The economy's fate hangs by a thread

The Indian economy is on the verge of a  free fall. The rupee lost three-and-a-half  per cent of its value against the dollar  in three days between June 17 and 20, and the fall has not stopped since. Foreign institutional investors have pulled Rs21,000 crore out of debt funds and are also pulling out large sums from  the equity market.

The flight from the rupee came to a head on June 20, the day after the US Federal Reserve announced plans to  wind up its $85 billion fiscal stimulus programme. The chief economic adviser to the finance ministry, Raghuram Rajan, has pointed out that there has been a similar dip in the exchange rate of most other developing countries. The rupee would stabilise, he forecast, once the Reserve Bank of India stepped into the forex market.

But the RBI governor, D Subbarao, has already struck a note of caution. India’s net liabilities abroad are now considerably higher than its foreign exchange reserves. Its balance of payments deficit touched 6.7 per cent of GDP in December 2012, more than twice the  ‘safe’ level of 2-3 per cent. Its external private borrowing is now close to $400 billion. Doubts are, therefore, beginning to arise in the international financial community over India’s continued solvency.

The June 20 shock has come at the  end of the two  most miserable years the Indian economy has known since the crisis of 1990. Economic growth has halved from 9.8 per cent in 2010-11 to 5 per cent. Employment growth is stalled and an estimated 25 million young people who would have got jobs five years ago are without work. For nearly three years, the government has been blaming the global recession for this decline. But it is itself the architect of the country’s misfortune.

Two utterly incompatible policies, pursued by the government in Delhi and the RBI in Mumbai respectively, are responsible for the end of the Indian dream. In 2008 and 2009, Delhi responded to the global recession with a fiscal stimulus running into hundreds of thousands of crores of rupees.

But in March 2010, when inflation came close to the 10 per cent level, the RBI  concluded that the fiscal stimulus was responsible  and  raised interest rates again and again until, by mid-2011, borrowers were having to pay 3 per cent more than a year earlier. This proved to be a monumental folly because most of the rise in prices in, and since, 2009 were caused by domestic supply shortages, especially of non-cereal food articles, and a rise in global commodity prices, especially oil. Curtailing domestic demand  was no remedy. Thus, while the high  interest rates had no effect on prices, they choked  industrial growth and  more than halved the rate of fresh  investment.

 The resulting rapid decline  of industrial growth sharply reduced the growth of tax revenues. This made sure that  the fiscal deficit would not  come down. Then, mistaking  effect for cause, the RBI  made the persisting deficit an excuse for  continuing with its high interest rate and tight money policies! The effect of this upon industry was catastrophic. Over the three years ending in August 2012, the cost of its inputs rose by 14 per cent but it was able to recover only 6.4 per cent of this by raising prices. As a result, its profits were squeezed mercilessly and its capacity to invest destroyed. The RBI is, therefore,  the architect of the  stagflation that now threatens the future of the country.

By September 2013, Delhi was convinced that the only way to break  the grip of stagflation was to bring down interest rates. But by then the economy faced another danger. Exports had ceased to grow and the balance of payments gap was widening rapidly. If investment  and consumer spending revived, imports would increase and the current account deficit would widen further. Thus, the only way to minimise the risk of a balance-of-payments crisis was to  cut subsidies in order to create fiscal space for  the revival of investment.

On  September 13, it announced a slew of measures that would cut central and state subsidies by close to Rs100,000 crores in a full year. But the RBI again dug its heels in. Despite the finance minister’s entreaties it cited continuing inflationary pressures and did not bring down interest rates either then or in its next two quarterly policy reviews in October and December. 

When it finally began to give ground in March, it did too little too late. Both then, and again in  May, it brought inter-bank lending (repo) rates  down a quarter of a per cent, but hedged even this measly reduction with warnings that it would not hesitate to raise interest rates the moment prices rose again. Since a rise in interest rates would bring down share prices immediately, the message  investors in the share markets received was that their money would never be safe. As a result, the withdrawal from Indian share and debt  markets has continued.

The July policy review is the RBI’s last chance to bring down interest rates very sharply in order to restart investment and consumer spending, make share prices start rising again and stem the outflow of foreign exchange. But to minimise the impact upon our balance of payments, New Delhi needs to  release some of the 77 million tonnes  of its  buffer stocks of food grains into the market to lower food prices and mop up money supply, and announce  additional cuts in subsidies. If the government and the RBI do neither, then economic collapse is only months away. India’s fate therefore hangs by a thread. 

The author is a senior journalist.

Views expressed are personal.