Indian Economy Situation Similar To 1991 – No Easy Solutions For Incoming Govt

Indian economy grew strongly till 2007-08 and then sputtered

Since the initial set of reforms in 1991, Indian economy has increasingly dependent on the global economic scenario in past 2 decades. From 2003-08, Indian economy grew at a strong pace primarily assisted by growth in global economy and liquidity flows. Low inflation levels during the period and focus on lower fiscal deficit in early part of the decade ensured that the country had fiscal stimulus measures in place when the economic crisis of 2008 struck.

The crisis resulted in global economy slumping which had a similar effect on India. Thereafter, in order to boost growth, Indian government embarked on a fiscal stimulus package which resulted in economic growth going back to ~ 8-9% by 2011. This also resulted in significant increase in fiscal deficit from ~ 3.5% in Fy2008 to ~ 6.5% in Fy2009.

However, not removing the extra stimulus in time led to a burgeoning fiscal deficit. At the same time, corruption charges in various departments led to delays in policy decision making which had a negative effect on creating supply side infrastructure and lack of capital expenditure investments from the private sector. This resulted in GDP growth rate coming down significantly to ~ 5% in Fy2013. Industrial production also faltered since 2010 onwards to less than 2% as on June 2013.

Growing fiscal deficit and Threat of Ratings Downgrade…

In a normal scenario, government could have provided a fiscal stimulus to arrest the slide. However, in this case, High fiscal and Current Account Deficits (CAD) coupled with slow growth rates provided the Credit Rating Agencies (CRA) such as S&P, Moody’s and Fitch a chance to review the sovereign rating of the country which currently stands at BBB- (lowest investment grade rating). As a warning, all 3 revised the outlook to ‘Negative’ from ‘Stable’ around April-May 2012. S&P even threatened to downgrade the rating in the next 2 years if correct measures weren’t taken in time. As the charts show, Moody’s history of rating changes for India’s sovereign rating indicate that it places greater emphasis on fiscal deficit and CAD concerns rather than GDP growth rates. Hence, significant downgrades occurred in early 1990s and in 1998. Rating upgrades happened during 2001-2005 when there was significant focus on sustainable fiscal deficit reduction.

Rating downgrade would significantly affect the borrowing capability of Indian companies in global markets as their borrowing costs would rise significantly. Also, it would create a negative image of the current government among the financial and investor community and create a negative perception among the general public. Hence, it was forced to embark on a series of reforms to correct the country’s adverse fiscal deficit situation. These actions have prevented a rating downgrade till date.

The fiscal spending/expenditure since 2009 is also marked by greater focus on generating demand side consumption rather than supply side long term infrastructure development. For instance, a significant portion of fiscal stimulus has been through wage increase for PSU employees, social schemes such as NREGA, farm loan waivers that negatively affected banks and benefited farmers, etc. All these ensured consumption-led GDP growth and helped the ruling government to win national elections for a 2^nd time in 2009.

For instance, social services have seen the highest average growth of 22% in the past 22 years outpacing developmental and non-developmental expenditure growth of 12-17%. This resulted in increase in revenue expenditure from 50% in 1998-99 to ~ 58% in 2012-13. Similarly, subsidies increased from 5% in Fy1999 to ~ 10% in Fy2013. The biggest drop was in capital expenditure from 28% in Fy1999 to 20% in Fy2013.

Fiscal deficit has to be financed through various means such as market borrowings, savings, provident funds, disinvestment, etc. Since 2005, market borrowings have steadily increased to become the largest source of bridging the deficit. It increased from 51% in early 2000s to ~ 90% of total funding requirements.

High and sticky inflation preventing steep cuts in interest rates

The consumption-led growth coupled with poor supply and increased market borrowings crowded out private investment and resulted in high and sticky persistent inflation levels. Consumer Price Index (CPI) continued to remain high at ~ 10%. Hence, Reserve Bank of India (RBI) has been unable to bring down key interest rates such as Repo. RBI actually cannot cut rates at all since it would deepen the negative real interest rates. Nevertheless, it took small rate cuts in recent quarters because of significant pressure from various stakeholders such as the finance ministry, industry bodies, etc.

Shift from financial assets to physical assets increasing

Whenever the economy is marked by high inflation and negative real interest rates, local small time investors shift their savings away from formal banking system to physical assets such as real estate and gold or precious metals. For several hundreds of years, Indian economy has been marked by high inflation and low growth rates. Hence, Indians have traditionally preferred to invest in gold in the form of jewellery and coins/bars. Situation in past few years have been similar and hence savings growth rate has declined in past few years. At the same time, investments in gold and real estate have increased significantly.

The shift away from financial assets to physical assets has caused liquidity crunch in banking system that is resulting in actual high cost of money for banks and subsequently to the real economy. This implies lower investments in long term fixed assets and resultant decline in production and other industrial metrics.

