When Indias newly re-installed Congress-led
administration unveiled its first budget in July, the stock
market responded by plummeting 6% on fears a fragile economic
recovery was in jeopardy.
Welcome to the tug-of-war between market expectations and
Markets assumed the decisive re-election of reformist prime
minister Manmohan Singh would spark a spate of reforms and
spending restraints hitherto blocked by the Communist party.
Instead, finance minister Pranab Mukherjee announced the
federal deficit would widen to 6.8% in a calculated
risk to boost growth, and hailed the wise and
visionary decision to nationalize the banking industry 40
The government continues to prime the fiscal pump by further
expanding welfare programmes and slashing key taxes. Over the
past two years, the central bank has injected further liquidity
by reducing interest rates and aiding the governments
This fiscal and monetary stimulus aims to soften the
slowdown in the business cycle. Weak consumer and market
confidence, destocking by firms and the poor external demand
have checked Indias growth rate. Industrial production
fell to 0.1% between January and March, from 7% a year earlier,
and it remains at its weakest level since 2002. Domestic
consumption has fallen from 8.5% in 2007 to 2.9% in 2008, and
still stands at just 1.6% in the second quarter of the
Nevertheless, there are signs the economy is improving. The
country grew by 6.1% annually in the second quarter of the year
compared with 5.8% in the previous quarter. Foreign capital is
pouring in, businesses are slowly re-investing, and consumers
are returning to the shops.
But there is now a dispute over which strategies to pursue
to make the recovery sustainable. Conservative economists want
the government to curb its spending while the central bank
concentrates on inflation. Meanwhile, the government is
focusing on public investment in the near term as the virtuous
growth cycle of domestic consumption fuelling investment
via surplus savings remains weak. This strategy will
generate enough revenues to soak up the deficit in the medium
term, it argues.
But ratings agencies are concerned about Indias public
finances. They say that without timely consolidation the
countrys BBB- rating is in jeopardy. The budget deficit
has jumped from 3.3% in the 2007 and 2008 fiscal year to an
18-year high of 8% the following year, including off-budget
outlays such as oil subsidies.
This makes Indias fiscal burden one of the largest in
the emerging world and the highest in Asia. While China entered
the crisis with a low level of public debt at 40% of GDP, and
the US at 40%, India faces an 80% public debt burden.
This fiscal deficit will endanger sovereign borrowings...
and has implications for interest rate structures, says
Rupa Rege Nitsure, chief economist in Mumbai at Gujarat-based
Bank of Baroda.
But the massive upturn in emerging market risk appetite in
March which helped Indian asset prices rebound and the
currency strengthen has meant that some analysts are now
arguing that the governments plan to contain the deficit
to 6.8% this year and 5.5% next are achievable. But the
situation has been complicated by an unforgiving drought:
farmers have suffered a record delay in the summer monsoon
rains, causing drought in 177 districts.
While government grain stocks will avert famine, there is
disagreement over the economic impact. Optimists say
agriculture only contributes 20% of GDP, and the affected
districts account for a mere 3%, so real growth will only be
reduced by a sliver: at a maximum of 0.5%.
Others say the impact could be far-reaching. Two-thirds of
Indias population lives in rural areas and higher food
prices will erode rural and urban purchasing power. This will
depress consumption, says Samiran Chakraborty, head of India
research at Standard Chartered in Mumbai.
The Planning Commission expects the economy to grow 6.3%
this fiscal year and 8% in the next, but it has yet to revise
its forecast until the full effects of the drought are
The government is expected to play it safe and maintain its
fiscal expansion. Chinas growth-at-all-costs philosophy
is well known by the mantra protect 8%; India has a
similar growth bias under the Congress party led by Sonia
It has placed rural growth at the heart of its populist
development agenda. Over the past few years, the government has
cancelled small farmers debts, expanded a rural
employment scheme and increased wages for state employees. This
was key to ensuring its unexpected re-election in May and is
vital to retaining its popularity.
FIGHTING THE DROUGHT
As a result, the battle to fight the drought could consume
yet more fiscal resources, which has sparked fears that
unbridled government borrowing could hike market interest
rates, choke off private investment and so derail the
economic recovery, says Chakraborty. Meanwhile, as the
central bank targets inflation, government borrowing costs will
jump, which will further exacerbate the crowding out of the
When the government borrows as much as it has, it is
inevitably going to put pressure on interest rates, and
therefore there is need for coordination between monetary and
fiscal authorities, says Reserve Bank of India (RBI)
governor Duvvuri Subbarao, in an interview with Emerging
Markets in the RBI headquarters in Mumbai.
The government 10-year benchmark bond has remained between
7.0% and 7.5% over the past few months and stands at the wide
end of the range, in anticipation of new supply. The government
is likely to raise around Rs4 trillion through net market
borrowing in the 2010 fiscal year compared with Rs2.6 trillion
last year, according to JP Morgan.
Many banks are close to their 25% limit for government bond
purchases which are guaranteed under the
held-to-maturity category as a percentage of their net
demand and time liabilities. As a result, if banks buy paper
above this limit, they have to be marked to market and will,
thus, expose them to potential losses if yields widen. This may
disincline some banks from buying government paper.
