Recovery time


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AFTER two years of gloom the clouds have begun to lift, despite the economy being hit by a twin blast. That we should have a recovery in the face of double adversity is remarkable. For, historically, two events have derailed the Indian economy: high energy prices and a poor monsoon. The last time these two struck in tandem, GDP actually shrank by 5 per cent in 1979-80 and inflation reached record levels. This year, we have had once again a sudden increase in energy prices as well as a drought. The first has caused a substantial increase in the oil import bill, while the second is expected to push down foodgrain production by a precipitous 10 per cent. And, naturally, there is widespread distress in the countryside, while petrol and diesel prices have reached new highs. By all past experience, therefore, we should have been in crisis just now.

Yet the economy is on the rebound, and inflation remains a low, low 3.5 per cent. Although GDP growth is likely to be around the same level as last year (5.5 per cent), the story in the two years is quite different because last year was a record year for agriculture. And so the mood in all but the drought-hit states (where there is large-scale distress) is decidedly more upbeat now, bringing to an end the gloom that set in when the internet bubble burst and cut short the mini-recovery of 2000.

Look at all the positives that have brought about the change this past year. The stock market has begun a modest rebound after losing value for three years in a row. The manufacturing sector had lost all zing, but is now reporting better numbers, with renewed growth in automobiles, cement, steel and a host of other sectors. Exports have shaken off their stagnation and we now have double-digit growth once again. More jobs were being lost than created, but there is now new life in the job market and pay rises this year will therefore be better than a year ago. Corporate profits have soared in the past half-year, and software is on the rebound. Even hotel occupancy has registered an improvement in recent weeks.

What few commentators have latched on to so far is the fact that the capital goods industry, which has been in terrible shape because of the lack of investment activity, is suddenly reporting good numbers, while bank credit is showing healthy growth – both significant pointers to an upswing. Although there is no sign yet that the economy will break out of the 5.5 per cent growth band that has characterised the past five years, the signs of a change in tempo are everywhere. And this time round, the recovery is likely to be more broad-based and more sustained than was the case with the last two mini-recoveries, in 1997 and 2000. If the situation is managed well, we could even see the economy getting onto a 6 per cent plus rate of growth, which only three other economies in the world are managing just now.



What has brought about this change? It can’t be any one factor. But among the contributory issues, there is the fact that the manufacturing sector has seen at least a partial shakeout and consolidation, with the losers going out of the market or being taken over. The result is that over-capacity no longer exists on the scale that was there five years ago. Cement is one example of an industry which has seen a fair amount of consolidation. Then, the slump in global commodity prices has ended, giving relief to companies producing steel and paper (to take two examples), and also aluminium producers.

Third, many Indian manufacturing firms have done a great deal of hard work through the last few difficult years: they have cut costs, improved productivity (Tata Steel produces more steel today with 60 per cent of its old workforce), understood the customer better (ask Bajaj Auto), reworked their financial structures so as to get rid of high-cost debt and emerged stronger and able to compete internationally. TVS Motors has bounced back smartly from being down and out, and so has Tata Engineering. Ballarpur Industries (or Bilt) is not the same paper company that it used to be, and firms like Bharat Forge are now global winners.



There is still more to the recovery story. Software had been on the skids, but is enjoying traction once again. The big companies in the business are now doing better than ever before and gaining in confidence about their own capabilities, while the IT-enabled sector becomes a bigger and bigger story. Some pharmaceutical companies have had notable successes in product development and international market penetration, while new growth is promised in areas like retailing (count the malls being opened in various cities) and entertainment (multiplexes are the new rage).

Interest rates, while still ruling higher than warranted, have dropped steadily to levels low enough to encourage a sustained boom in housing finance – which means lots more home ownership (translated into cement and steel consumption, more work at construction sites, downstream growth in home furnishings, etc). The telecom sector has been fairly sizzling, and insurance is doing well now that the new private players have begun to give the state-owned firms a run for their money. Consumer durables could do better, but spending should revive with the change of tempo in the job market and growing confidence among consumers that the worst phase of corporate downsizing is over and jobs are therefore more secure.

None of this means easy pickings in the market, though. Consumers are increasingly price- and value-conscious, as testified to by Hindustan Lever’s troubles. Maruti was able to shake off slackness in the car market only after slashing prices, and the airlines have given travellers never-before deals in order to fill the seats. Competition in telecom continues to grow, and here as well as in other sectors, no winner can rest on his laurels.

No sooner had Hero Honda emerged as the market leader in two-wheelers than Bajaj Auto began playing catch-up, while TVS Motor is hot on the heels of both and gaining ground. Retail finance margins are now wafer thin as the banks hunt for safe lending options, and consumer durables get cheaper all the time. The result is that it has become more difficult to pick out the sustained winners, and therefore investment in shares becomes more difficult to call.



