While the developed world debates withdrawal of stimulus packages and fears double-dip recession, India is eyeing 9% growth on strong savings and infrastructure-driven investment.
The divergence between macroeconomic policies in India and those in the advanced economies in recent months has been striking. Fiscal tightening has been under way since fiscal 2009-10 itself. Monetary policy too has been progressively tightened in recent months although it is not as tight as some would like.
In the advanced economies, talk of exiting the fiscal stimulus has not been matched by strong action everywhere. There are serious doubts as to whether this is the right time to begin a big exit despite the fact that public debt has reached its highest levels in years. Monetary tightening is not happening. In the US, the Fed is expected be accommodative in its forthcoming monetary policy announcement.
The divergence in policies between India and the advanced world reflects divergences in underlying economic conditions. In July, the International Monetary Fund’s World Economic Outlook revised its forecast for world economic growth from 4.2% in April to 4.6%.
But this is based largely on expectations of high growth in emerging markets. There is not the same optimism about economic prospects in the advanced economies. Nouriel Roubini, who is credited with having the forecast the global financial crisis, maintains that a double-dip recession is very likely, especially in Europe and Japan.
The global financial crisis drew a massive and concerted response from governments in the advanced economies. A massive fiscal and monetary stimulus was adopted. The stimulus worked. It helped a slide into another protracted depression. The world economy recovered and then it appeared to gather steam.
So what has gone wrong with the script in recent months? Well, Greece was undoubtedly a big shock to the world economy. Not because Greece in itself poses a problem for the world economy but because it was a symptom of a broader malaise: fiscal overstretch.
We have known that governments can spend their ways out of trouble in a recession, but economists insist this is possible only so long as government borrowing does not breach certain limits. There is a sense that once government borrowing reaches 90-100% of GDP, markets will become averse to supporting further government borrowing.
When Greece happened, people started looking closely at fiscal deficit projections, public debt-to-GDP ratios and current account imbalances in the advanced economies and were horrified at what they saw. They concluded that there was no choice but to cut back on the fiscal stimulus.
Unfortunately, it appears that the recovery is not strong enough to withstand a big exit. Governments in advanced economies are in a fix as to how fast to move in respect of exiting the fiscal stimulus. There is not much that monetary policy can do to provide more stimulus when interest rates are as low as they are today.
It is not just the absence of freedom of action in respect of fiscal and monetary policy in the present conditions that worries markets. There have been renewed concerns about failures in the banking sector. Banks in the advanced economies hold large amounts of government debt, so the Greek debt crisis revived fears of another banking crisis.
Regulators in the EU ran stress tests on 91 banks. They claimed that the tests showed that the banks could withstand a setback to the world economy except for seven small banks. But the tests have been criticised as being not adequately stringent. Whether there is an implosion in banking again or not depends on whether the EU economies can muddle through long enough without a major default.
The Indian situation presents a refreshing contrast. Most forecasts for Indian economic growth have been revised upwards and the revisions are seen as credible despite the uncertainties in the world economy.
Growth is expected to be anywhere in the range of 8.5-9%. There is a clear roadmap for an exit from the fiscal stimulus. Monetary policy has become tighter with fighting inflation the priority now.
The PM’s council of economic advisers thinks the projected rise in the savings and investment rate in 2010-11 and 2011-12 provides a firm basis for a return to growth of 9%. In 2007-08, our savings rate was 36.4%. It declined in 2008-09 and 2009-10 thanks to government dis-savings caused by the need to provide a fiscal stimulus.
Thanks to the fiscal corrections introduced subsequently, the savings rate is expected to rise to 35.5% in 2011-12, enough to finance an investment rate of 38%. An investment rate of this order, in turn, can easily deliver growth of 9%.
But this begs the question: what happened to the coupling thesis? In 2008-09, we found that we were far more dependent on global economic conditions than we had supposed. As the global crisis peaked, our growth rate dropped to 6.8%. Why should things be any different if the advanced economies were to go through another recession?
There are reasons to expect a different outcome now. We were coupled with the world economy not so much through trade as through our dependence on capital flows. In a time of financial crisis, there is a flight to safety and out of emerging markets. This impacts domestic interest and exchange rates. It also impacted corporate investment in India as corporate investment had been financed by foreign borrowings to a greater extent than suspected.
In the months ahead, these adverse factors may not come into play. A setback to global growth is unlikely to translate into a financial crisis. Investors are bullish about growth prospects for India and are unlikely to exit en masse if the world economy falters. Indian companies unwound much of their exposure to foreign debt during the crisis and will not have run up similar exposures again.
These propositions will be tested if there is a double-dip recession in the advanced economies. If they hold up, that would give us a new basis for confidence as to India’s growth prospects. Unlike in 2003-08, growth of 9% would be less vulnerable to the vagaries of the world economy.
It would be more investment-driven with infrastructure as a key driver. We would then be having the best of both worlds: the benefits that go with integration and the lack of vulnerability that comes with being driven by domestic demand and financed by a high savings rate.
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