What Ails the Indian Economy?

October 1, 2013

By Deepankar Basu and Debarshi Das

Summary: The slowdown of growth rate in India is an outcome of the nature of high growth experienced in the recent past. The high growth had a narrow base, the vast majority of the poor did not share its benefits. The growth was helped by foreign capital inflow. Because of this very fragility the time of fast growth is coming to an end. The article further argues that the fundamental mismatches in the macroeconomy, such as persistent deficit in current account, needs to be tackled head on, rather than managed through capital account surplus. Such ad hoc-ism ends up mortgaging country’s sovereignty.

1. Introduction

It can hardly be denied that the Indian economy is going through a rough patch. Annual growth rates of real GDP has fallen from the 9% range witnessed in the mid-2000s to less than 5% in 2012-13. Industrial production has slowed down considerably with negative growth in some key manufacturing industries like car manufacturing. Despite this overall slowdown, retail inflation, especially food price inflation, remains persistently high (it is currently in the double digits), adding to the burdens on the aam aadmi.

While the domestic sector is not doing too well, the external sector is in a far weaker position. At 4.8% of GDP, the current account deficit (CAD) of the Indian economy is one of the highest in the world today and, according to the Reserve Bank of India, much above what could be considered a sustainable level. The rupee has taken a severe beating over the past few months. It fell by 35% (against the US dollar) since January 2012,   reaching a historical low level of 68.80 rupees per US dollar on August 28, 2013. Even though it has recovered some lost ground, the rupee is still way below its level a few months back. The sliding rupee is expected to further stoke inflationary pressures (due to an increase in the cost of key imports like oil), and make the situation even worse for the economy.

How did the Indian economy arrive at this unenviable situation?


2. The mid-2000s growth process

To understand India’s current macroeconomic problems, especially its external sector woes, one needs to step back a little and analyze the growth process over the previous decade. In the peculiarities of the growth process can be discovered the seeds of today’s problems.

Figure 1: Gross domestic capital formation (gdcf) as percentage of GDP (in current prices). Source: Economic Survey, 2012-13


3. Investment and the Spirit of Animals

The period since the early 2000s, especially the period from 2003 to 2008, was a period of exceptionally high growth. Annual growth rates of real GDP hovered around 9 percent per annum, never before witnessed in the Indian economy. Analysis of the components of aggregate demand – consumption expenditure, investment expenditure, government expenditure and net exports – shows that one of the drivers of the recent episode of growth in the Indian economy (2003-04 to 2008-09) was investment growth. This can be seen from the juxtaposition of three facts:

1. The share of investment in GDP climbed up rapidly: Investment expenditure as a share of GDP increased from 27 percent in 2003-04 to 37 percent in 2008-09; over the same period, consumption expenditure declined from 62 percent of GDP to 55 percent of GDP. In Figure 1 percentage of gross domestic capital formation (gross investment, including both private and public investment) as percentage of GDP is plotted. Note the sharp rise of the blue line around 2003-04.

2. Investment registered much higher growth rates compared to the other components of aggregate demand (especially consumption expenditure): average annual growth rate of consumption expenditure between 2003-04 and 2008-09 was 6 percent; investment expenditure increased, over the same period, at an average rate of 16 percent.

3. If we now look at the supply side, we see a corresponding growth. Figure 2 shows that the index of production of capital goods (a measurement of the production of investment goods like machinery, etc.) rose at a much faster rate than the general index of industrial production since 2005. Thus, the increased investment expenditures were met by an increase in the production of investment goods.

Figure 2: index of capital goods production and the general industrial production index (base 2004-05), source: Ministry of Statistics and Programme Implementation, Government of India.


Therefore, it is clear that investment expenditures by firms increased rapidly during the mid-2000s, pushing up aggregate demand in the macro economy. Production increased to meet this growing level of aggregate demand. Rise in production led to increasing incomes of the population, which led to growth of consumption expenditure. This increased level of demand led to a further round of increases in production, and income. This is called the “multiplier effect” of investment, which contributed perhaps to a phase of rapid economic growth.

What caused the investment boom? Investments by capitalist firms are made with the expectation of earning future profits. Thus, factors which lead to buoyant profit expectations excite what John Maynard Keynes called the “animal spirits” of capitalist investors, and prod them to make investments. This immediately provides a clue to the investment boom of the 2000s in the Indian economy.