Increasing imports of sensitive items

India is poor in sensitive raw material resources such as oil and gold. Further, because of wrong pricing policies in various sectors, no investments have happened in important sectors like fertilizers, oil and gas, coal, etc. As a result, India is currently the 4^th largest consumer of oil and gas and with increasing requirements, it will soon become the largest importer as well. Despite having the 3^rd largest coal reserves in world, India will soon become the 2^nd largest coal importer as well. For incremental requirements, India already imports fertilizers instead of producing it domestically. India is already the largest consumer of gold since it doesn’t have much domestic reserves.

  

Reduced Import Tariffs Leading to Higher Trade Deficits with Key Trading Partners

Trade deficit (TD) which represents net of exports minus imports is also negative. It mainly comprises of oil and gas, gold and coal imports because of lack of sufficient domestic resources for the same. At present, India has the largest running trade deficit among major economies of ~ USD 190 bn in absolute terms. It will soon cross USD 200 bn if the government fails to control imports and incentivize exports.

Deficit numbers are further skewed on account of non-favorable Free Trade Agreements (FTA) signed with various countries such as South East Asian countries and China who have been able to dump their goods in Indian markets at cheaper prices. Domestic manufacturing has been unable to compete which these imported goods on price. Hence, they have not invested in building new capacities. Meanwhile, consumption of the goods continue to rise. Hence, imports have increased. Our import basket now includes almost all items of daily requirement. India has become a dumping market for the trade partners. The following chart shows how import duty rates on consumer goods has come down significantly from 50% in 2004 to ~ 15% in 2010. Even mining has come down from 65% in 2006-07 to 20% in 2010.

 

Inability to improve export competitiveness despite depreciating currency

India is strong in conversion process and low end engineering. Hence, more than 50% of total exports are value added imports such as refined crude (crude oil imported, 18%), studded jewellery (gold imported and processed, 15%), engineering goods (components imported, 22%) and pharma and chemicals (RM imported, 15%), textiles (cotton imported or domestically procured, 9%). Remaining exports are basic commodities (zero to low value addition) such as agri-goods and bulk commodities).

India also has strong supply of cheap manpower which should ideally help labor-intensive industries like leather, textiles, gems and jewellery, Information Technology (IT, low cost manpower), etc. At present, 65% of the population is between 15-60 years of age which is considered as the productive age.

CAD was also affected due to a ban on exports of commodities like coal and iron which got embroiled in corruption cases. This resulted in ban on mining and slow production growth in their output which also affected domestic industries.

Because of value added nature of exports and lack of manufacturing competitiveness, INR depreciation doesn’t help much in improving exports. Further, foreign customers of Indian goods and services are re-negotiating contracts to dilute the benefit of lower INR to Indian companies.

Declining Productivity leading to lower share of manufacturing in GDP

India’s productivity improved from 2000 to 2005 coupled with low inflation but has deteriorated since then, especially after 2009-10 with decline in labour production and higher inflation.

Services sector meanwhile improved its productivity through training by private sector which improved its share in total GDP.

Total Factor Productivity Index (as calculated by RBI) shows that it grew faster during 1998-2004 and slowed down since then. Labour productivity grew by 12% average in 1998-2004 as compared to 10% in 2005-2011. In contrast, wage increase was 6% on average during first period as compared to 11% in second period

NREGA is blamed as one of the reasons behind the decline in productivity in India with shift of labour away from farms. This coupled with increase in MSP for seeds has resulted in higher food inflation. It has also impacted the fiscal deficit as government has to bear the entire cost of wages, materials, unemployment allowance, and admin expenses. While works completed have come down, wages have increased at CAGR of 13% in past 6 years.

NREGA is also marked by poor administrative and planning skills, inadequate awareness, discrimination, corruption and irregularities, delayed wage payments, and most importantly creating non-useful assets. Thus, it cannot be a long term solution to the unemployment problem of India.

NREGA wage increases have pushed cost of manufacturing upwards since Indian producers had to increase their wages to retain labour in addition to absorbing higher RM and energy costs. NREGA also reduced migration within the country by 30%. Labour intensive sectors like leather and textile industries are gradually shifting to other countries. For instance, Tirupur based textile exporters have started shifting to Vietnam.

Thus, the high interest rate scenario, lack of stable policies for industries and poor competitiveness and productivity led to lower growth in investments into fixed assets by manufacturing sector.

