India: sustaining high growth needs new reform momentum

Author: M. Govinda Rao, NIPFP, New Delhi

India’s economic growth accelerated significantly in the latter half of 2010. The growth of real GDP during the final two quarters of 2010 averaged 8.9 per cent as compared to the 7.5 per cent recorded during the corresponding period in 2009.

The acceleration of growth has been broad based and is seen in all the three sectors – agriculture, industry and services. While the agricultural sector has shown a strong recovery due to the bountiful rainfall, growth in both industry and services has accelerated due to buoyant domestic demand.  The outlook for the rest of the year continues to be optimistic and it is expected that the for 2011, the economy may register a growth rate of close to 9 per cent which is higher than most forecasts, including those by the Reserve Bank of India and the Economic Advisory Council to the Prime Minister at 8.5 per cent.

On the external front, both imports and exports have recorded strong growth, and although the former has increased at a faster rate increasing the trade deficit, the current account deficit is likely to remain within manageable limits due to continued strength of invisibles and inflow of capital. On the fiscal front, the realisation of higher revenue from auctioning the broadcast (by about 1.3 per cent of GDP) spectrum is likely to offset increased outlays on subsidies,  With tax collections up, the fiscal deficit of the central government relative to GDP is likely to be lower than that budgeted by half a percentage point, at 5 per cent. The consolidated deficit of central and state governments is estimated at about 8.5 per cent of GDP, which is lower than last year’s by about 1.5 percentage points. Thus, the government has initiated measures to gradually withdraw their stimulus to provide greater space for the private sector and to render greater flexibility in monetary policy calibration.

The Indian economy has shown a much stronger recovery from the impact of global crisis than most  of the G20 countries, partly due to the fiscal expansion prior to the crisis. In fact, fiscal expansion in India started before the onset of global economic crisis. The expansion of the rural employment scheme, the farm loan waiver, significant increases in fertiliser subsidies and increases in the wages of government employees actually increased the expenditure by over 4 per cent of GDP over the budget estimates. These decisions were taken in the budget in February 2008, much before the Lehman crisis unfolded. This unplanned fiscal expansion was indeed a profligate policy but, nevertheless, helped to soft land the economy during the crisis and helped in its fast recovery.

Despite the optimistic economic environment, there are several challenges in the short and medium term and the most immediate concern for the policy makers is inflation. Despite the expectation of good agricultural production, consumer prices have continued to increase. The rising international price of crude oil will further increase fuel costs and could create a cost push inflationary situation. Combating inflation while maintaining the growth momentum will be the most immediate challenge faced by policy makers.

Like other emerging market economies, there is a significant inflow of portfolio investment and, to a lesser extent, foreign direct investment and this is likely to put pressure on the exchange rate even though the country is likely to have the trade deficit of over 9 per cent of GDP and a current account deficit of about 3 per cent of GDP. Ensuring a competitive exchange rate in the wake of surging capital flows is an important challenge. So far, the inflow has not been too large and the problem has been manageable, but if the inflow surges there will need to be intervention.

A major medium term worry is achieving fiscal consolidation. The Finance Commission recommended that the consolidated fiscal deficit of the central and state governments should be contained at 5.4 per cent (the prevailing level is about 8.5 per cent) and the central government deficit should be brought down from the budgeted level of 5.5 per cent in 2010-11 to 3 per cent by 2014-15. In addition, the government is embarking on a major program to ensure food security, universalising healthcare and expanding education facilities. Together, these programs could cost an additional 3 per cent of GDP. The government will have to generate additional revenues or re-prioritise expenditures and undertake disinvestment to the tune of 6 per cent of GDP in the medium term to achieve these objectives

Improving the competitiveness of the Indian economy in the long term requires further liberalising reforms. Although tariff levels have been significantly reduced, there are sectors such as agriculture where the government will have to liberalise. Similarly, while there is considerable room for  freeing foreign direct investment, there are sectors such as retail trade where liberalisation is called for, particularly as the employment potential in these sectors is large. Equally important is the need to liberalise India’s archaic labour laws.

Poor infrastructure continues to be a constraining factor in maintaining a high growth rate in the economy. The shortfall of electricity at peak demand is estimated at more than 12 per cent and there are problems in generation, transmission as well as distribution. The investment in roads is not taking off at the pace planned and large investments are needed for augmenting urban infrastructure and services.

The revival of high growth is heartening, but sustaining it over the medium and long term calls for immediate initiatives to revive the reform momentum. Unfortunately, even after the government emerged stronger after the last general election in mid-2009, it has been bogged down with serious issues of governance and unless it cleans up its own act quickly, the economy will continue to underperform from its potential.

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.

This is part of a special feature: 2010 in review and the year ahead.