The most heartening change, in the whole melange of upswings, is what one can see taking place in the troubled infrastructure sector. The Indian economy remains severely under provided in this sphere, but change is clearly in the air, and taking place on the ground. Not just with regard to the economic infrastructure of transport systems and power, but also communications and even the urban infrastructure in our blighted metropolises. With telephone connections growing by some 40-50 per cent annually, the telecom revolution has finally arrived, and it is a safe bet that within five years India will move from under 40 million telephones today to 100 million phones and more.

The ambitious national highway project is ahead of schedule, though complaints have surfaced about the quality of work being done, and of poor maintenance on the finished stretches. Ports have seen a radical improvement in performance in recent years, and some of the privatised ports have achieved efficiency levels comparable to Singapore, Colombo and Jebel Ali. With more privatisation planned, port capacity should increase further, and deliver quicker ship turnaround so that the shipping rates from India become more reasonable and help exporters compete.



Even the power sector is seeing change, in that deterioration has been arrested while one or two states have begun to report improved performance parameters. If the pressure for change can be sustained, in three or four years time the worst of the power problem would be behind us. That leaves the railways (for which a major investment programme is being drawn up) and the airports, whose privatisation has been inordinately delayed. As a snapshot, the infrastructure sector in its totality continues to present a messy picture. But look at it from the perspective of five years ago, and the improvements become obvious.

If the physical infrastructure provides the sinews of the system, the financial sector presents its life blood. And as in the case of infrastructure, while serious problems remain the worst may be over. The banks are now in better shape than perhaps ever before, the Unit Trust problem has been fenced in, and other than the exposure of provident and pension funds to suspect state paper, the situation is now under control. Of course IDBI and IFCI still need fixing, but the new law on bad loans is certain to lead to a lot more loans being repaid, to debt recovery tribunals becoming more effective, and of company promoters realising that they can’t have their cake and eat it too. In short, while all loans won’t suddenly get repaid, the level of non-performing assets will come down.

One of the abiding failures of the past half century has been in managing India’s cities – the result of underpricing urban services, then under-investing in them, and following confused policies with regard to land. But now even the cities are getting a face lift. In the capital, which has become progressively unliveable, half a dozen steps have been taken that are beginning to make a noticeable difference. Polluting industries have been shut down and relocated in new, approved areas on the outer fringes. The public transport system has shifted completely to compressed natural gas (CNG) as fuel, reducing automobile exhaust pollution in substantial measure. More than a dozen flyovers have been built, smoothening traffic flow at key intersections, and more flyovers are under construction.

Power distribution has been privatised, and the two companies that have taken over the business are busy investing for providing a radically improved service. Now a three-phase metro rail service is under construction, which will take a great deal of pressure off the surface transport system, and perhaps persuade people to use cars and scooters less than now. The cumulative impact of all this is that life in the capital is going to be far more bearable than might have seemed possible just two short years ago.



It’s not just Delhi, Mumbai too is busy investing in urban infrastructure. It had two initial advantages over Delhi, in that it already had a high-capacity train service and a very good power supply system. But the train service was stretched, and now its capacity is being expanded by over 50 per cent as part of the biggest urban renewal project that the city has seen. Many flyovers built over the past few years have eased the flow of traffic through the main arteries, but even more ambitious traffic plans are now being financed by the World Bank.

It’s not difficult to imagine that urban renewal projects on a smaller scale are being launched in other cities as well. In Hyderabad, for instance, roads have been widened, the Hussainsagar lake that separates Hyderabad from Secunderabad has been cleaned up, both power and water supply have improved dramatically, and municipal records (including the city’s notoriously unreliable land titles) have been computerised and are easily accessible. Tax collection has been given a fillip too, though with how much success is not known.



Such steps are not enough, of course. One-third of Delhi’s citizens live in unauthorised developments or on the pavements; that figure is close to half in cities like Mumbai. These are people who do not get access to the basics: clean water, sanitation, electricity, a proper roof over their heads. Given the income levels and the scale of the problem, there is no easy answer. But two things do need to get done: land and dwellings that are frozen because of rigid laws need to get freed so that they come into the market; the increased supply will drop prices and make housing affordable for many more people than is the case now. And second, urban services need to get charged for.

Migration into the cities is encouraged by the fact that people can squat on public land without cost (other than what is paid to the local tout or political fixer), use free electricity because it is stolen off the wires, and free water and sanitation because there are public handpumps and the good earth. While the political system has a vested interest in keeping things this way (think of ward politicians and their need for local vote banks), cities cannot permanently continue to have half their population free-loading; solutions will have to be found.

