Why Nations Fail. K.P. Krishnan, the Indian finance ministry's point man
for all things capital markets, is re-reading the book by two US
economists Daron Acemoglu and James Robinson. Krishnan's second dive
into the acclaimed book since its release last summer is to find answers
to the deep problems his employer, the government of India, faces with
an economy in a tailspin.
The answers are simple, really. The Massachusetts Institute of
Technology and Harvard economists argue that the economic success - or
failure - of a country depends on the strength of its political and
economic institutions.
But an anodised steel-like institutional
framework is something India sorely misses. Years of political
ineptitude have corroded the resilience of the world's thirdlargest
economy by buying power. This despite warning lights on the government's
dashboard going off regularly for at least two years now. When it
rains, it is said, it pours. By the time India's stock markets closed on
August 16, trading desks were in shock - the Bombay Stock Exchange's
benchmark index, Sensex, had lost nearly four per cent, the sharpest
single-day fall in four years.
The gradual decline began in early
2008, after the rupee-dollar rate touched 39. The rupee has been
floating down like a feather against international currencies for nearly
four months now. Between April 30 and August 23, Indians had to pay
nearly one-fifth more for the US dollar, the world's preferred currency.
The dollar was worth Rs 63.22 end of trades on Friday, August 23, and
Deutsche Bank predicts it could touch Rs 70 in a month. Credit Agricole
says it will not recommend buying the dollar at below Rs 75.
Krishnan,
the bureaucrat who was part of a crack team that decided on India's
response to the 2008/09 global meltdown, was anything but rattled at a
recent seminar in Mumbai. At least, he didn't show it. The battered
rupee, he said, "is a passing threat… this is a short-term threat." The
next day, August 21, the pound sterling breached the Rs100 mark. The
Indian currency has depreciated nearly one-fourth vis a vis the pound
sterling since mid-March: Rs80.71 on March 12 versus Rs100.32 on August
23.
With its current account deficit (CAD) - the difference
between exports and imports of goods, services and transfers - at an
all-time high and a currency that had not shed value despite years of
high inflation, it was only a matter of time before investors lost their
unbridled optimism from the days of a once-robust economy. The trigger
for that volte face came from half way across the world. On the back of
intermittent signs of a recovery, the US Federal Reserve has hinted the
end of low-cost money on tap, which means monetary tightening and
consequent rise in the interest rates there. That was the cue for global
funds to suck back billions back into the world's biggest economy from
emerging markets. India was not spared. Between August 16 and 22, nearly
foreign institutional investors were net sellers of Rs2,975 crore worth
shares. FIIs are restive in other markets such as Indonesia, Brazil and
Mexico.
Vulnerable IndiaClearly, the
Indian economy is in a much more vulnerable state
than it was at the start of the financial crisis in September 2008.
Then, India had a credible response to the meltdown set off by the
collapse of investment bank Lehman Brothers. In a series of measures,
the government infused liquidity into the system, cut duties, and
overall boosted demand. The stimulus cost an estimated Rs 1.85 trillion.
(One trillion equals 100,000 crore.) Such spending could be afforded
only because India was growing at a fast clip: GDP growth was 9.4 per
cent in 2006/07 and 9.3 per cent 2007/08, the two years preceding the
Wall Street meltdown. And tax revenues had jumped 20 per cent in each of
the years. The stimulus worked wonders: after a relatively slower GDP
expansion of 6.7 per cent in 2008/09, growth bounced back to 8.6 per
cent and 9.3 per cent each in the following two years.
Cut to today: GDP
is growing at a much slower rate of five per cent with predictions that
it will dip to a sub-five per cent level. Which means, the state
treasury is looking less healthy, especially when expenses are rising at
an unexpected pace. For instance, India sets aside more than one-third
of its import bill for crude oil imports. Oil prices have risen about
$12 a barrel in the last three months - a $1 increase in crude prices is
a $900 million hole in India's trade balance - but they are expected to
stay around $110. That's the good news but the bad news is that some 20
million tonnes per annum (mtpa) new refining capacity coming up in the
West Asia region will mean a lower demand for India's fuel exports,
which brought in nearly $59 billion in 2012/13.
If that's not
all, the impact of the depreciating rupee will blow a hole in India's
finances. "In rupee terms, if this slide continues, the effect will be
huge," says Vandana Hari, the Singapore-based Editorial Director at
energy specialist Platts Asia. Each rupee that the Indian currency
depreciates on the US dollar, Rs10,000 crore gets added to the country's
import bill (about Rs6.7 trillion in 2012/13). The dollar has become
expensive by nearly Rs 11 since May. CAD, at $88 billion was 4.7 per
cent of GDP in 2012/13, nearly double the 2.5 per cent level that RBI
thinks is sustainable. Finance Minister P. Chidambaram is confident he
will keep CAD under $70 billion this fiscal year but not all - the
markets, for sure - are convinced.