The early 2000s was a period when the State promised to give away access to huge pools of natural resources – mines, forests, land, rivers – to the Indian (and foreign) corporate sector for a song[1]. This promised giveaway by the State seems to have generated expectations of phenomenally high profits among Indian (and foreign) capitalists, which, in turn, excited their animal spirits and facilitated the investment boom.[2] Foreign capital seems to have participated in this bonanza too. Note the steep rise in direct foreign investment flowing into India after 2004-05 (Figure 3).

Figure 3: Foreign direct investment to India, in billion rupees, at current prices. Source: Reserve Bank of India.


But the high growth of GDP encountered supply constraints. This took the form of weakly growing agricultural production and inadequate growth of key infrastructures (like power, roads, communication networks, transportation capacity, etc.). The inability of the growth process to sufficiently address these supply constraints created inflationary pressures, aided in no small measure by rising oil prices in the global economy since 2009 (see Figure 4 for a time series plot of the inflation rate in India).


Figure 4: Consumer price inflation in India (red) and the U.S. (blue). (Source: Federal Reserve Board of St Louis)



4. Capital Inflow and Credit Market:

A second, and interrelated, set of drivers of growth was changes in credit market conditions. From mid-2000s onwards, one finds a rapid rise in the flow of credit in the economy. Figure 5 illustrates that in last ten years, total domestic credit to the private sector, as a proportion of GDP, has gone up from around 30% to more than 50%. The share of domestic credit provided by the banking sector to GDP has increased by 20 percentage points, from 57% to 77%, over the same period. To be sure, these increases are part of a long term trend observed since mid-nineties. However, the increase from around 2003-04 has been rapid and sustained.

Figure 5: Domestic credit provided by the banking sector and domestic credit to private sector, as percentage of GDP (1960-2012), source: World Bank Development Indicators


Higher disbursal of credits seemed to have spurred higher spending (both consumption spending and investment spending), helping in achieving rapid growth. But what explains the rise in credits? A major reason could be the inflow of foreign capital. Figure 6 plots the net inflow of total foreign investment and also breaks it up into its two major components, foreign direct investment and foreign portfolio investment.

Figure 6: Net foreign direct investment, portfolio investment, total investment, in billion rupees, source: Reserve Bank of India


Although eratic in movement, the sharp rise in net inflow of foreign capital after 2003 cannot be missed. In the eleven years from 2000-01 to 2011-12 the total capital inflow (net) has increased more than seven times. The current inflow is close to two thousand billion rupees a year. High capital inflow might have added to the liquidity of the banking sector as a whole, and helped in driving up debt-financed spending through the following two channels.

First, the commercial sector financed its projects by depending on foreign capital. From 1997-98 to 2011-12 the commercial sector in India had a gradually increasing percentage of its financial resources from non-bank foreign sources. The percentage rose from 3.7% (1997-98) to 20.9% (2007-08) to settle at 18.5% (2011-12). Since 2004, external debt of India rose by 3.4 times. External commercial borrowings by India companies were about one-third of the total debt. Importantly, in last 22 years this share rose by nearly 20 percentage points. For the top ten borrowers (all big corporate houses), in last six years the total external borrowing rose by six times to more than 100 billion dollars.

The second route might have worked through the easing of the non-interest rate dimensions of credit availability. Commenting on the mechanism Aspects of India’s Economy is succint,

Borrowing at rock-bottom interest rates in the US, speculative finance invaded ‘emerging markets’ like India from 2003-04 on in search of higher returns. Net capital inflows as a percentage of India’s GDP soared from 2 per cent in 1998-2003 to 4.8 per cent in 2003-2008, peaking at 9.2 per cent in 2007-08.14 The increased liquidity in the banking sector in India fueled the rapid growth of lending for homes, cars and other such items. Outstanding personal loans made by commercial banks rose from a few percentage points of GDP at the start of the decade to 7.6 per cent at end-March 2005 and 10.3 per cent at end-March 2008.15 In response, IIP growth in India rose steeply, from 7 per cent in 2003-04 to 11.5 per cent in 2006-07.

