Potential Pitfalls of Indian Economic Policy

You’ll likely have noticed a lull in the postings on India since Steven’s last article. There’s a reason and it’s simple. In terms of policy moves, the new Prime Minister has had to wait for his budget release dates. Till now, he’s made decent impressions on regional allies, bungled a railway-fare hike, taken precursory measures to tackling India’s lumbering bureaucracy, and gotten into a mess over interfering with judicial independence.  Nothing important right? But now that the budgets are being released this week, our writing has returned. 

Our Western audience, based entirely in the United States, likely won’t be used to this scenario. To give you an idea of how important budgets are in Westminster Parliamentary systems like India, let’s turn to the country from whom India copied much of its governing architecture. The British Prime Minister, David Cameron defined his government’s entire economic policy around the 2010 Emergency Budget which he released soon after his governing coalition was formed. Cameron’s every economic move since can be traced back to the austerity he kicked off four years ago. 

That’s not to say Narendra Modi’s budget will necessarily define his entire premiership; India is in a totally different set of circumstances than Britain after all. But it’s an indicator of how important budgets are. Unlike the United States, parliamentary systems demand regular, complete budgets. If they don’t pass on time, new elections are called immediately. There are no shutdowns, no continuing resolutions, and no legislative fiascoes without consequences. 

That doesn’t mean ballyhoos can’t be raised over what’s actually in those bills; they are, and Modi has plenty of room for error. Steven made a very pessimistic prediction a few weeks ago in which he worried that the fiscal discipline Modi promised would necessitate draconian cuts to social welfare programs. That’s a sound basis for worry. The Prime Minister, despite the uniqueness attributed to him by Indian media, resembles most right-of-center politicians with a pro-business bias. On economic stimulus, their professed focus is largely on infrastructure, human capital, and research investment as opposed to social welfare programs (an all together legitimate and economically sound preference). However in practice, their budgets end up slashing more spending than they adequately invest. This has been true of Tony Abbott in Australia, David Cameron in Britain, and Stephen Harper in Canada.

But unlike those three Western Prime Ministers, Modi has a track record in massive infrastructure projects through his tenure in Gujarat where he received widespread praise for dams, road building, and power grid projects. Immediately upon entering office, he set his sights on creating a “Diamond Quadrilateral,” a cross national high speed rail project that pays homage to his BJP predecessor’s “Golden Quadrilateral,”  a national highway which was finished under the last two Indian governments. Additionally, Indian economists and businessmen aren’t nearly as hawkish on the deficit as their Western counterparts; instead they’re demanding expanded investment. It would boost India’s productive capacity, increase the ease of doing business, and likely raise demand. Makes sense right?

But unlike Australia, Britain, or Canada, India actually has a “deficit problem.” India’s cross breed currency regime (alternating in the midway between a fixed and floating currency) leaves dangerous room for a crisis should India’s balance of payments deficit continue. In this kind of crisis, one where India would run out of foreign reserves to pay for imports, the rupee would have to rapidly lose value or public expenditure would have to be drastically cut. For now a far off event, India got a shadow glimpse at it when the rupee’s value plunged in 2013. Considering that no politician or Central Banker in India is even remotely interested in adjustments to India’s currency regime, the focus on curtailing deficit spending will continue in the short-to-medium term. That’s why Arun Jaitley, India’s new Finance and Defense Minister, joins his boss in calling for fiscal retrenchment even while advocating increased investment.

But that’s impossible. You can’t cut your cake and eat it whole. Provided that nothing about the rupee’s exchange mechanism or India’s trade imbalance changes, Narendra Modi will face this impossible duality in all his future budgets. Steven’s prediction was that Modi would err on the side of massive cuts. Considering the circumstances, his first budget will likely try and balance the two opposing forces of cuts and investments instead.

