India and S&P

by Véronique Queffélec on avril 25, 2012


Global credit rating agency, S and P’s downward revision of India’s economic outlook cannot be said to be surprising. But at the same time this need not be taken too seriously. Interestingly enough, the S and P statement was almost a reiteration of the observations made by Professor Kaushik Basu, chief economic adviser, earlier while addressing a Washington think thank.

In revising down S and P cited sliding investments, slowing growth and widening current account deficit as reasons. S and P also forecast a much lower rate of growth for the current year than those predicted by the Reserve Bank or the government at 5.3%. The credit rating agency has also threatened overall downgrade for India unless things mend quickly.

Essentially,these trends were highlighted earlier by the Prime minister’s Economic Advisory Council in its report early in February. If anything subsequent developments further worsened these further. However, excepting for the deepening current account deficit, fall in investment rate and slower growth rates could be reversed with some policy shifts.

The question is: are the three issues flagged by S and P structural in natural somewhat ingrained in the current state of the Indian economy or these are basically episodic developments which can quickly be brought back into course.

First, take the question of flagging investment. India’s investment is now driven by private sector and these have fallen steeply. At the firm level, investment decisions have been shelved or stalled for a variety of reasons, first of which is the prevailing high rates of interest. As is widely known, interest rates have been jacked up by the Central Bank for nearly two years by close to 4%. Indian policy interest rates are by far highest among emerging economies, let alone the developed ones. The rate was revised down for the first time last week, but even then at 8% it works out to lending rates of 12-13% for the best borrowers. Large investments cannot be sustained at such high rates.

Hence, we have been witnessing secular fall in investments. Gross fixed capital formation fell from 32.9% and 32.3% in 2007-8 and 2008-9, respectively, to 30.4% in 201010-11. The entire slowing down of fixed capital formation (investment) in the post-Crisis period has been ascribed to fall in investment by the private sector by the PMEAC.

Investment can be kick-started by primarily lowering interest rates and then by hastening the process of project clearance. India has sufficient number of very large projects held up which can restart the investment process for which the government clearance process will have to be rationalized. It might be difficult but not impossible to achieve. A reversal of the investment cycle would mean the economy can pick up its lost growth momentum once again.

Secondly, the current account deficit is also going up and reaching alarming levels. The severe imbalance in merchandise trade is the cause for the bulging current account deficit. Because of the run-away increase in the oil import bill and ever rising gold imports of the country, the trade balance went into deficit of $185 billion in 2011-12. This could be rolled over on account of large inflows from overseas. Although, portfolio investments and FDI have increased in 2011-12 compared to previous year, these were far below the highs attained two years back. Nonetheless, the inflows were buoyant enough to sustain the bulging trade deficit. These could not be expected to remain as robust next year as well and that can put pressure on meeting the trade deficit.

India has always shown current account deficit and the problem is not unknown. However, some of the superfluous imports –like gold—can contribute majorly in containing the large deficit. Gold imports alone is reported to have touched $50 billion in 2011-12. If gold imports are contained, this can significantly contribute to manging the trade deficit. The other vulnerability of the external account is the rising oil import bill. A change in the fuel subsidy policy can bring about some changes in the import bill.

However, a major structural constraint for the Indian economy if=s the food inflation, which is proving to be inherent with India’s growth process. As growth has lifted people above poverty line, food demand has risen. The nature of food consumption basket is also changing in favour of vegetables, meat, eggs, fish, fruits and milk, as opposed to an earlier dependence on food grains. Thus, the nature of India’s food inflation has changed from food grains oriented inflation to more disified food basket (as mentioned) oriented inflation. This will call for a restructure of India’s food economy.

Nevertheless, the situation could still be manageable if some policy sihiftrs are introduced like allowing FDI in multi-brand retail. This can augur entry of global food retail chains and therefore development of back-end infrastructure for food retail. Because of lack of such facilities, huge volume of food items are getting wasted. There are kinks in the food retail chain as well, resulting in episodic spurts in food prices.

These are the policy shifts which India needs to introduce. These are the policy reforms which Professor Kaushik Basu had mentioned not likely to be taken up until a clearer political mandate is available after the 2014 elections. S and P had underlined that the political environment is lacking for such reforms measures. The pitch was earlier queered earlier with a rather atavistic budget which proposed sweeping powers for government departments in their taxation power. The budget was somewhat reminiscent of the budgetary exercises and economic policy formulation of pre-reforms era. These must have somewhat nudged the confidence of the global investors who have come into the country in good numbers in the last two decades.

Belatedly, the finance minister today has conceded that the revision announced today was a warning signal. Hopefully, the government will take it up.

Source: Lexicon ltd India