So, inflow of capital helped boosting up growth, however short-lived it may have been. There was a further reason why the government encouraged inflow of foreign capital. This is the imperative of meeting the deficit in the trade of merchandise and services. High deficit in current account, arising out of the fact India imported far more than it exported, necessitated inflow of foregin exchange to pay for the excess purchase. We will come back to this issue later but it should be intuitively clear that such a strategy could prove to be extremely risky. First, flow of capital, especially on account of portfolio investment, is volatile (as can be seen from Figure 6).  But the current account deficit is stable, high and rising. In effect, the policy makers were attmpting an unsustainable strategy. Second, this was a phase of easy money in the US. In the aftermath of the dotcom bubble burst and recession, the US government adopted a policy of low interest rate (which was feeding another bubble). The liquidity created in the US was in search of higher return across the globe, and India attracted a part of it. There was no guarantee that the good time would continue. But it was necessary that it continued, for Indian policy makers counted on it to finance the current account deficit.


5. Whom Did The Growth Touch?

High that it was, the growth was not broad-based. Debt-financed spending could be performed by those with sufficient assets to show as bank guarantee. As a consequence many sectors producing for the rich experienced rapid growth. Passenger car industry grew at an annural rate ranging from 6% to 26% in the years from 2005-06 to 2010-11. As Figure 7 depicts, production of consumer durables grew at a much faster rate than consumer goods as whole. This is an indication that the sectors producing expensive durables goods like televisions sets, fridges, passenger cars were expanding faster than the average. Another sector which basked in the scorching growth of the time is real estate. According to data available from the Central Statistical Organization, the net domestic product of the housing sector incrased by 67% (at 2004-05 prices) between 2004-05 to 2010-11.

Figure 7: Index of production of consumer goods and consumer durables (base: 2004-05), source: Ministry of Statistics and Programme Implementation, Government of India.


The narrowmess of the growth is also testified by the absence of “trickling down” of prosperity. There has been little dent on the calorie deficit of the average Indian. In rural India, which is furthest away from the enclaves of growth, percentage of people whose consumption expenditure is not sufficient to buy 2400 calories of food has gone up from 80% to 90% in the five years 2004-05 to 2009-10. Urban India which is expected to be the beneficiary of the high growth has suffered too. The percentage of urban people not affording to buy 2100 of calorie went up from 64% to 70%. Both these increments are the sharpest increases in comparable time period in the last 30 years for which estimation has been made (see this article for details).


6. External Sector Impacts of Growth

To analyze the impact of the growth on the balance of payments of the Indian economy, let us start by studying the trade balance. Figure 8 plots India’s exports and imports, as a percentage of GDP, since 2001-02. Several things are worth paying attention to in this chart. First, for every year since 2001-02, imports have been higher than exports, giving rise to substantial trade deficits. This is however the continuation of a long run pattern. Barring few exceptional years, India has always purchased more from the rest of the world than what it sold to the rest of the world. Second, the trade deficit has been growing over time, with the largest growth taking place between 2003-04 and 2008-09, precisely the years of exceptionally high growth. Third, exports have been growing at a steady pace over this period, increasing from 10 percent of GDP in 2001-02 to 18 percent of GDP in 2011-12. Thus, the widening trade deficit is not the result of stagnant exports but of unusually high growth in imports (relative to the growth of exports), especially since 2003-04.

Figure 8: India’s Exports and Imports (as a proportion of GDP), 2001-02 to 2011-12 (Source: Table 7.1 (A), Statistical Appendix, Economic Survey of India, 2012-13)


What caused the relatively high growth in imports? Two factors seem to have been important.

First, the Indian economy witnessed relatively higher growth rates over this period so that the demand for imports (into the Indian economy) grew faster than the demand for exports (from the rest of the world). Figure 9 highlights this by plotting the growth rates of GDP for the Indian and US economies. For every quarter since 2003, the Indian economy grew at substantially higher rates than the US economy (the US has been one of India’s largest trading partners in 2007-08 and 2008-09; but recently China has displaced the US from the top position).

Figure 9: Year-over-year growth rate of real GDP for the Indian (blue) and the U.S. (red) economies since 2003. (Source: Federal Reserve Bank of St Louis)


Second, over the past few years, production has become increasingly more import-dependent. While more research is needed to ascertain the reasons behind this, a reasonable hypothesis seems to be the following. An increasingly larger part of the consumption expenditure underlying the growth process has become more outward oriented. Using economic terminology, one would say that the preference of consumers have changed in favour of imports. There are two reasons why this might have happened. First, since income inequality has increased over this period, larger shares of consumption expenditures are coming from the rich. Since elite consumption might be more outward oriented, i.e., elites tend to consume higher shares of imported goods (e.g., electronic items, clothes, cars, etc.) & services (e.g., vacations in foreign countries), this would increase the outward orientation of aggregate consumption expenditure. Second, since this period has been a period of high inflation, wealth holders have been searching for avenues to hold their wealth that can preserve its value in the face of increasing prices. As a hedge against inflation, to speculate on future price movements and also for cultural reasons, there has been an explosion in the demand for gold. Since India does not produce much gold, the demand has naturally translated into an increase in the demand for imports.