Much of that scepticism
emanates from what some think as policy failure over rising gold imports
in recent years. Today, gold is the second largest import item after
crude and petroleum products, beating electronics to third place. The
surge in gold imports is both a consequence of unabated inflation which
gold is used as a hedge against, and a rise in prices of the yellow
metal. CAD is usually covered by foreign inflows - both institutional
investors and foreign direct investment (FDI) - or by dipping into the
country's forex reserves.
With capital flows drying up, India
will tread the slightly-risky path of using debt to finance CAD. "We
have no option but to rely on debt inflows in the immediate term," says
Paresh Sukthankar, Executive Director at HDFC Bank. A recent report by
ratings firm CRISIL showed corporate India had a outstanding foreign
exchange debt of over $200 billion as of March 2013, of which close to
45 per cent is short term. The short-term foreign debt outstanding in
March 2013 is nearly $100 billion, which is to be redeemed by March
2014. Forex reserves stood at $279 billion as of August 13.
In
simple terms, this means a 2008-like strategy is not an option before
India. "After and in 2008 and 2009, we survived because of the stimulus,
which was a consumption stimulus. But we are not in that position
anymore," says Devendra Kumar Pant, Chief Economist, India Ratings and
Research.
The government's response to the rising CAD and overall
sagging economy has proven to be too little, too late. To be fair,
Chidambaram saw things early. Soon after he moved ministries to Finance
from Home in July 2012, the government took bold decisions on easing
rules for business - widely billed as "reforms 2.0". The reference was
to the first set of economic reforms that Manmohan Singh, today prime
minister, ushered in as finance minister in 1991.
Chidambaram was
at the forefront of the changes announced that seemed to shake the
government out of the stasis it was in. With an aim to trim subsidies,
diesel prices were raised by Rs5 a litre and supply of subsidised
cooking gas was capped. Up to 51 per cent overseas ownership was allowed
in multi-brand retail and 49 per cent FDI permitted in airlines. Other
changes eased FDI in telecom and oil and gas. But save for the
Rs2,058-crore deal between Abu Dhabi-based Etihad Airways and India's
Jet Airways, little came by way of foreign inflow. Without growth,
foreign investors will shun India, says Samiran Chakraborty, Head of
Regional Research, South Asia, Standard Chartered Bank. "The message
that is going out is that we will push for reducing inflation and
financial stability, and that growth is sacrificial." So much so that
the government's recent measures of higher import duties on gold and
silver, clamping down on foreign investment by companies, easing
external commercial borrowings limits, and permitting quasi sovereign
bonds have had little effect on the ground.
Caution: Pain AheadPartly,
it is monetary policy that tripped Chidambaram's efforts over the past
year. In much of his five-year term, RBI Governor D. Subbarao, due to
retire on September 4, single mindedly waged a war against inflation.
Questions are now being raised on the pace of interest rates hikes and
whether his stance on inflation, widely seen more due to India's supply
constraints and less a function of excess money sloshing around, was the
optimal one. In the second week of August, in a debate in the Rajya
Sabha on the state of economy, Chidambaram said the RBI must focus on
growth and employment.
But that is easier said than done with
consumer price inflation running in double digits for over a year. A
direct casualty is crimped household consumption and savings. Even
wholesale price inflation, indicative of the pace of price rise in the
broader economy, which was on a downward spiral for some time, has
started to inch up and is hurting business.
Gujarat food
processor Kamdhenu Foods is unable to take large orders in recent
months. "We couldn't accept an export order for 6.5 tons of bitter gourd
slices because its price has jumped up from Rs10 a kilo three months
back to Rs25 a kg now," says Bipin Shah, General Manager.
With
fuel prices set to rise soon, bankers say resultant inflation will again
put pressure on interest rates. The recent monetary tightening is
already having a spillover impact: Axis Bank, HDFC Bank and ICICI Bank
have hiked lending rates.
The banking sector, already under
stress due to higher bad loans, is getting shocks from new industries as
the effects of a decelerating economy spread. State Bank of India, the
country's largest lender, got a shock in the first quarter of 2013/14
from the rising slippages in the agricultural sector. There is another
looming danger in infrastructure loans. "There are issues of asset
liability mismatches in the banking industry because of shorter maturity
deposits and longer term loan to infrastructure companies," says S.
Viswanathan, a managing director at SBI.
