"Paranoid optimism", a phrase I first came across in The Economist in 1999, perfectly captures India's current economic mood.
It is the farmer’s hope that this year’s crop will be better than ever, mixed with a fear that it might be ruined by too much heat, too much rain or some other calamity.
Among the Fragile Five club – India, Brazil, Indonesia, South Africa, and Turkey – the country seems to have come a long way from last May’s economic turmoil, when it was severely affected by the United States Federal Reserve’s asset purchases.
Since then the Indian rupee has recovered half its losses, the nation’s benchmark stock index is near an all-time high, consumer price inflation has slowed to 8.1 per cent, foreign portfolio investors are bullish on India from higher growth expectations and the current-account deficit has shown marked improvement.
The economic fundamentals are improving after hitting a nadir last year, but this by no means is a turnaround. To a large extent, the euphoria – along with the stock market, portfolio inflows, and the rupee – is riding on the hope that the elections in April and May will eject the Congress-led coalition and Narendra Modi, the leader of the business-friendly opposition Bharatiya Janata Party, will become the prime minister. Investors clearly disagree with the current finance minister, P Chidambaram, that what Mr Modi knows about economics can be written on the back of a postage stamp.
Is the optimism justified, or is it the triumph of hope over recent experience? The balance of evidence points to the latter.
Economic growth almost halved to 4.6 per cent in the first half of last fiscal year from 8.5 per cent before and for two years after the global financial crisis. Just nine months back, India faced a mini crisis as external shocks – mainly the expectation of the Fed’s exit from ultra-loose monetary policy – exposed India’s macroeconomic vulnerabilities. Currency, equity and bond markets came under pressure. High inflation, current and fiscal deficits, and political uncertainty made investors nervous.
That Mr Modi will lead India’s next government is not a foregone conclusion. While opinion polls favour Mr Modi, the outcome of India’s multiparty first-past-the-post system is not easy to predict. And even if the BJP comes to power, there is no certainty that it will do what is needed to kick-start and sustain economic growth. Though Mr Modi did a commendable job in Gujarat, he is yet to spell out his detailed national economic agenda, which will call for some tough choices.
The first challenge is to reverse the investment slowdown in India.
As a recent report from the IMF highlights, the marked acceleration in economic growth India experienced in the years preceding the global financial crisis was tied to a surge in investment activity. Gross fixed investments as a share of GDP rose from an average of about 24 per cent during 1996-2004 to a peak of nearly 34 per cent by mid-2008. However, the ratio then fell sharply to about 30 per cent in 2011-12.
The report concludes that the investment slowdown has been primarily driven by weak business confidence and policy uncertainty. The implication for the new government is clear – economic policy and agenda will need to be clearly articulated and adhered to. So far, Mr Modi hasn’t done that.
The second challenge is restoring India’s fiscal health.
Approving the goods and services taxes should be a priority. Not only does it represent the single most important revenue reform, but it will also help boost growth by removing distortions and creating a single Indian market for goods and services.
India’s subsidy system is archaic – more than a century ago, the viceroy of India, Lord Curzon, declared that “any government that by indiscriminate almsgiving weakened the fibre and demoralised the self-reliance of the population would be guilty of a public crime”. This is a truism today as it was then – subsidies on food, fertilisers, power, and fuel remain untargeted, badly governed, and opaque. Converting these subsidies to targeted transfers will have better beneficial effects and achieve the desired outcomes at a lower fiscal cost. Of course, doing so will require political courage.
Third, inflation needs to be carefully managed.
Although it has recently subsided, high and persistent inflation remains a key vulnerability. Lowering inflation calls for a simpler monetary framework and greater operational independence for the central bank.
Finally, India’s financial and corporate sectors need competitiveness-enhancing reforms.
India’s most vulnerable 10 per cent firms are much more likely to default than they were in 2009. Corporate profitability is under pressure from rising financing costs, delayed projects and slow growth. Indian banks’ vulnerable portfolios – defaulted and restructured loans – are close to 10 per cent of their gross loans. Further, loans remain highly concentrated, with India’s ten largest conglomerates accounting for almost all of banks’ net worth.
Much needs to be done to address these issues – enhanced financial sector supervision, stronger prudential regulations, efficient legal framework and regulations to limit concentration will help. Broadening access to finance should also be high on the agenda – India’s unorganised and small enterprises, which contribute most to the country’s employment, have very limited access to bank finance.
All the brouhaha about Mr Modi’s economic magic notwithstanding, it might be best to hold off the celebrations for some time, for the choices remain as tough as ever.
Amit Tyagi, is the vice president of the National Bank of Abu Dhabi
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