Dithering is the root of India’s problems; Rather than soothing investors’ nerves, the central bank’s stop-start measures have the whiff of panic

August 21, 2013 4:46 pm

The dithering state is at the heart of India’s problems

By David Pilling

Rather than soothing investors’ nerves, the central bank’s stop-start measures have the whiff of panic

Not long ago it became fashionable to liken India to a tortoise, poised, by virtue of its democratic institutions and favourable demographics, to overtake the Chinese hare. Now there is a better comparison. More and more, it resembles a deer caught in the headlights. To be fair, the headlights are dazzling and the deer has few places to run. Likeemerging market economies everywhere, India is suffering from the prospect of a gradual withdrawal of stimulus by the US Federal Reserve and a rise in American interest rates. That has produced a giant sucking sound as risk capital retreats. The hot money outflow, though, is just the start of India’s problems. Growth has almost halved from a few years ago to 5 per cent, unacceptably low for a country with such potential and so much poverty. The current account and budget deficits are troublingly wide and the rupee has been dropping like a stone. Sotto voce, officials have been mouthing three of the scariest words known to humanity: International Monetary Fund.For weeks the government has been piling on measure after measure to stop the rot. The rot is unimpressed. India has three times raised tariffs on the import of gold. It has imposed capital controls on Indian individuals and companies wishing to send money abroad. On Wednesday, the Reserve Bank of India injected liquidity into financial markets, partially reversing previous tightening. Rather than soothing the nerves, these stop-start measures have had the whiff of panic. Investors have pulled out funds and the rupee has continued its slide. It is now heading towards a record low of Rs65 to the dollar, down 17 per cent since May. The only good news has come from July trade figures, which seemed to show that a weakening rupee was boosting exports and discouraging imports.

The hope is that the sliding rupee will help reduce the current account deficit and eventually bring India’s economy back into equilibrium. It is a slim hope. That is partly because the effects of depreciation are not universally benign. The weakening currency has jolted confidence. India, with its stunted manufacturing sector, is not a big exporter. Because it is a big importer of oil and coal, a falling rupee will add to energy costs. It will also make fuel subsidies more costly, putting further strain on a budget deficit already at 5 per cent of gross domestic product. Finally, a falling rupee is bad for inflation, already running dangerously close to 10 per cent.

Kaushik Basu, chief economist of the World Bank and, until July last year, chief economic adviser to India’s government, says the panic is overdone. Unlike in 1991, when foreign exchange reserves fell to the equivalent of just three weeks of imports, today’s reserves provide a more healthy buffer of seven months. India has only limited foreign currency debt.

That is fine, so far as it goes. But crises rarely present themselves twice in the same guise. One possible conduit for trouble is the heavily leveraged corporate sector, which has significant exposure to foreign currency-denominated debt. Corporate woes could quickly spread to state-backed banks, where non-performing loans and more murkily defined restructured loans are already approaching 10 per cent of total assets.

India, then, has a short-term and a long-term task. The short-term one is to bring stability. Raghuram Rajan, who takes over as central bank governor on September 5, can play his part. He is well placed to show grim resolve by raising interest rates until capital outflows are stemmed and the currency stops falling. That, though, could very well hobble growth, pushing it down towards a once unthinkable 4 per cent. Still, Mr Rajan may feel he has no choice. When you are stuck between a rock and a hard place, sometimes you have to choose the hard place. The government will also need to control spending. That could have significant social consequences – not to mention electoral ones, so close to a national poll due by May next year.

If the short-term problems are difficult to tackle, the long-term ones are more intractable still. The present crisis is the culmination of a long slide. After years of dithering and policy reversals, India has dealt a severe blow to foreign investors’ confidence. Last year it attracted less than $20bn of foreign direct investment, less than a tenth of that pulled in by a slowing China.

If anything, domestic supply constraints are even more serious. The construction of infrastructure has proceeded at the pace of a Mumbai traffic jam. Productive investment in mining and manufacturing has been hobbled for years. Take the crippling clashes over coal and iron ore. The role of the state and the judicial system is to act as an arbiter, setting and implementing laws that balance competing claims over the use of land and resources. Which should take priority? Development or the environment? Drinking water or water for industry? Tribal or farming land rights, or the land interests of mining companies?

The ability of the state to resolve such issues is critical for growth prospects. Lack of trust in that state lies at the heart of India’s economic failure. Restoring faith in the currency may be the easy part.