The Indian Economy: Hubris, Nemesis....but Redemption is many years away

It’s rather unusual, if not unprecedented, if in the same week India features on the front page of the Financial Times, and is the subject of a leader in The Times. Consider also these headlines this week in the Wall Street Journal about India: “Shoppers, Shopkeepers Worried About Prices”, “Rupee Decline Hits Study, Emigration Plans”, “Rupee Fall Damps Festival Gold Buying”. These headlines are not what India needed after it celebrated Independence Day, and launches of an aircraft carrier and a nuclear missile submarine. Although not directly related the price of onions rose to UK levels this week. Prices rose not just because of a drought in some states but because heavy rains rotted much of the crop in other states. It seems India cannot even ensure onions are kept dry.

So what has prompted these headlines and the perception of crisis? The Indian rupee fell 16% since May 2013 to Rs64 to the dollar and over Rs100 to the UK pound, great news for tourists buying clothes in FabIndia, but spelling disaster for the Indian economy with prices of imports rising considerably. The Mumbai stock index, Sensex, fell to its lowest level for a year. The Indian government claims that the crisis has been caused by a tightening of monetary policy in the US, with increased bond rates attracting global investors who feel the US is a far safer place for their money than India. This claim has a veneer of truth but if the Indian economy was in better shape then international investors would not have abandoned it.

The causes of the crisis are manifold but in short they include slower growth, perhaps 5% this year, down from highs of 9% recently, and a growing current account deficit which reached 4.8% of GDP in March. One major contributor to the increasing import bill has been the level of oil and coal imports. India continues to import coal despite it holding the third largest reserves in the world. The power industry in particular has demands which Indian coal producers are unable to meet in the short term and this will rise in the medium term until domestic coal producers increase production. India already suffers from power cuts and this coal crisis will further deter Indian and foreign investments in industry generally.

High interest rates have also deterred investments in the Indian economy. Rates of over 7% impeded investments that India badly needed, and now in the midst of this crisis a rise in interest rates cannot be ruled out to protect the value of the rupee. Conversely there is now no likelihood that lowering interest rates dramatically as in the UK will have any significant effects because of the deep structural issues that operate as a brake on the Indian economy.

India also has a high budget deficit of -5.1%, although this is, for example, lower than the UK’s -7.6%. But the most important thing is that the markets have faith in the UK’s measures to reduce this deficit and its overall public debt. Further problems will arise if India is unable to fund these deficits except at the cost of higher interest rates.

The Indian state also incurs huge costs in its subsidy programmes notably oil, its work programme (NREGA) and the new Food Security Act. Oil subsidies affect kerosene, cooking oil, power stations and motor cars. Earlier in the year the Indian government announced a reduction in the level of subsidies but the fall in the value of the rupee has wiped out any savings. It is estimated that each Rs1 fall against the dollar adds over $1b to the subsidy bill. Moody’s suggested that fuel subsidies could rise to $25b this year. Politically it would be difficult to reduce the prices that consumers pay.

In this context Sonia Gandhi, President of the Indian National Congress, and the governing UPA coalition launched the food security programme this month which may cost $21b this year. The programme seeks to provide basic foodstuffs to up to 57% of India’s population. As an aside Sonia Gandhi said the programme would be “corruption free” although it’s unclear as to how she can make such a guarantee.

In addition, the National Rural Employment Guarantee Act (NREGA) launched primarily as a work programme in 2005 and to improve rural infrastructure costs c$10b annually. Often the estimates for welfare expenditures bear no relation to the actual costs. While the aims of this welfare schemes are laudable they may foster an era of welfare dependency, and one cannot help thinking that the money would be better spent on infrastructure and education, in particular ensuring an educated workforce. But with an election due by May 2014 one cannot envisage the UPA coalition reducing welfare expenditure significantly because of the importance of the rural electorate.

The immediate responses to the rupee devaluation have been limited. Increased duty has been levied on gold and TVs imported as hold baggage. Apparently Indians import over 1 million TVs in this manner. Perhaps one should ask why India appears to be unable to produce TVs or build a strong domestic brand.

Dr Duvvuri Subbarao, Governor of the Reserve Bank of India (RBI), whose lecture I attended at the LSE earlier in the year (link here), has been blamed for much of the crisis and, in particular, for keeping interest rates high. But it is difficult to allocate blame to Dr Subbarao when so many of the factors leading to the crisis have been outside his control: from poor infrastructure and education, budget and current account deficits, to excessive spending on welfare. Dr Subbarao did joke that the current global recession would end when he left office. With his term due to end in early September 2013 that is actually true for most of the developed world but it may be the beginning of a very difficult period for the Indian economy with the possibility that the fall in the value of the rupee may trigger a recession.

Dr Subbarao will be succeeded by Dr Raghuram Rajan whose credentials are impeccable apart from the fact that he has been an adviser to the Indian Finance Minister. Dr Rajan has been Chief Economist at the IMF, and before the global financial crisis of 2008 made a presentation foreseeing the crisis and blaming excessive risk-taking in the markets. He was dismissed as a Luddite by Larry Summers, formerly US Treasury Secretary. So, Dr Rajan can say the unpalatable, and this is going to be crucial attribute in the months and years to come.

The Indian state is riddled with nepotism, cronyism and corruption. As an example putative MPs take out large loans to cover their election expenses knowing that corrupt money will flow in to their personal coffers if they are elected. India needs to stop protecting its own industries and businesses as this hinders the development of the economy. For example, a few months ago a liberalisation of the retail sector was mooted but the conditions were so restrictive it seems Tesco and Wal-Mart amongst others do not want to invest. Overall India has grown as far as it can within its structural boundaries. Dramatic change is necessary.

India needs its Blackships moment; in the mid-nineteenth century the latest American warships arrived at Edo Harbour to force Japan to open itself to the wider world. Thus began Japan’s journey to a fully developed nation, although not without various issues. But the point being that an external shock is necessary for India.

A radical modernisation is necessary in education, infrastructure – Mumbai is only getting a metro system this year – in banking, and to enable foreign companies to invest without conditions. If present conditions continue the downturn will provoke civil unrest. One can only hope that the present crisis focuses the minds of the business elite, and they in turn pressurise future governments to modernise.