Undue optimism

The state of economy

There have been many optimistic forecasts about the Indian economy, in recent weeks. Most have relied on the 2.4 per cent industrial growth in May and a rise in the sale of cement and automobiles to conclude that the worst is over. But Pranab Mukherjee’s recent forecast that the Indian economy will grow by nine per cent in 2010-11, strains belief.

In times of recession it is one of the finance minister’s tasks to ‘talk up the economy.’ But at what point does responsible propaganda cease to do good and start to do harm? Mukherjee’s prediction may have crossed that line. For instance, his  confidence could easily persuade millions of small investors, who got burned in the crash of 2008, to invest once more in shares.

Mukherjee’s forecast might have been more credible if the reasons he gave for expecting growth to rebound had been more credible. At an interactive session organised by the Goa chief minister, he asserted that the increase in spending power that his budget had created, especially in the rural areas would pull the economy out of the trough in which it finds itself today.

But agriculture is facing a drought. The area sown has dropped and the yield is likely to drop even more, especially in rain-fed areas. Thus the  additional spending will at best prevent a contraction in rural demand. It will certainly not give it the fillip that Mukherjee is so confidently expecting.

But this apart, he is wrong because his economics is  flawed. His reasoning is that the economy, having grown at 6.7 per cent last year, is likely to grow again at around seven per cent this year and nine per cent next year is only a two per cent jump. Industry’s response to the rise in demand caused by last year’s fiscal stimulus (and the Rs 2,37,000 crore) will automatically bridge the gap.

But this will not happen. First the actual growth rate today is far lower than the government is willing to concede. After deducting the large increase in civil servants’ salaries, pensions  and arrears, (a sum that by a quirk of national accounting is considered a real increase in GDP), the actual growth rate was 5.7 per cent in 2008-9 and only 3.8 per cent in its second half.

This year, with a decline in agriculture virtually unavoidable and at most a four per cent growth in industry, the real growth of GDP may fall short even of the World Bank’s prediction. Where then will the additional five per cent come from?

Mukherjee seems to think that the recovery of demand will automatically push up industrial growth. It will, but only till industry exhausts its excess capacity. Beyond that growth can only come from fresh additions to capacity, and that requires additional investment. Unfortunately, Mukherjee has chosen to finance the fiscal stimulus not through deficit financing but by borrowing from the commercial banking system in sums that defy the imagination.

As a result, all the money that got released for lending to the private sector, by the RBI’s reduction of the cash reserve ration from 9 to 5.5 per cent, was swallowed up by the government, and channelled into consumption instead of investment. Nominal interest rates did not therefore come down and as the price rise reversed itself under the weight of recession, real interest rates rose to unprecedented levels.

The government’s huge borrowing programme will continue to crowd out private investment. According to a Swiss bank study, the private sector had postponed almost one million crore rupees worth of investment by the middle of last year by an average of 18 months. That was before the global recession began! Today there is hardly a single new share issue being floated in the share market.

Nor is the public sector filling the gap. The entire capital investment envisaged in the budget amounts to Rs 25,000 crore — a pathetic $5 billion. Against this, China has initiated $650 billion worth of investment projects between January and March this year. Those who have  grown accustomed to talking of China and India in the same breath would do well to ponder over what the difference signifies.

The truth is that the government has blown it! The global recession had given it a once in a lifetime chance to fill the yawning infrastructure gap that has kept serious foreign investors out of this country. With demand collapsing, a fiscal stimulus was urgently needed. So for once the size of the fiscal deficit did not matter. But the government chose to stimulate consumption today, with a truly regal disregard for India’s tomorrow.

There are only two ways left to revive investment without borrowing still larger sums from the banking sector. The first is to ask the RBI to buy up government bonds through open market operations. This will lower their yield, and therefore the floor beneath prevailing interest rates, while increasing the lending base of commercial banks.

The second, and more direct route would be to subsidise the interest on loans for infrastructure projects and for some of the one million crore worth of postponed projects, in order to bring the effective rate of interest down to around seven per cent. Not only will this unfreeze the logjam in investment but the subsidy will automatically end when markets revive and long term interest rates come down.