Thus, a combination of relatively high growth, and a shift in the pattern of consumption expenditure led to a relatively faster growth of imports compared to exports. The result was a large and rapidly growing trade deficit.


7. Macroeconomic Imbalance         

Another way to understand India’s current economic problems is to relate it to the basic macroeconomic imbalance created by, and underlying, the mid-2000s growth process. Let us start by recalling that the Indian economy invests more than it saves, i.e., total investment expenditure (what is known as gross domestic capital formation) is higher than the sum of private and public sector savings (what is known as gross domestic savings). This is true for most years since 1950-51, and has been true for every year since 2004-05 (for details see Appendix Table 1.6, Economic Survey 2012-13). Moreover, the gap has been growing over time, from 0.4% of GDP in 2004-05 to 4.2% of GDP in 2011-12 (see Figure 10).[3]

Figure 10: Savings and Investment in India (Source: Table 1.6 (A), Statistical Appendix, Economic Survey of India, 2012-13)

What does the investment-savings gap signify? It means that the Indian economy is investing more than it is savings. Thus, the difference between the two needs to be covered through capital inflows, i.e., by the purchase by foreigners of Indian assets. That is precisely where the external sector becomes important in sustaining the basic macroeconomic imbalance, i.e., as a source of funds to cover the gap between investment and savings. Hence, the growing dependence of the Indian economy on foreign capital and the fundamental savings-investment imbalance of the Indian macro economy underlying its growth process are mirror images of each other. While such an imbalance has been with the Indian economy for most of the years since independence, it was significantly worsened during the investment boom in the 2000s.


8. Slowdown in Growth

How did the growth process come undone? Four factors seem to have played a role. First, the growth process was not broad-based; it was based on the consumption expenditures of a small section of the population. The limits of such a narrow-based growth process might have shown up by 2010. Second, a moderate supply shock in 2011 in the form of rapidly rising crude oil prices had an adverse impact on growth, but kept inflation high (and rising since 2012). Third, the investment boom might have led to the creation of excess capacity in key sectors of the economy, which then started acting as a drag on investment growth. Fourth, some or many of those promised projects did not materialize due to the resistance of the people. That punctured the buoyant profit expectations of the corporate sector and dampened investment growth.

A combination of these four factors put a brake on investment growth and ushered in the downswing phase of the business cycle (with growth rates falling every quarter since early 2010) that the Indian economy is currently passing through (GDP growth has fallen to 4.4 per cent per annum in the first quarter of 2013-14).


9.How bad is the external situation?

As we have seen, India’s balance of payments (BOP) has certainly deteriorated over the past few quarters/years, but it is far from what economists call a BOP crisis. The foreign exchange reserves are comfortably big, and the external debt is nowhere near crisis proportions. This last point is important: usually the strain on the external sector is most worrying when the external debt of a country is high and rising. Figure 11 shows that India’s external sector debt has hovered around 20 percent of GDP for the past decade. Thus, there is no evidence of a trend of increasing external indebtedness of the Indian economy.

Figure 11: External Debt as a proportion of GDP (Source: Table 8.4(A), Statistical Appendix, Economic Survey of India, 2012-13)


What about the sliding rupee? It is important to keep in mind that the slide of the Indian rupee (INR) against the US dollar (USD) is part of a long run trend (see Figure 13). In the medium run, i.e., over a period of a decade or so, the movement of the nominal exchange rate is largely governed by the differential rates of inflation in the two economies. Figure 4 shows that inflation in consumer prices has been much higher in India than in the US over the past decade. Thus, part of the reason behind the INR losing value relative to the USD is to take account of the relatively higher inflation in India. Of course, the slides of the rupee in the very recent past (i.e., over the past few months) is the reflection of a global phenomenon: capital flight from “emerging market economies” towards the U.S. economy due to expectations of a recovery in the U.S. economy and possible rollback of the Federal Reserve’s unconventional monetary stimulus program known as quantitative easing (QE). While forces of speculation might also be driving up the short run volatility of the rupee, a medium or longer term perspective suggests that the declining rupee is not a matter of grave concern; the exchange rate movement might just be a reflection of the rupee “correcting” its value by taking into account the difference in the inflation rates and the yawning current account deficit.

