Is the India growth story over?

Unexpectedly weak growth in the first quarter of 2012 was a slosh of icy water in the hot Indian summer. The near-halving of GDP growth to 5.3% in the first quarter of 2012 from a stellar 10.1% in the same period in 2010 has led some analysts to question whether India’s high-growth phase was a blip.

However, a close look at the underlying causes of the present downturn suggests that it is cyclical, although with deep underlying distortions that need a fundamental overhaul to put growth back on track. The structural drivers capable of sustaining high growth rates over a long period remain in place.

Economic mismanagement

The current economic slowdown is, more than anything else, a result of economic mismanagement, principally arising from fiscal indiscipline. Its genesis lies in the damaging drought of 2009 that pushed up food price year-on-year inflation to an average of 15% for two successive years. This happened in the presence of ongoing, structural shifts: real per capita income rose 39% between 2004–2005 and 2009–2010, leading to a higher intake of proteins; the government raised the minimum support prices of cereals during this period; and higher welfare spending boosted rural incomes and consumption. Rising demand exacerbated supply constraints, since Indian agriculture is characterized by stagnant productivity, a long-term decline in yields, lack of public investments resulting in weak rural infrastructure, market imperfections such as inefficient supply chains and high taxation in some states.

These forces and the resulting demand–supply mismatches made inflation more generalized, spilling over into overall price increases that averaged 10% by 2010–2011. This invited monetary tightening at a time when the economy was rebounding from the crisis shock to a robust growth of 8.4%. But fiscal policy failed to complement monetary policy and address supply-side constraints. On the contrary, unrestrained fiscal expansion boosted aggregate demand through the continuation of fuel subsidies and welfare spending. As a result, the fiscal deficit, which had doubled from 4.1% of GDP on the eve of the crisis to 8.5% of GDP in 2008–2009 as a result of stimulus responses, widened to 9.3% of GDP in 2009¬–2010 even as the economy recovered. This fuelled inflation, especially as subsidy expenses remained uncontained at well above 2% of GDP. Fiscal profligacy also impacted the external sector through oil imports, which feed 80% of India’s overall energy requirements. Energy demand was unhampered despite rising global prices.

Global economic downturn

This fiscal situation persisted into 2010–2011 even as inflation remained high. When the global economic situation took a turn for the worse in the middle of 2011, the economy, highly dependent upon external funding, was already vulnerable. India was running a current account deficit of 2.7% of GDP when the global situation deteriorated, leading foreign investors to become risk-averse and European banks to start shrinking their balance sheets. Combined with an already vulnerable domestic economic situation, these external events caused growth to contract sharply from 8.1% in the second quarter of 2011 to 6.7% in the third and 6.1% in the fourth and finally 5.3% in the first quarter of 2012. Likewise, the current account deficit worsened to an unsustainable 4.3% of GDP in the fourth quarter of 2011, leading to steep and steady currency depreciation and making macroeconomic management more difficult and complicated.

India’s short- and long-term growth prospects

In the short term India needs to tame inflation and revive the investment cycle if the economy is to break out of the stagflation in which it is presently trapped. Policy changes are needed to reinvigorate growth, including reducing subsidies to improve internal and external deficits and lower inflation; stimulating infrastructure investments through specific interventions in land, environment and other issues; and reassuring foreign investors scared off by policy errors.

In the longer term, the structural basis of India’s long-term growth will be founded upon a rich demographic dividend, with the share of earners rising in proportion to dependents. If they are gainfully employed, this vast pool of labor will translate into rising incomes, savings and growth. India will have an opportunity to enjoy the transition dynamics of development, where labor moves from low-productivity agriculture into higher productivity manufacturing and services sectors; these trends will be supported by an existing base of private entrepreneurship that has withstood and flourished amid global competition.

One could argue, as some commentators have, that India’s “demographic dividend” may be squandered through lack of education and a lack of employment opportunities. But India’s dysfunctional politics can only delay, not derail such prospects. Given India’s positive structural features and the need for Western investors to deploy their pools of long-term capital to sustain their aging populations, there is little doubt that India’s potential for sustained economic growth and development remains intact. The current weak macroeconomic fundamentals are a symptom of a deep cyclical downturn. They do not say the Indian growth story is over.