May 19, 2012
As Europe descends into an ever-deepening crisis, the much-touted Indian growth story also seems to be nearing its end. Though the two trends are not unrelated, attributing India's predicament solely or principally to what is happening in Europe would be wrong. On the other hand, there are similarities in the two experiences that should be taken into account when framing policy to deal with India's problem.
In India, the evidence that GDP growth is slipping and falling way short of the government's 9-10 per cent target is not the only issue. Even as growth slows, inflation, which had emerged as the country's principal challenge, is showing no signs of going away. Inflation had initially declined a little as compared to the peak levels it had reached last year; but it is now again bound upwards. With the government committed to raising the prices of oil in line with the spurt in international prices, this problem will only worsen. Lower growth and higher inflation seem to be the projection for the immediate future.
Incipient stagflation
To the government's discomfiture, this incipient stagflation is also not serving to reduce the pressures on the balance of payments front. India had been recording trade and current account deficits that were rather easily financed by the large capital flows the country had attracted. But with international oil prices rising sharply, and a combination of speculation and investor flight to safety increasing the demand for imported gold, India's import bill rose sharply in the last financial year. In the event, despite exports having held their own in 2011-12, the current account deficit has burgeoned. The result is weakness of the rupee that now seems to have become the target of speculation, resulting in a sharp downward slide in its value.
A collapsing currency is a sure negative signal for international investors, and can accelerate their exit. A downward spiral is a possibility that therefore needs to be pre-empted.
However, there appears to be no convincing response from the government thus far. The RBI is wary about stoking inflation by reducing rates to spur growth. The deficit on the government's budget and India's relatively high public debt to GDP ratio are preventing the government from raising expenditures (as it did in response to the global crisis of 2008). This is partly because of the government's own fiscal conservatism. But the more important reason is the fear that larger fiscal deficits or higher taxation would upset foreign investors and hasten their exit.
In the event, we have the Finance Minister speaking of the need for austerity and harsh decisions amidst a slowdown in growth. That could convert falling growth into a recession. Further, the “harsh decisions” involve measures such as cutting subsidies to reduce expenditure and raising oil prices. Combined with the increase in the prices of imports as a result of the rupee's depreciation, these administered price hikes would only fuel inflation, and further aggravate the tendency towards stagflation.
Bandwagon effect
The potential for a cumulative slide has already triggered a bandwagon effect. Rating agencies have downgraded India and international investors, heeding these agencies, seem to be reducing their exposure. Shaken by this response, the government seems set to implement austerity.
That could worsen the downturn without correcting either inflation or the balance of payments. Prices could rise, the rupee could fall and this process could continue till (for reasons no one knows yet) the downturn touches bottom. This scenario is a possibility that policy needs to address. But it is precisely at this juncture that the government appears constrained because of the legacy of financial liberalisation in the form of the accumulated presence of foreign finance in the country. All policy thus tends to be viewed first in terms of the effect it would have on the confidence of those investors, rather than its efficacy in addressing the problems at hand.
Similarity with Europe
It is here that the similarity with the European predicament is apparent. Countries in Europe accumulated large private or public debt as a means to driving growth, encouraged by the easy access to credit that proliferation of finance entailed. That seemed acceptable so long as growth was the norm. Borrowers were seen as being capable of meeting their commitments, based not on additional borrowing but on income expansion. When the global crisis slowed growth or brought it to a halt, this belief was challenged.
In countries where private debt predominated, such as Ireland, the recession resulted in defaults that made lenders wary and froze the credit pipe. That only aggravated the problem, leading to a worsening of the recession, increased unemployment and a larger number of defaults. In many of these countries the response to the crisis was a bank rescue that involved the substitution of public for private debt. Households and firms remained mired in recession, but creditors cut their losses and the debt was passed on to governments. In time, however, these countries as well as those, like Greece, where public debt was the main problem, found that reduced revenues resulting from the recession and larger debt service commitments had left a huge hole in their budgets. On the other hand, their ability to borrow more to finance expenditures and service debt had been significantly curtailed.
Thus sovereign default, which was earlier a developing country problem, became a possibility in the developed world, if additional credit to meet expenditures was not forthcoming. However, additional credit to “help” countries avoid default was provided only on the condition that they opted for austerity. Cutbacks in government expenditure were expected to reduce deficits and release the wherewithal to finance future debt service commitments. This imposed huge burdens on the people in the form of increased unemployment, reduced incomes and a collapse of social security outlays.
The outcome was contrary to expectations. Rather than reduce deficits and generate surpluses, the output contraction resulting from expenditure cuts reduced revenues, making it impossible for these countries to meet their deficit reduction targets. A cycle of enhanced austerity, lower growth and worsening debt service capacity followed, with no solution in sight. It is clear from this that in bad times countries need to get out of the slowdown-austerity-recession cycle by substantially increasing expenditures to restore growth and employment. This would, over time, also raise the revenues to finance some of their debt commitments.
Though there are important differences between India and Europe, there are two similarities here that need to be recognised. The first is that India's fiscal deficit and debt to GDP ratios have been declared to be unacceptably high by international finance. The government has also been overly sensitive to the perceptions of international investors because of the latter's large presence in the country. This explains the call for austerity. Catering to the interest of global finance and allowing it to influence or determine policy not only increases economic instability, but also induces an element of “policy paralysis” because of a reduction in the state's room for manoeuvre. Central to that paralysis is a self-imposed limit on spending resulting from a fear of raising resources through taxation and financing expenditures with borrowing. Second, a government afflicted by such paralysis when confronted with slowing growth or even stagflation, tends to adopt policies that trap the country in a recession. This has already occurred in Europe. It is a real possibility for India.
Lesson for government
The way out, as clarified by economists with divergent inclinations, is to escape from this vicious cycle by expanding spending, and finding ways other than expenditure contraction to address inflation or balance of payments difficulties. But that requires not only ignoring the demands of finance, but also countering its speculative manoeuvres. In contexts like India, if recession hits, controls on the movement of footloose and speculative capital are a must to give the government the required room for manoeuvre. That is the lesson the government must glean when seeing its own image in the European mirror.
(C.P. Chandrasekhar is Professor, Centre for Economic Studies and Planning, School of Social Sciences, Jawaharlal Nehru University.)
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