Uneasy on cloud nine

The Indian economy has grown at a surprise 8.9% clip in the July-September quarter, thanks to a robust summer crop and a surge in consumption demand. Moving forward, this momentum is likely to continue through the remaining two quarters of the fiscal, which means we may end 2010-11 with close to 9% growth.

The numbers are good news, indeed. They not only make India’s economy count among the fastest to recover from the global financial crisis, but also put it back on the trajectory it charted before the crisis.

A closer scrutiny of other economic indicators, however, leaves us with very different impressions. The outlook for the broader economy may remain as good in the short run as it is now, but there are serious risks to sustaining the growth momentum over a longer term.

While the strong recovery has been largely attributed to a fast revival of domestic demand, the slow recovery in the industrialised world — or even a double-dip recession in the US and parts of Europe, as is feared — would be a definite constraint to accelerating growth of Indian economy.

Downside risks

The essential difference between now and the scenario that prevailed in 2007 is that most of the favourable conditions that supported growth in the pre-crisis period are no longer there.

Low inflation and interest rates between the high growth years of 2004 and 2007 meant the sharing of increases in income was more equitable and, therefore, more sustainable than earlier. High growth also meant higher revenues for the government, which, in turn, allowed it to spend more on such measures that help broadbase growth, yield political dividend and create a virtuous cycle of economic expansion. At the same time, fiscal deficit could be reduced and public debt cut.

In contrast, even as growth has returned to the pre-crisis trajectory, the systemic weaknesses that bogged the Indian economy before the boom years are also back.

“The older vulnerabilities have not gone away; in many cases these may have deteriorated,” said YV Reddy, former governor of Reserve Bank of India.

The fiscal deficit of the central government, which had progressively declined through the pre-crisis years to 2.6% of GDP in 2007-08, rose to 6.2% in 2008-09 and 6.6% in 2009-10. The figure is expected to drop sharply this year, but that would not represent a systemic improvement because much of the decline will be because of the one-time windfall from the auction of 3G spectrum. If one factors in off-budget items and deficits in state budgets, the combined fiscal deficit would top 10% of GDP, or nearly thrice the pre-crisis level.

The return of foreign investors to the stock market is a vote confidence in the Indian economy and its recovery from the global crisis, but Indian policy makers face an uphill task in managing FII inflows that have further accelerated in the wake of monetary easing in the United States. While FIIs have helped the Sensex cross its previous record, the copious inflows — $29 billion so far this year — affect the stability of the currency market and threaten to create asset price bubbles.

An appreciating rupee hurts exports. More importantly, as exports remain sluggish, a growing trade deficit coupled with FII inflows has pushed the current account deficit in the latest quarter to 4.3% of GDP — the highest in many years.

The deterioration in these two deficit figures has prompted some experts to compare the situation with that which existed before the balance of payments crisis that India faced in 1991. But the huge pile of foreign exchange reserves that India has will cushion it against any threat of a repeat of a 1991-like situation.

Inflation biggest challenge

The biggest concern, however, relates to inflation. And, as Reddy said, commodity prices pose the biggest risk.

Though the wholesale price-based inflation rate has steadily declined in recent months to 8.6% in September, food prices continue to rise at a double-digit pace.

“When fiscal deficit is high and government finances are strained, the onus of managing inflation increasingly shifts to monetary authorities,” Reddy said, referring to the steady increase in interest rates by the RBI.

As the latest GDP numbers showed, consumption contributed 6.7% to the growth in July-September quarter, while investment contributed 4.3%.

“The surge in consumption in rural areas has been supported by the government’s rural programme and the good harvest, while urban consumption is reflective of pent-up demand and consumer confidence,” said Rohini Malkani at Citi Investment Research & Analysis.

The question is: how long will this sustain?

The rising interest rates have begun to affect business confidence and new investments. As investment slows, industrial growth is likely to moderate. For the next two quarters, the drop may be offset by a higher growth in farm output, and, as the government’s chief economic advisor Kaushik Basu said, we may still finish 2010-11 with 9%. But how the scenario will pan out thereafter remains unclear.

Road ahead could be bumpier