How is this possible? The thinking goes that the government cuts in areas where there’s massive amounts of unneeded or even harmful spending. To placate Steven’s concerns, this isn’t in welfare programs; rather, India has a subsidy problem. The Indian government subsidizes spending on everything from oil, to food, to pesticides. It keeps prices down and while holding populist anger at bay. But economists frequently criticize these subsidies as wasteful market distortions. To someone like Modi, they’ll be an easy target and his electoral mandate may just let him try what his predecessors couldn’t. Accordingly, the government then theoretically directs investments to attract foreign capital and make it easier for business to operate. The thought is that this slowly brings down the trade imbalance by increasing the capital account surplus (the foreign investment coming in) while decreasing the current account deficit (the money flowing out). The combination of these two then decreases the balance of payments deficit (a negative total of current account + capital account excluding reserves) which hopefully starts to turn positive over time. Therefore, the government offsets the possibility of a currency crisis while increasing internal business activity. A win-win right?**

Here’s the problem. It’s a delicate strategy that’s next to impossible for even the most disciplined governments to pull off. The angel that used to save these governments in the past was that massive trade deficits run by the United States would create a huge market for foreign companies. But the United States is still recovering from its own recession and has been slowly pulling back on monetary stimulus (likely thought to be the trigger for much of the recent economic trouble in developing countries). On top of that, without the surge in foreign demand, India’s internal demand is likely to suffer from subsidy cuts on consumer goods. It’s easy to criticize subsidies but they came into existence (and stuck around) for a reason; they’re popular because they make goods cheap. India’s still a terribly impoverished country and it’s easy to forget that while walking in affluent sectors of Mumbai or Delhi. 

There’s another problem. Its pretty well accepted by this point that Modi will increase infrastructure investment, which is good. But not all investments are created equal. Take Indian Railways, a sector so important that its budget is released independently of the main budget. High speed rail would be a great addition to India’s transportation system, but it would cater to a select population of rich and (maybe) middle class passengers who’ve already been defecting to airlines in recent years. But the railways are still the abode of the poor man in India. The old trains and their tracks, which still dominate India, are in drastic need of repairs and upgrades. If the repairs aren’t made, then the government will have nothing to show for the recent price hike. There’s a worry that funds spent on high speed rail could sap money for basic improvements that would be felt far more broadly. In short, will the new government focus on the big flashy projects, or the more subtle, less visible, but more effective improvements? 

My predictions of a balanced strategy comes, as you can see, with huge drawbacks. If the upcoming budget takes this trajectory, then growth likely wont return back to 8-10% for some time. But that wouldn’t entirely be Modi’s fault. More than we realize, political leaders can be helpless to events beyond their control and their nation’s economic performances are often dictated more by those events than by those leader’s actions. That’s not to say reforms don’t count; on the contrary, reforms often exacerbate or soften trends. But India’s situation is reflected in other developing countries for a reason. American policy in particular is a huge determinant of what goes on worldwide and it isn’t in the developing world’s favor right now. 

That being said, on July 7th, Narendra Modi will demonstrate his vision of Indian economic policy to the world. I truly hope that he beats my predictions; perhaps there’s a way out of the conundrum that I haven’t foreseen. But it looks grim. On a more positive note (which I think the new Prime Minister would appreciate me ending on), his electoral clout allows him to push things in a manner that Indian governments haven’t been able to since the eighties. In that, there lies the possibility for renewed focus on corruption and managerial competence, two things India needs as much as a change in economic policy.

It could lead to other policies as well, ones not as great. But either way, we’ll be there to witness it. 

Chirag 

**Technical Note. When I indicated the term “Balance of Payments Deficit (or Surplus),” I was speaking in the narrow sense of not including the effects of foreign exchange reserves when totaling the capital account. Had those been included, balance of payments would have been zero since Capital Account + Current Account = 0

The deficit India has just means that India is having to buy Rupees on the foreign exchange markets by selling its own foreign exchange reserves. However, should India run out of foreign exchange reserves, the  equation above would have to be drastically altered inducing the Balance of Payments Crisis. 

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