drastic reductions in these subsidies in 2013-14
Current Account Deficit (CAD)
11. The CAD of 4.8 percent of GDP in 2012-13 and the projected CAD of 3.8 percent in 2013-14 are clearly unsustainable. The CAD to Current Receipts (i.e exports of goods and services and other current receipts such as remittances) ratio is 20 percent. A gap of 20 percent between Current Receipts and Current Payments is a cause for great concern. The Indian authorities view a CAD/GDP ratio of 2.0-2.5 percent to be sustainable (Rangarajan Committee Report 1992). More recently, Dr. Y.V. Reddy has posited a seminal idea that since the CAD would vary over the economic cycle, the most secure position would be a CAD of 2.5 percent at the peak and an average of zero, implying thereby that over the cycle there should be years when there should be Current Account Surpluses. Dr. Reddy’s formulation is something that the authorities should work towards in the medium-term but this is not within the realms of possibility in the immediate ensuing period.
Financing the CAD
The financing of the CAD needs to be clearly delineated from the reduction of the CAD. The financing of the projected CAD of 3.8 percent of GDP in 2013-14 (US $ 70 billion) would be easily financed through foreign direct investment, portfolio investment (expected to be small), External Commercial Borrowing and banking capital flows.
It is important to recognise some of the vulnerabilities of India’s external sector. As of June 2013, the short-term debt (less than one year) on a residual maturity basis amounted to US $ 170 billion (44 percent of total external debt) and equivalent to 60 percent of total foreign exchange reserves. Moreover, portfolio investments outstanding amounted to US $170 billion, of which US $ 39 billion are in debt securities. The experience the world over is that periods of large portfolio inflows are followed by periods of large portfolio outflows and as such this vulnerability needs to be taken into account in any assessment of India’s external payments position.
Reduction of the CAD
Reducing the CAD can be achieved by a combination of policy instruments viz. (i) deflating the economy through fiscal policy, ( ii) direct controls on capital outflows, (iii) exchange rate adjustment and (iv) monetary policy.
The fisc is already under stress with competing needs for expenditures and the need to moderate taxation while the economy is slowing down. A drastic cut back in government capital expenditure would impact adversely on private investment, especially in areas where private industry is dependent on sales to the government. A drastic reduction in revenue expenditure would require a reduction in subsidies which may not pass the political economy test. If the red line of the fiscal deficit of 4.8 percentage of GDP in 2013-14 is maintained it would be a major achievement.
Direct Controls on Capital Outflows
At the worst of times India has not attempted to curb capital outflows by non-residents. In the recent period, capital controls were imposed on outflows by residents for both corporate and individuals. These outflows are, as it is, small and would not have any material impact on the CAD. In fact, it generated fears that curbs on outflows on non-residents would be next on the cards. The authorities have done well to clearly assure that there would be no curbs, whatsoever, on non-resident capital outflows. Furthermore, the curbs on resident corporates have been eased. As part of its October 2013 monetary policy review the RBI could alter the adverse sentiment overseas if it were to raise the resident individual annual capital outflow limit from US $ 75,000 to US $ 100,000 and also assure that the erstwhile limit of US $ 200,000 would be restored in a calibrated manner.
By S.S. Tarapore
“Savak Sohrab Tarapore, B.A. (Honours Economics) Sheffield University (1958), MSc.(Economics) London University (1960) and Doctor of Laws honoris causa, Sheffield University (1996) was a career central banker. He joined the Reserve Bank of India in 1961 as a Research Officer in 1961 and retired as Deputy Governor in 1996.During 1971-79 he was seconded to the International Monetary Fund. Since retirement he has chaired a number of official Committees/Boards and he is a regular columnist in financial newspapers.