Nevertheless, analysts say the banking system still has
excess liquidity, while credit growth is likely to remain
comfortably below deposit growth in the coming months as
demand for new loans remains weak, says Siddhartha
Sanyal, economist at Edelweiss Capital, one of Indias
largest investment banks.
The government is banking on yields on sovereign paper
remaining stable. Bond yields have risen in the recent
past, but I dont see a sharp hardening of the rates in
the near future because there is enough liquidity in the system
and private-sector demand remains stable, says C
Rangarajan, chairman of the prime ministers Economic
Advisory Council, in an interview with Emerging Markets in New
However, after being one of the most aggressive in loosening
monetary policy in Asia, the RBI is faced with the difficult
task of ensuring monetary conditions remain calm and loose.
After dipping into negative territory, the wholesale price
index is now positive while the consumer price index is in
double digits. The threat of supply-side price shocks looms
In a bid to anchor inflation expectations, Subbarao is quick
to sound a hawkish note: If the supply shocks tend to
fuel inflation expectations as indeed they will in a
country like India, where food takes up the majority of the
consumption basket then monetary policy inevitably
becomes the first line of defence.
The difficulty for market players is that unlike his
predecessor, YV Reddy, who was seen and liked to be seen
as an inflation hawk, the jury is still out on
Subbaraos views on the relative emphasis of growth versus
price stability. I have not really thought in terms of
establishing a reputation for a particular stance, he
Subbarao says the RBI is attentive to the balancing act of
establishing price stability without destabilizing markets or
choking off the emerging engines of growth. I am hoping
to get the balance right and that the market will interpret it
to be the right balance, he says. It is very
important for the central bank to be transparent to tell
the market what we know.
Analysts say that, in the coming months, the RBI may hike
the cash reserve ratio the percentage of cash commercial
banks must keep in reserve rather than make a rate hike
in the near term. This would not fundamentally restrict the
presently ample liquidity conditions. Instead, the policy and
its timing risk spooking markets if there are concerns about
the future supply of credit, and could bring the recent spate
of interest-rate cutting by commercial banks to an abrupt
While the central bank is independent, it still faces
opposition to any move to tighten rates while the government
embarks on its deficit-financed spending spree. Its ability to
function is complicated by the RBIs mandate for growth
and role as government debt manager. Finance minister Mukherjee
said in mid-September, At this point of time I cannot
accept dear money policy or credit curbs as it will have an
adverse impact on growth.
Subbarao says he will maintain loose credit conditions to
stimulate private-sector expansion. We are hoping that
private demand for credit will pick up in the second half of
the year, and we will continue to provide liquidity to get
banks to lend, he says.
But he is calling for the government to commit to
medium-term fiscal consolidation to boost market confidence.
The government aims to bring it down to 5.5% next fiscal year
and 4.4% in 201112. For now, it is awaiting the 13th
Finance Commission report in December that will advise on a
plan to implement this fiscal consolidation. Everyone
knows this fiscal deficit is not sustainable, and I dont
think the country can afford this year after year, says
Rangarajan. But as the economy recovers and private
demand picks up, the government will put in place a programme
to bring it down over the next two to three years, he
For now, the government argues revenue buoyancy once
high growth kicks in combined with the sale of
government stakes in state-controlled companies will help rein
in the deficit. But given the failure of the first Fiscal
Responsibility and Budget Management Bill, which legislated a
3% deficit target, there is scepticism that a medium-term
programme of deficit reduction will be met. The way the
government is going with its large borrowings has left me with
the impression that it will shy away from fiscal reforms and
other necessary liberal policies, says Nitsure at Bank of
The lessons Indian policy-makers draw from the crisis will
be crucial in determining the pace and composition of any
reform process. The left in the ruling Congress party have less
appetite to make tough spending decisions or accept the virtues
of the market in driving rural development: premised on the
idea that Indias macroeconomic policy mix is sound.
The country is decoupled from the global economy as it can
grow by 7% purely from activating domestic demand. But it
is coupled with global business cycles if India wants to grow
at 9%, says Sanyal at Edelweiss Capital.
Indias healthy fundamentals have helped pull the
economy out of the global crisis. It is less trade dependent
than its rival China. And, over the past year, the private
sector has still been able to turn to Indian state banks, which
control 70% of the sector, for credit. The banks are flush with
liquidity thanks to laws forbidding investments in risky
products and overseas markets.
Analysts say the government needs to remove costly oil
subsidies, reform labour laws and modify the rural development
programme to optimize productive investment. Most
controversially, Indias increasingly complex
market-orientated economy necessitates a deeper and more
liberalized financial sector, say some analysts.
Last year, Indias Planning Commission was advised by
the High Level Committee on Financial Sector Reforms to
privatize Indias banks. This would channel investment
into more productive sectors, lower the cost of capital through
competition and bring the underbanked into the economy, argued
the report authors Raghuram Rajan and Eswar Prasad, who are
(perhaps unsurprisingly) ex-IMF economists.
However, real financial reforms conflict with the soul
of the Congress party, says Saugata Bhattacharya, chief
economist at Mumbai-based Axis Bank. And while the government
has huge borrowing needs, radical reforms are even more
unlikely. Thankfully for India, real reform is not a
prerequisite for strong growth in the near term.