Unfortunately for India,
then, options that will yield immediate benefits are limited. The
economy is unlikely to shake off its sluggishness in the medium term -
until 2015/16 or even later, according to some. Sonal Varma has a list
of big ifs to see the needle will move on the economy. "If you start
making the right moves, if there is change of guard and if there is a
clear focus in reviving growth, it will take about 12 to 18 months for
things to start turning," says Varma, Executive Director and India
Economist at Japanese financial house Nomura. "The rupee is a symptom of
the problem, there is a crisis of confidence and the credibility of
policymakers has taken a hit."
The Congress Party-led United
Progressive Alliance government just does not have enough time or
numbers with to kickstart large-scale reform measures with general
elections scheduled before the summer of 2014 and key sections of the
UPA are already in election mode, as also the principal opposition
coalition, the National Democratic Alliance, led by the Bharatiya Janata
Party. Result: a polity distracted from the needs of the economy. "We
don't have a thought leadership for the society that will emerge
tomorrow. We need to do quite a few things to make this [growth] work,"
says Kishore Biyani, Chairman at retailer Future Group. Pre-election
surveys show regional parties gaining strength at the hustings, likely
increasing political instability at the Centre - which doesn't portend
well for the economy.
Where does the economy go from here? GDP
growth is already at a 10-year low of five per cent in 2013/14 against
6.2 per cent the previous year. CRISIL is downright bearish. "All our
forecasts - growth, inflation, fiscal deficit and CAD - are under
revision and they will be revised unfavourably," insists D.K. Joshi,
Chief Economist at the firm. One voice sounds ominous ahead of the
release of GDP data for the April-June quarter on August 30. "The way
the Indian economy is going, it is testing my optimism," Kaushik Basu,
Chief Economist, the World Bank, said recently at a seminar in New
Delhi. Basu, who was Chief Economic Adviser to the government of India
until a year ago, is predicting a 4.8 per cent growth for April-June.
Still,
two factors hold out some hope. The biggest drag on the economy comes
from the services sector and industries, which together make for about
85 per cent of India's GDP. But it is agriculture, despite its smaller
contribution to the economy, which could stop the economy from stalling.
The Indian Meteorological Department has recorded normal to excess
rainfall in 30 of the country's 36 meteorological sub-divisions between
June 1 and August 14. The area-weighted rainfall has been 13 per cent
above normal.
There has been a notable rise in area under
cultivation of pulses (25 per cent more), coarse cereals (15 per cent)
and oil seeds (15 per cent) this season from 2012/13. Total crop area
sown has increased over nine per cent. "If you compare agriculture
output, we will achieve the same growth that we did in 2011/12, which
will have a deeper impact on inflation," says Himanshu, an agrieconomist
who teaches at New Delhi's Jawaharlal Nehru University. (He goes only
by his first name.) Farm output in 2011/12 grew 2.5 per cent from the
year before - it was 1.9 per cent in 2012/13. Nomura has a four per cent
target for agriculture this year. "I expect very strong agriculture
growth this year, which should help the rural economy," says Adi Godrej,
Chairman of the locks-toshampoos Godrej group. Farming is the primary
economic activity for some 70 per cent of Indians.
The second set
of strands in the wind that augurs well for the economy is the five
state polls and the general elections. Odd as it sounds, elections are
good news for the economy, for money - often black, unaccounted for cash
that otherwise will not find its way into the system - boosts growth.
"Five states are going for election, and with a general election,
election spending will provide a stimulus," says Ajit Ranade, Chief
Economist at Aditya Birla Group, which runs metals to telecom
businesses. Other small gains to be had in the coming quarters include
the impact of a falling rupee on exporters.
Then, there is the
man being billed as the one with the silver bullet: Raghuram Govind
Rajan. The RBI governor-designate has not spoken of his new assignment
and little in his academic past indicates his monetary DNA, if any. But
the street has already set expectations for him. In the first six
months, says Rajesh Mokashi, Deputy Managing Director at ratings agency
Care Ltd, Rajan's priority should be to balance inflation and growth
dynamics. In the longer term, he should focus on asset quality in
banking, fix potential asset-liability mismatches on bank books, and
issue new banking licences.
Time will tell if Rajan can deliver
growth even while reining in inflation. But, to be sure, India's
fundamentals are strong in the medium and long term. Hundreds of
thousands, if not millions, are joining the middle class even at a five
per cent rate of GDP expansion. Its workforce is adding a million every
month, making it the youngest among major economies. Sanjeev Sanyal,
global strategist at Deutsche Bank in Singapore, points out that China
has reached the end of its demographic boom. "This offers a good
opportunity for India to take the place vacated by China," he says. But,
he adds, India has to get its act right in terms of governance,
property rights and primary education. In other words, building
institutions - the biggest takeaway from Why Nations Fail. Sometimes the
best fixes are found in truisms.
