The Indian urban middle classes have never had it so good. Almost every urban Indian is expecting an unceasing flow of easy profit from the stock market. But the economy is heading for a setback and so is the stock market.
Growth over three years has been financed largely by growing domestic savings, less by current account deficits, which are high but not unsustainable despite high oil prices. But current account deficits are higher than Brazil or China. The Rupee keeps rising, unlike the Chinese Yuan. Domestic demand has driven Indian growth, while exports drove Chinese growth. We have supply constraints in every sphere – tradable manufactured goods, physical infrastructure and social infrastructure. So investment in new capacity is booming. So is public and private investment in physical and social infrastructure, triggered by lower interest rates of recent years, External Commercial Borrowings (ECB’s), and fast rising tax revenues.
The last boom in investment in new capacities was in the late 90’s, but did not cover as wide a span of the economy. The new India story has attracted huge foreign investment in Indian equity markets and real estate, helped by low American interest rates and fears about the American economy’s decline.
The inflows are due not only to low interest rates in the US and Japan, but also the Indian growth of three years, relatively lower Price/Earnings (almost half) ratios in India as compared to China, the perceived security of Indian investments, the easy repatriation of funds. ECB’s have added to liquidity. The RBI has tried to soften the inflationary impact of this liquidity by hesitant raising of interest rates, and more often by restraining bank liquidity. But the surge in liquidity continues, with its inflationary potential.
Notwithstanding the expansion of liquidity (21 per cent in money supply over the year), inflation is said to have been contained. This is a mirage. Only import costs have declined because of the rising rupee. Subsidised fuel and power prices despite rising imported crude prices, add Rs 70000 crore this year alone to oil company losses. Low fuel prices have kept the price index low.
Government's fiscal deficit is fictitiously low. Yet it is higher than in comparable developing countries. Apart from concealing the reality of inflation for the consumer through subsidising consumer prices for fuels, the prices of primary products (food, etc) are rising. Hence the claimed inflation in the wholesale price index is a poor indicator of actual expenses of most consumers.
In addition, the rising Rupee is hurting exports, depressing industrial growth, causing unemployment and adding to inflationary potential. Another negative influence is the hidden inflation because of subsidised fuel prices. It is overseas fund flows into stock markets that have helped stimulate the economy. But it also has inflationary potential and strengthens the Rupee. The dilemma is to slow these inflows but not hurt economic growth. Reserve Bank of India (RBI) has put restraints on companies borrowing overseas, and raised Cash Reserve Ratios to restrain bank liquidity, though without raising interest rates which would hurt consumer and home loans and so, industrial growth.
Are rising stock prices, large foreign fund inflows, a rising Rupee, declining exports, apparently low inflation and high levels of Gross Domestic Product (GDP) growth sustainable for long? They are not. Many things can go awry: decline in domestic and export demand, rising rupee exchange value reducing export margins, collapse of the American economy, swamping of the domestic market with cheap imports as exporting countries like China look to Indian markets, and rise in oil prices.
Unlike china, India has been unable to hold its Rupee exchange value from rising. This is because Chinese fund inflows are less volatile, being from direct investments and substantial export surpluses. Our growth depends on low interest rates, easy availability of cheap foreign funds, foreign investment in stock markets, and substantially increased government investment in physical and social infrastructure helped by booming tax revenues due to economic growth. These have stimulated industrial investment and domestic demand, not exports. A fall in foreign fund inflows will hurt growth; and negate these growth stimuli unless replaced by direct investment. This is happening but very slowly. Faltering growth will depress tax revenues and government investments.
Equity prices have risen too fast, too quickly. Slowing down of industrial production, rising crude prices, adding to already high government deficits, rising rupee values, rising imports, falling exports, will hurt the economy. If fuel subsidies are cut, inflation will rise. If subsidised prices continue, government spending on other sectors will reduce, hurting growth. To meet the high oil subsidy costs, either retail fuel prices must rise or government must raise taxes to meet the costs or cut its infrastructure spending.
The dilemma of heavy dependence on volatile foreign fund inflows, and the sharp increase in world crude prices must soon be resolved. Reining in foreign inflows could hurt economic growth. To manage high crude oil prices without raising inflation, growth and dependence on volatile foreign funds must be moderated.
