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Forward, Cheerleaders!

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It is that stage of the cycle again, when the economy begins to crowd the headlines. It does so only when it is doing badly. This time the news has been broken by a foreign agent called Standard & Poor's. But its reasons for pessimism are not foreign; they have solidly domestic roots. It stressed three factors in particular – the gaping fiscal deficit, the adverse balance of payments, and the political climate.

The balance of payments has been adverse for many years; the current account deficit has, however, been more than covered by capital inflows. As prospects in the rest of the world worsened, inflows of capital tended to rise. Although the reserves are no longer rising, they have not gone down either, which suggests a rough equivalence between current account deficit and capital inflows. There are no signs of any change in this pattern. The chief economic adviser is reported to have said that a large volume of loans taken by the European Central Bank to rescue banks will mature in 2014, precipitating a major crisis, and that Indian growth will simultaneously shoot up. It is not clear that he saw a relationship between the two events – that capital funds will then flow into India. He also seemed to expect that in the next general election, scheduled for 2014 unless there is a mid-term election, some party will get a majority and will then have no political reason to avoid taking firm policy measures. Even though these ideas come from Kaushik Basu, they remain in the realm of speculations, and are not invested with high likelihood.

Whenever there has been an outflow of funds, the Reserve Bank has let the exchange rate slide. This irregular but steady depreciation of the rupee has been the only policy designed to improve the balance of payments; and obviously, it has not made any decisive difference. So drift is the most likely scenario as far as the balance of payments is concerned.

Ever since the Congress-led government was elected in 2004, its finance ministers have declared their intention to bring down the fiscal deficit and continued to run ever larger deficits. A deficit finances expenditures of benefit to the ruling party. It adds to the public debt, but the economy has hitherto grown fast enough to keep the debt-GDP ratio reasonably low even while the debt went up. Standard & Poor's appears to expect an end to this happy coincidence, presumably because the growth rate would decline. Pranab Mukerjee, the finance minister, reassured the world that while Standard & Poor's was a timely warning, there was no need to panic. He seemed to imply that he would take timely action. He has avoided taking action during all the years he has been finance minister. But maybe he meant that he had been taking action all the time by financing a good deal of his deficit by expanding money supply. More fastidious finance ministers would abjure such opportunism because of its inflationary impact; but then, our government is less scrupulous.

If this is the government's view of economic policy, it is difficult to see what difference it would make if the government got a majority in 2014. If political competition became less intense, the government may be tempted even more to take the people for granted and increase deficit financing. Standard & Poor's may therefore have stronger grounds for marking down India outlook than it realises: the question is not whether the outlook will deteriorate, but how fast. Its ratings may be taken seriously by countries which borrow on international markets. India has not, and does not; so it can afford to ignore warnings. But not everyone is so lucky. Indian big business does borrow abroad; in fact, its borrowings are an important part of the capital inflows that keep the balance of payments afloat. If, as Standard & Poor's fears, India's credit rating worsens, it is these business borrowers that will pay the cost. It will not be just in the form of higher cost of credit; that can to some extent be anticipated and provided for. It will be in the form of depreciation of the rupee, which will be unpredictable both in its extent and its timing. The government will feast itself on fiscal improvidence, but it is India's big enterprises that will pay the cost in the form of depreciation and macroeconomic uncertainty.

The prime minister shows considerable camaraderie with big businessmen. He has some on his advisory bodies; he takes others with him when he visits his counterparts abroad. It is for them to convey to him that he needs to bring discipline to his public and external finances if business is to lead India to the next stage of prosperity and influence. The country pays a high price for a spendthrift government.

(This story was published in Businessworld Issue Dated 14-05-2012)