The impressive economic performance even in the wake of severest economic crisis shows the resilience of the Indian economy. In part, this must be attributed to the fact that India escaped the global financial contagion, as the Indian banking sector was not exposed to sub-prime lending and risky assets. India’s continued good performance demonstrates its resilience and the fact that much of the growth in India is fuelled by the high rates of domestic savings and investment.

Although India weathered the financial turbulence well, the global environment did impact adversely on the economy. The global financial crisis caused large outflows of capital as institutional investors liquidated their holdings and created turbulence in the Indian stock market. This led to serious liquidity problems for the Indian manufacturing sector and adversely impacted on the real sector of the economy. The decline in the exports affected many sectors such as textiles, gems and jewellery, chemicals, tourism, information technology and automobiles and parts. Despite these effects, the economy recovered much faster and, after thirteen months of continuous decline, exports registered a remarkable turnaround with growth of 18 per cent in November, 2009. There has also been a surge in capital inflows in recent months. The Economic Advisory Council to the Prime Minister estimates the foreign direct investment at $37 billion and net portfolio investment at $24 billion for 2009-10. These large flows could put pressure on the exchange rate and reduce flexibility for monetary policy if the Reserve Bank decides to sterilise them in the coming months.

Despite the optimistic growth scenario, the Indian economy faces several challenges. The first is that even as the green shoots appear, inflation has shown a rising trend, warranting exit from the authorities easy monetary policy stance. Increases in prices, particularly those of food items, are mainly caused by failure of the monsoons to deliver good rain, and this could create a spiral requiring the exit earlier than desired.

Second, the government cannot continue with large fiscal deficits and will have to initiate fiscal consolidation in the next fiscal year. The fiscal consolidated deficit for central government and states in 2008-09 was 10.4 per cent and it is 10.2 per cent in the current year. Much of this was not incurred in providing the stimulus but was due to additional outlays on subsidies, pay revisions, farm loan waivers and the increased coverage of employment guarantees. These had significant counter-cyclical impact, but cannot be considered as a targeted fiscal stimulus package. The impact of large deficits in India was to increase consumption demand rather than infrastructure spending, in contrast to what was done in China. Persistence of high fiscal deficits could crowd out private investment; the large interest outgoings due to debt overhang will crowd out productive spending. There are issues of sustainability of debt and inter-generational equity associated with unproductive borrowings as well.

Third, maintaining a high growth momentum requires easing of infrastructure bottlenecks. Although a considerable part of the increase in investment will have to come from public private partnerships, the government will have to substantially augment its own spending to provide viability gap funding. Even in the years of fiscal expansion, the capital expenditure of the central government actually shrank; as a ratio of GDP it declined from 2.5 per cent of GDP in 2007-08 to 1.8 per cent in 2008-09 before partially recovering to 2.1 per cent in 2009-10. A careful analysis shows that in the central plan outlay of 7.5 per cent of GDP in 2009-10, the budgetary contribution is only 53.5 per cent. In fact, in many infrastructure sectors like coal, aviation, petroleum, power, roads and railways, the budget contribution in the plan outlay is estimated at just 19 per cent and with the remainder expected to be mobilised from internal and extra budgetary sources. Augmenting infrastructure spending in the face of the need to contain the fiscal deficit is a difficult challenge policy makers will have to grapple with.

All these challenges call for reviving the reform momentum. Yet, pursuing economic reforms, like reforming the labour laws or privatisation of public enterprises, will be contentious. Fortunately, the general election in 2009 has ensured a more stable government which has the freedom to pursue serious reform, given that it does not have to initiate populist policies for another 4 years. Hopefully, the next year’s budget will include substantial initiatives on policy and institutional reform.

This is part of the special feature: 2009 in review and the year ahead.

Dr. M. Govinda Rao is the Director of the National Institute of Public Finance and Policy (NIPFP), New Delhi and a Member of the Economic Advisory Council to the Indian Prime Minister.