Riddle of the 5.3 per cent

By all accounts, last quarter was a perfect storm. Agricultural output fell because of weak monsoons, exports were battered as global growth slowed even further, the government was forced to strangle spending to limit the rise in fiscal deficit, and investment continued to languish.

So it was a relief that growth fell only to 5.3 per cent from 5.5 per cent in the previous quarter. But the year-on-year growth prints are obfuscated by base-year effects, that is, by what happened in the same quarter last year. A purer measure of the growth momentum is sequential quarter-on-quarter growth. And this shows that growth slipped to nearly 4 per cent, with both agriculture and industry growth turning negative.

On a sequential basis, overall growth has probably bottomed in the current quarter. Most high-frequency indicators, such as the purchasing managers index, suggest that. However, the pick-up will be modest as the full impact of the sub-par monsoons will show up this quarter, the government will need to curb spending even further, and global growth will probably continue to languish. But the turnaround, however modest, won't show up in the year-on-year growth rate, which, given the high base of last year, will actually slow further. Sadly, this is yet to be internalised by the market or the authorities.

The story of how we got here from 9 per cent growth is now pretty familiar. As the global economy slowed over the last three years, the government reacted by washing their hands of any reforms, refusing to withdraw the 2008-09 fiscal stimulus, letting loose a regime of regulatory uncertainty that choked off investment, and blaming Greece for all its woes. Added to that was the monetary authority's late reaction to rising inflation, which meant that by the time monetary policy was tightened, high inflation expectations had already become entrenched. All this came to a head late last year as the rising current account deficit, created almost entirely by the fiscal deficit, unnerved foreign investors, sparking off one of the worst episodes of rupee depreciation.

What has made matters worse is that India has not even enjoyed the "benefit" of lower inflation from falling growth. Instead, inflation has remained stubbornly high. The authorities and many in the market have raised this as a puzzle. But there isn't one. India's growth has fallen from 9 per cent to 5 per cent not because of slowing consumption but because corporate investment has declined sharply. When corporate investment falls, it has an insidious impact: it lowers the productive capacity of the economy. While demand has slowed, growth in capacity has been slower, so that despite the lower growth, there is little excess capacity in the economy. Consequently, inflation has remained high. Add to that the hardened inflationary expectation, which, as per the RBI's own survey, is around 13 per cent today.

But all is not lost. The new economic policy team in Delhi, through its September reform blitz, has changed investor sentiment, although in recent weeks it too has fallen silent. It now appears that the government will survive the opposition's onslaught against FDI in multibrand retail. Hopefully, the cabinet will approve the proposed National Investment Board that could potentially restart the investment cycle. The implementation of direct cash transfers holds out the hope of lowering the subsidy bill markedly and allaying a key concern of rating agencies.

But these measures are unlikely to put the economy back on a sustained high-growth path. India today needs deep second-generation reforms that change the institutions that govern the economy. In the heady days of 2003-08, when India grew at 9 per cent, we did not pay much attention to these institutions. Indeed, the jury was still out on the first-generation reforms of the 1980s and 1990s, as growth hadn't done anything remarkable till then. And then the 2008 global crisis occurred. In the face of rising uncertainty and slowing global growth, India's investment and GDP growth dropped sharply. Rather than rallying support for second-generation reforms, loose monetary and fiscal policies were used as easy options. An intractable political situation was bandied as the reason. But under the pressure of falling global growth, the inadequacy of the first-generation reforms became evident and India's institutional weaknesses came to the fore.

Unfortunately, it took sleazy stories of corruption to raise the spectre of India's investment being largely delivered through underpricing resources and flouting regulations. If growth had remained at 9 per cent, we would have looked the other way, but with growth at 5 per cent we have turned indignant and righteous.

Reversing these perceptions now requires implementing difficult second-generation reforms, not just keeping calm and carrying on. But so far, a national consensus on such a need has been elusive. The burgeoning public indignation hasn't been tapped to rally support. Instead, it is being exploited to trade charges on what went wrong and who was responsible.

So what would be the core elements of such change? I would place a permanent fiscal responsibility act that commits the government to hard budget constraints, a framework to price natural resources transparently, a land acquisition framework that balances the interests of sellers and buyers and a transparent set of election finance rules very high on that agenda.

To be fair, the government has embarked on some of these changes. The direct cash transfer scheme is one and the national goods and services tax (GST) is the other. A national GST can be gamechanging. For the first time, India will have a single, unified consumer market and a tax base capable of delivering significantly higher revenue, addressing the second key concern of the rating agencies. But this needs the opposition's help to be passed. There is really no technical impediment holding up the GST, just the fear in some quarters of doing so before the 2014 elections. The big fight over GST was fought when the states implemented the value added tax, back in the early 2000s. An easy compromise would be to pass the needed constitutional amendment in the budget session, but hold back implementation till a new government comes into power in 2014. Hopefully, both the government and the opposition will see past their own interests and do the right thing. If this is done early, then along with a sensible budget, it won't let 2013 be another wasted year.

The writer is senior Asia economist, JP Morgan Chase. Views are personal, express@expressindia.com

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