Low growth rates are envy of other nations

Capitalism is by some measures a merciless system. Investor confidence wanes as quickly as it accumulates. Bank runs exacerbate the afflictions of struggling banks. Entire nations are subject to the same mechanism — capital tends to pack its bags and take flight to more liquid shores at a time when it is needed most. India, strangely, now finds itself in this position.

As recently as the first half of 2011, the consensus was that the country would grow at 10 per cent per annum  over the long run — an exponent that would make it the world’s second-largest economy by 2050. But suddenly the numbers don’t look so rosy. At last release, gross domestic product (GDP) growth figures stood at just under 7 per cent and industrial production declined just over 5 per cent as compared to the preceding period. A comparable slump surfaced in early 2009 (well during the depths of the global recession) when industrial production fell about 7 per cent — the only difference is that this time, there may not be any overriding external factors to blame.

What worries investors at the moment is that the slowdown has been induced by the Reserve Bank of India (RBI) — making it seem a matter of policy rather than natural phenomenon. The institution has raised interest rates throughout 2011 to curb inflation, which currently sits at around 7.5 per cent. Inflation had dropped sharply from 9 per cent at the end of 2011, paving the way for the RBI to slash interest rates — a move widely expected in late January. Historically, inflation at 7.5 per cent is low by Indian standards. The RBI has been given a rare window to address the slowing economy and stimulate spending. This will likely spell the end of the upward trajectory that the rupee has been on as of late, but conversely will revamp demand for India’s exports.

“The central question to India is whether the RBI can stabilise economic performance without losing sight of inflation. If it is successful, this soft landing will be the prerequisite for a recovery in the second half of the year,” Bank Sarasin-Alpen, a Swiss private bank, said in a 2012 strategy outlook published last week.

The problem is that inflation is likely the result of other factors; not simply an overheating economy. Structural issues such as supply-chain bottlenecks relating to individual firms as well as larger infrastructural shortcomings could easily account for rising prices. Monetary policy can also sometimes be used as a political tool for appeasement during electoral cycles. High inflation tends to be the bane of the masses; this holds especially true for poverty-stricken India.

The economic model that has been in place for the good part of 20 years now; responsible for India’s special growth, has also allowed the government to run a current account deficit. Thus far, it has been financed by inflows of capital from abroad. A two-decade bull run and the cheapening currency have made it quite an attractive place for foreign investors to deploy funds. Now that India is on the precipice of a slowdown, the fiscal dynamics of this growth model are now at risk as capital is now escaping rather than rolling in.

Sreedhar Sreekakulam is a Partner at S.H. Bhandari & Company, a chartered accountancy firm based in India. He shed some light on the reasons behind the recent money outflows. “You may have noticed recent trends in corruption curbing and black money being brought back from outside India. All opposition parties support this movement for political mileage in the coming elections. In effect, the companies who have parked funds in these ‘front’ companies are becoming more cautious. On the other hand, there are Indian companies with foreign earnings who have a choice to park their cash outside India and earn a better ROI [return on investment]. They can earn more because of the depreciation of the Indian rupee. The slowing economy is down to the trouble in global markets, but it is also due to the government’s inability to curb inflation, and the banks tightening lending.”

The falling rupee is an area of vital concern for Singh’s government from the perspective of rising inflation and capital flows. In late November, it fell to an all-time low against the dollar — surging above 50 rupees per dollar for the first time ever. The plunge happened abruptly, and cast a country thus far well insulated from outside recession, in a new light to investors.

Overall, a cheaper currency is not necessarily a bad thing — the trade deficit should improve with cheaper exports. Plus, India’s government generally borrows locally, selling most of its bonds to domestic banks. If creditors were largely foreign then the currency would have been a much larger issue. Public sector debt stands at 55 per cent of GDP — a very reasonable number especially compared to European credit mongers. The problem is that since banks are tightening credit, Indian companies have had to go abroad to borrow money — and they are getting killed by the depreciation. To counterbalance the effect, they have started moving deposits abroad as well; hence the capital outflows. It isn’t that easy however. A significant portion of India’s foreign loans at the corporate level are supplied by European banks — who on account of their own travails are curtailing lending. Some firms are suffering from the insulation.

The RBI is a respected institution that by and large, knows what it is doing. The Indian banking sector, regulated by the RBI, has grown at a furious rate for years. Loan portfolios are three times the size they were in 2005 — usually an indicator of indiscipline. Non-performing loans however are under 3 per cent today, down from around 20 per cent 15 years ago. Unfortunately this seems to show that banking sector growth carries the economy and when banks become cautious, the brakes are on. The RBI provides the cushioning they need in tough situations. It was reported that some were allowed to escape losses on loans to the government-owned dead weight, Air India. > Provisioning requirements are however lax compared to other nations. If forced to book heavy losses, these banks would sink a lot quicker. They are hence far more frugal when lending to the private sector.

The big question is — what can the government do to stave off a descent into growth around 5 or 6 per cent this year?

Firstly, it is important to note that the country’s leaders would need to sideline their political objectives. The tools are available but they’re likely to bruise whoever uses them. Reforms could be expedited — specifically those addressing supply-chain issues linked with inflation.

In addition, red tape around infrastructure development projects needs to be cut up faster. Mobilising banks to open up credit streams should also be on the agenda: lowering capital requirements for local banks to free up funds and easing regulations on foreign banks lending to Indian businesses. These could even be short-term measures to galvanise the economy out of its current state.

The government could itself try and affect the exchange rate by selling off some of its 300-odd billion dollars in foreign reserves, and buying up rupees.

The great Indian machine is built in such a way that strong growth is essential to conceal some of the structural deficiencies in the economy; not to mention toxic assets on bank balance sheets and the government’s current account deficit. The current state is by no means a disaster, but investors are unforgiving. India must make itself attractive to them, even if just for the short term; buying time to get their deeper-lying ducks in a row.