Increasing CAD and Trade Deficit = Negative and Growing Balance of Payments

The lack of investments and savings has a direct impact on CAD (CAD is the difference between the two effectively). In recent years, both have come down as explained above. As a result, CAD has been worsening and will worsen further in future. If the rates are cut, savings will decline even further which will have a spiraling negative effect on CAD. India’s CAD has increased in recent years to ~ USD 87.8 bn in Fy2013. Further, it is expected to increase further to ~ USD 100 bn in Fy2014. It has one of the largest running CAD among major economies in absolute terms. (though, in % terms, there are others)

Increasing dependence on Volatile Capital Flows

Because of continuous rise in trade and CAD deficits, INR has weakened in the past 2 years. To arrest the slide, we are now dependent on capital flows (both FDI and FII) and remittances. Strong capital flows in recent years on account of global liquidity flows and easy monetary policy by central banks of developed economies such as ECB, US Fed, etc. helped maintain INR at current levels. RBI along with government also tried to attract NRI remittances through higher interest rates for that population. It also increased limits at regular intervals for FIIs in several categories of debt markets. It has tried to simplify investment rules and processes and has reversed some of the tax laws prevailing to FII investment. To attract FDI, it has opened up certain sectors such as airlines, retail, etc. The recent buyback and open offer proposals from companies like HUL, Diageo, CRISIL, etc. are also helping bringing in some much needed foreign capital.

Leading to High External Debt

However, these are not stable long term methods to attract capital. As an example, recent Fed talk of tapering caused huge capital outflows from India with INR finally crossing 60 against USD. Also, these capital flows come with a cost. For instance, the foreign investors demand dividends, royalty, foreign remittances, etc. from their investments in India. Instruments such as FDI, FII, External Commercial Borrowings, banking capital, etc. fund today’s CAD but create liabilities for future generations. Already, the external debt of the country (government and private sector combined) now stands at ~ USD 370 bn which is higher than the forex reserves. At the same time, our debt servicing capability has been deteriorating since 2004.

Even after exports and capital flows, the balance of payments (BOP) is negative which has to met through forex reserves of RBI. It indicates that India is spending much more than it is earning and saving. This is a frightening scenario as our import cover in terms of foreign reserves have come down to less than 6 months from a high of ~ 19 months.

Finally leading to INR depreciation and Lower Forex Reserves

RBI avoids a fixed exchange rate or range in view of the experience of South East Asian crisis of 1997. Selling reserves and gold holdings cannot be done all the time. Hence, RBI also avoids excessive intervening in the currency market and lets INR slip beyond a point.

Currency depreciation can be predicted by inflation and productivity differential. Since inflation differential between US and India is ~ 8%, INR should depreciate against USD by ~ 8% each year, assuming that the differential remains constant. The productivity differential also deteriorated in the past few years as shown above.

Conclusions

The problems affecting India are not cyclical but structural in nature. The problems are a creation of some of the well-intentioned but non-practical policies of the present government and solving them in the next 5 years is not going to be easy. The problem is similar to 1991 or worse. The capital flow story will be temporary and can reverse at any point. Further, while Fitch revised its outlook to ‘stable’ from ‘negative’ recently, S&P and Moody’s are only waiting to downgrade at an appropriate point in time.

The political scenario also isn’t rosy either. Both national parties are struggling and will not able to win a majority on their own. Further, they will find it difficult to win the 5 major states decisively. Hence, it will be a coalition government. A 3^rd front government may find it difficult to understand the complex issues at hand and thereafter to solve it itself will be a huge task.

Hence, all fundamentals point against INR depreciation from current levels. There may be temporary pullbacks towards 58.5 but over the medium term, INR has a target of will depreciate further to 62.5-62.7.

India will not benefit much from the improvement in US economy either. Exports to US form only 15% of exports. IT will not benefit much as inflation is leading to wage increases which in turn is reducing the labour arbitrage advantage. Outsourcing destinations are also shifting to cheaper locations such as Philippines, South America, etc. US also introduced Immigration Bill which is an indirect form of protectionism and import tariffs. Thus, IT exports are going to grow in single digits only. IT saved India in early part of the first decade but now a new sector is needed for the country.

Indian economy is in a similar situation to Latin American economies of the 1990s (Brazil, Argentina, Mexico). Hence, it makes sense to study the economic histories of these countries in early 1990s.

Possible solutions

The only silver lining is that the external sector forms a small portion of total GDP. Total exports and imports together form ~ 70% of GDP which is unlike some economies like Singapore where it is around 2x. Hence, the real economy is not impacted much by INR depreciation.

Beyond a level, INR depreciation would finally make locally produced goods cheaper than imported goods. That would cause investments to pick up and cause GDP to grow again. But that would not be a correct way to restart the investment and capex cycle. Ideally, India needs to introduce protectionism like the Middle East and US which are quietly introducing labour laws and bills that favour local production and employment. It should avoid signing new FTA agreements, especially with Europe which may cause even basic necessities like Milk to be imported. In case of South East Asia FTA, India needs to impose huge tariffs that make domestic production competitive. Luxury goods which are totally imported need to be banned or need huge import duties.

India needs real interest rates to move into positive territory for the entire economy to decisively turn positive. For that, RBI can actually raise interest rates or tweak rules to increase deposits in the system. This tweaking can bring back capital into the banking system and improve liquidity which in turn can reduce the actual cost of money and kickstart the economy.

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