Figure 12: Indian rupee (INR) – US dollar (USD) nominal exchange rate (Source: Federal Reserve Board of St Louis)


10. What can be done?

While the Indian economy is not facing a 1991-style BOP crisis, there are certainly lots of weak spots that need to be addressed.

First, the strategy of trying to balance the current account deficit with capital flows is not a sustainable long term strategy. It puts the economy at the whims of international financial interests. An alternative long run strategy needs to be put in place. The main thrust of the alternative strategy should be to try to balance the current account, at least in the medium run. This would involve encouraging a broad-based manufacturing exports growth relying on pro-labour and pro-environment industrial development. In the short run, the main thrust of policy should be towards reducing import demand of oil and gold. Steep hikes of taxes on the prices of cars (and other luxury items of consumption, including gold and silver) and inflation-indexed government bonds might be useful in this regard.

As a policy tool, an increase in taxes on cars (and other luxury items of consumption) has several advantages. A decline in car sales would reduce the demand for oil (the largest component of India’s import bill) and improve India’s trade balance. It would partly address the increasing congestion on Indian roads, and would also reduce the ecological imprint of India’s growth process. Moreover, it would also offer an incentive to move towards the expansion of public transportation. While a steep tax on car prices might depress the car manufacturing sector (which is already in recession), the (possibly) increased revenues of the government can be used to re-train workers who lose their jobs and redirect labour flows into more environmentally friendly industries. Even if the government revenue does not increase, the other benefits of the policy would certainly recommend it highly.

Inflation indexed bonds could be used to address the desire of wealth holders to hedge against inflation by demanding gold (and worsening the trade balance). Wide availability of inflation-indexed government bonds can induce wealth holders to switch away from gold. Additionally, the revenue generated by floating these bonds can be used to increase infrastructure investment and address the long run supply constraints of the Indian economy (which is one of the ways to reduce inflationary pressures in the long run). Of course, this recommendation rests on the assumption that a substantial part of the gold demand arises from the desire to protect against inflation. If this assumption is invalid, and if a large part of the demand is instead driven by speculative reasons, then floating gold bonds might be more relevant.

Second, while the external debt burden of the overall macro economy is not high, there are many corporate sector firms that have loaded up on external debt. This is a matter of concern because many of these firms have not protected themselves from the possibility of falling price of the rupee against the dollar. Thus, a depreciating rupee will increase the debt burdens of these corporations. This might even lead to bankruptcies, which might have macroeconomic implications. The RBI and the Finance Ministry needs to make advance plans to deal with such a scenario.

Third, the banking sector seems to have been caught up in the surge of capital inflows witnessed in the past few years. As a result, many large public sector banks seem to be saddled with large amounts of loans that will most probably never be repaid. Thus, the assets of many banks will likely worsen over the next few quarters and years. Should these banks be helped by the government in strengthening their balance sheets by lending them money? This is a question worth thinking about. Since most of these are public sector banks, there will be less resistance to such a move than if these were private sector banks (in which case the government lending funds to these banks would most probably lead to dilution of the weight of existing private sector shareholders).

Finally, despite the slowdown in recent years, the Indian economy remains the second-fastest growing economy in the world. Much more than growth per se, what is problematic is the nature of that growth, i.e., its distributional and environmental implications. So, a re-orientation of the growth process to make it more distributionally just and environmentally friendly is the need of the hour. Not pandering to the growth fetishists.


[1] Major scams involving natural resources such as coal, natural gas or common property such as mobile phone spectrum licence took place during this time. The full picture of these scams is yet to emerge. Legislations facilitating the transfer of resources, such as the SEZ act, were passed during this period. They promised to hand over resources to private companies, while paying little attention to labour laws or environmental safe guards

[2] For a similar argument see here. In personal communication with one of the authors, the same argument was also made by Amit Bhaduri.

[3] One crucial difference between the Chinese and Indian economy is that the former generates higher total savings (private and public) than total investment (private and public), whereas the latter generates lower total savings than investment. The result is that the Chinese economy is a net lender to the rest of the world (i.e., on a net basis it purchases assets from the rest of the world), and the Indian economy is a net borrower from the rest of the world (i.e., the rest of the world purchases assets from the Indian economy).

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