Low Equilibrium Trap

The exultant reaction over a handful of economic measures in mid-September has given way to the resigned awareness that, in the near term, the economy is jammed – between a government struggling to tame a burgeoning fiscal deficit and a central bank jittery about elevated inflation.

Inept policy making has led India’s economy to a new equilibrium. It is a growth rate between five and six per cent, a level that led one economist to conclude it had “stabilised”. Another wondered at how quickly people had resigned themselves to what will probably be the worst performance in a decade. And everyone implied there are no quick fixes in sight.

Gross domestic product (GDP) grew 5.3 per cent in the second quarter (July-to-September) of 2012/13. This is the second-lowest quarterly growth rate in the last decade. In the first half of the fiscal year, the average growth rate has been 5.4 per cent, a level around which some economists think it will end the year.

The last time the economy grew slower was in 2002/03, when it grew four per cent.

Manufacturing is almost stagnant and fresh investments have been low over the last three quarters. New investment rose 4.6 per cent in the second quarter to`4.55 trillion. According to Pronab Sen, Principal Adviser in the Planning Commission and former chief statistician to the government, the little new invest- ment that is coming is from companies importing machinery to expand existing factories. And a bit of construction activity. Headline grabbing investment activity has not yet begun, he feels.

It is the financial sector and trade that now keeps the economy moving. Both these segments have been boosted by government spending. “Most of it (government spending) is driven by salaries,” explains Sen. This, in turn, helps fuel demand in other parts of the economy such as construction.

However, government spending could also keep the economy in its low equilibrium. It is closely linked to what is regarded as the most dangerous fault-line in the economy: the size of the fiscal deficit.

The fiscal deficit, which is the difference between the government’s income and expenditure, is bridged by borrowing. Beyond a threshold, government borrowing crowds out others and pushes up interest rates. Eventually, all of this shows up in high inflation.

Inflation and interest rates are the source of divergence between the Reserve Bank of India (RBI), which controls monetary policy, and the government, which tweaks fiscal policy.

Over the last three years, India’s monetary and fiscal policies have not moved in tandem. The RBI has tightened monetary policy to combat inflation. The government has diluted monetary policy by increasing spending even as an economic slowdown hit its income.

If the RBI has to cut interest rates, something the government wants, the fiscal deficit has to narrow. But the government’s income is under stress – the last budget assumed the economy would grow around 7.5 per cent, and, thereby, that income would be higher.

In the budget, the fiscal deficit was forecast to be 5.1 per cent of GDP. Since then, finance minister P. Chidambaram has said there would be an overrun but has vowed to restrict it to 5.3 per cent of GDP. All of this squeezes government spending, one of the three drivers of growth today. This is what finance ministry officials say they have been telling their colleagues in the government, as preparations begin for next year’s budget.

There is no getting away from more pain if the economy has to move out of its low-equilibrium trap. Interest rate cuts will not be forthcoming otherwise, as the RBI likes to point out.