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Challenges following the crisis

This edition of our quarterly update presents a gloomy picture of India’s economic environment. As the UPA administration turns towards its last lap in office, it is burdened with an economy plagued by conflicting imperatives of persistent inflation and tight liquidity. Asset prices continue to fall and consumer demand has slackened, specifically in areas of discretionary spending. Money is not only expensive; it’s terribly scarce. Investment plans are on hold for all but the most essential. The tools available to manage this odd situation are limited. Substantial easing of liquidity by the Reserve Bank, to pump prime the economy, would put added pressures on price stability and further weaken a falling currency – none of which could construe as good news. Doing nothing will only make things worse, prolonging recovery.

This situation raises two fundamental questions. First, how did this happen and second, how long will the agony last? Most commentators easily explain these events as the result of the global financial crisis, starting with the collapse of Lehman followed by a near failure of other reputable banks. The linkages in the global economic architecture are several and the malaise of the United States’ financial system has spread into Asia. This explanation whilst accurate is not the entire truth. The global financial crisis is not the reason of India’s woes but actually the trigger. India too has, over the years, been an accomplice in several transgressions. To begin with, liquidity was too slack for too long allowing the creation of bubbles in asset prices – specifically in the stock markets and property. Credit was growing at about 40% for two years and India’s consumers, despite being up to their eyeballs in debt, sustained leveraged spending as if there was no tomorrow. The economy, logically responded by growing at 9% and everybody lived with the illusion that good times were here to stay.

The government too, defying logic, went on a massive spending binge, ostensibly to serve political agendas. Farmer debt write-offs, pay commission settlements, food, fertiliser and oil subsidies, constitute a growing list of wretched initiatives that have added some 400 basis points to India’s fiscal deficit. They may not reflect in official figures as the Treasury has cleverly chosen to keep them off balance sheet. Eventually however someone has to pay and it’s usually the economy. The oil and fertiliser companies are compensated through bonds that no one wants to buy, despite being offered at discounts. Such spending programmes soak money out of the system making it scarce and expensive for private borrowers. They damage the balance sheets of government institutions such as PSU banks and large oil companies with grave long term consequences. Most importantly, they leave little resource for projects that are essential such as transportation, urban renewal and other infrastructure. Current account spending is really akin to a temporary emotion enhancing drug whilst capital spending creates the foundations for longer term sustainable development.

This brings forth the second question – how long will the problems last. The liquidity crisis will probably tide over in three to four months as panic begins to abate. The Treasury and Reserve Bank have acted decisively with the easing of money supply and through other initiatives that are meant to inspire confidence. But some sectors will take a lot longer to recover. Property leads the list as asset price corrections have only just begun. Developers are losing their holding power and desperate sales will shortly follow lowering valuations further by perhaps 20-30%. This will decrease the value of wealth and to that extent affect spending as consumers are enveloped in the shadows of a negative wealth effect phenomenon. Auto sales and those of other lifestyle products will suffer for a bit longer – as new employment generation is dampened and salary increases curtailed by employers. As liquidity improves and confidence, that the world has not ended, is restored things will limp back to normal. The economy will plodder along with growth rates of 6-7% in the mid-term. But the real problem will remain the structural flaws in the system now burdened with gross fiscal mismanagement. This will take many years to clear and that too with bold political conviction. FDI and FII flows may remain subdued as investors lose confidence in India’s growth propaganda complemented by its falling credit ratings. Eventually, as always, the cycle will turn as India is far too important to ignore. Perhaps ironically the UPA administration will not have to preside over these economic challenges. This will possibly be someone else’s problem.

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