One reason why solutions have not been found so far is because of the uniform explanation for poor infrastructure in the country: under investment. And this is primarily on account of not charging proper taxes for the services provided by municipal bodies. In most cities, property taxation, stamp duties and the like are nominally high and therefore designed to encourage evasion, while large sections of the population are protected through a focus on historical costs, thereby preventing open real estate deals. At the same time, power rates have traditionally been lower than cost in Delhi, and water charges so low as to be barely more than collection cost.

Delhi is now wrestling to find a rational way to tax property, and if the effort succeeds then other cities might follow suit. Armed with more revenue, India’s big cities could certainly hope to provide better services to the majority. Since India already has the world’s largest urban population, and the urbanisation ratio will keep climbing, the management of the big cities will become a steadily greater challenge. That the challenge is now beginning to be met is therefore most encouraging, and constitutes part of the good news at the year end.



In the countryside, the central challenge remains the need to diversify Indian agriculture, and move away from the focus on foodgrains. Per capita grain availability is now more than 200 kg, which is perfectly adequate from a nutrition point of view (a family of five can eat 3 kg of grain daily). With more than 90 per cent of the population reporting that it gets two square meals a day, grain consumption is unlikely to grow at much faster than the rate of population growth (barely 1.7 per cent).

Indeed, food habits are becoming more diverse as more people move above the poverty line and get beyond subsistence levels. Rapid consumption growth is showing up in fruits and vegetables, sugar and tea, and edible oils. Already, as a consequence, grain accounts for less than half of what constitutes ‘agriculture and allied activities’, since there is also poultry, fisheries, milk production and livestock breeding. It is all these activities that have to be encouraged through the state’s support services and through the creation of the required infrastructure (like cold storages and quick access to international markets) so that agriculture can get new momentum.



The problem is that the state continues to focus on the grain economy and also insists on intervening on input and output product prices, clamping down marketing controls and distorting markets while persisting with a procurement model that has simply outlived its utility and become a public liability. There is no reason for the Food Corporation to stock 55 million tonnes of grain when the buffer stock requirement is barely a third of that figure.

The other problem in the countryside is plain governance failure. Teachers don’t teach, so that 60 per cent of school students drop out by Class V (this does not get reflected in the literacy numbers because if you can write your name the government considers you literate). Hospitals spread disease rather than cure patients – and cure needs medicines that are usually missing in the public health system. The public distribution system does not function in the needy areas (in Kalahandi and elsewhere, the starving were found to have sold their ration cards!). And when it comes to law and order, it is the law of the jungle that prevails in large parts of the troubled northern states, while armed insurgency remains a problem in at least half a dozen states.

It is doubly ironic, therefore, that state administrations that fail to deliver the goods while employing whole armies of employees, are now bankrupt. By one count, more than a dozen state governments are unable to pay staff salaries on time, and many have taken on financial liabilities (through the provision of various guarantees, for instance) whose full extent has not been fully reported. The central deficit too remains high, and on a comparable basis is now perhaps higher than when the reform process got under way with the 1991 budget.

While this is debilitating enough (and causing unease to both the IMF and the international rating agencies), it also prevents the government from pursuing counter-cyclical policies, like pumping in investment when private demand is slack. If the privatisation/disinvestment business had continued smoothly, Arun Shourie may well have been able to deliver the promised Rs 80,000 crore over the next five years and in the process eased fiscal pressures substantially. But with skirmishing not yet over on the subject, the finance minister will get little joy from this particular corner.



For all the problems that continue to exist, a watershed has been reached. Many of the most important problems identified 12 years ago have been tackled with varying degrees of success. Even in sectors where a lot of work still remains to be done, the hump has been crossed. Unless the system falls apart, things will now continue to happen in improving the infrastructure, making the manufacturing sector more competitive, diversifying Indian agriculture, privatising unproductive assets in government hands and opening up the system more completely to the world. The only issues where the toughest part of the uphill climb still lies ahead are with regard to plain old governance and fiscal discipline.



While it is important to keep the eye on those two balls, policy-makers must also begin to look in an altogether new direction. For the novel worry from an unexpected quarter is the result of India’s success in software exports. A year or two ago I had in my annual Seminar article, considered the possibility that India’s software exports would reach a point where India would have more dollars than it could handle. Well, that situation has been reached faster than I had expected. India is already awash in dollars. And this is not because of capital inflows or non-resident Indian remittances (though it is that too, as we will see), but because India now has a surplus on its trade account.

This is such a novel situation that most people simply have not understood what it means. After all, though India began its life as an independent nation with fat dollar and sterling balances, as soon as development spending under the five-year plans got under way the country began running a trade deficit. Other than one freak year in the 1970s, it has been that way for the past 55 years. Indeed, economic theory tells us that this is exactly as it should be: a developing economy is by definition capital scarce and therefore needs to bring in capital by way of equity investment or loans (on commercial or concessional terms), and these are used to finance that part of imports which is not financed by exports. In other words, capital imports finance the trade deficit. But what if there is no trade deficit in the first place?

India’s software exports were next to nothing five years ago, and last year totalled over $8 billion (or 2 per cent of GDP). That was enough to propel India into a trade surplus year (trade being in both goods and services) – the first time in a quarter of a century. It was a small surplus, but one that will now get steadily bigger, as the figures for the first half of the current year (till September) suggest. By next March, the full financial year’s exports of software and IT-enabled services will have reached more than $ 10 billion, and with fresh momentum in the sector the figure next year is expected to be over $13 billion, or 3 per cent of GDP, making it India’s largest single export item, bigger than the combined total of cotton textiles/garments. And mind you, this didn’t exist as a significant item a decade ago. It’s like striking oil.



Which is wonderful, except for the fact that the traditional view favours a weak currency for a developing economy – if Rs 50 translates into a dollar instead of $1.25 (which is what it would be if the exchange rate was Rs 40/dollar), then your exports are cheaper in international markets and you can sell more. Simultaneously, products from overseas become more expensive in domestic markets, so that imports gets squeezed and domestic producers get more elbow room. A weak currency works continuously to feed this encouragement of exports and discouragement of imports, whereas a trade surplus caused by the software export boom changes this calculus and converts what has been a weak currency into a strong currency, because you are now earning more dollars than you are spending.

And that has serious implications for all the other export sectors that depend on a weak currency. Imagine the plight of those who export tea and cotton and tobacco and sugar and a host of other commodities on which price competitiveness is critical, if the rupee were to keep moving up against the dollar? Software would continue to boom, since it has 30 per cent profit margins, but other sectors with 3 and 5 per cent margins would certainly suffer.



Indian exporters operating on thin margins have been able to bet so far on the certainty that the rupee would lose ground every year, since that has been the historical experience. After all, the rupee slipped from Rs 4.76 to the dollar in 1949-66 to Rs 7.50 and then slid (under the floating rate system) to Rs 18 in 1991 and further to Rs 49 early this year. To a large extent the loss of exchange value reflected the higher inflation rates in India, but it is also true that Manmohan Singh was able to sharply cut tariff protection rates a decade ago by pushing down the rupee vis-à-vis the dollar from Rs 18 to Rs 31 in next to no time, and thus neutralise the impact of the tariff cuts while encouraging more exports.

Readers will recall that Indian exports did suddenly spurt in the mid-1990s in response to these price signals. But if the rupee now becomes a strong currency, then that kind of corrective action is no longer possible. Indeed, India does need to drop its tariff rates further, since they remain the highest in the world. But this time round, the finance minister and the Reserve Bank will not be able to neutralise it by dropping the rupee. So tariff cuts will mean more intense competition from imports, in everything from paper and aluminium and from steel to copper.

Inflation rates in India have over the few years become much lower than the historical average of around 8 per cent; but they remain about two percentage points higher than inflation rates in the advanced economies. Logically, the rupee should continue to drop against the currencies of those countries by about 2 per cent a year, to reflect the differential inflation rates. Instead, the rupee has gained this year against the dollar, and may continue to do so for the foreseeable future.



Indeed, the rupee would have gained much more in value if the Reserve Bank had not countered its rise by mopping up dollars from the market and selling rupees. And it has been forced to do this because the interest rates in India are high, compared to the rest of the world. Overnight money in the US, for instance, fetches around just over 1 per cent (at an annual rate). In India, in contrast, the Reserve Bank offers 5.25 per cent. This would be fine if you knew that the rupee would fall by 4 per cent against the dollar. But if the rupee is rising, then the difference in interest rates is an open invitation to NRIs to borrow in dollars overseas and pump that money into India, and make a killing at virtually no risk. Indeed, NRIs seem to be doing just this and it is this trend, along with the regular flows of portfolio investment as well as foreign direct investment, that has created the strong dollar inflow.

The Reserve Bank has responded by buying up as many dollars as it can, and because this means pumping rupees into the market, the danger is of a runaway growth in money supply, which at some point can provoke greater inflation. To prevent this unwanted side-effect, the RBI has been selling government bonds and taking back the rupees, but there are limits to all this and if the software surge continues, the combined impact of a trade surplus and of capital imports will force the rupee to rise. One solution is to allow Indians to spend and invest more overseas, so that you encourage the reverse flow of dollars, and to a limited extent this is what the RBI has started doing.

The more substantial solution to the unwanted capital inflow is to drop domestic interest rates. Here the RBI is constrained by the severe political pressures against dropping interest rates on savings instruments like provident funds and post office savings deposits (which offer 9 per cent and more, tax-free as well as risk-free). These rates are clearly unsustainable, and point to the tensions between political impulses and economic logic. Indeed, political pressures also come in the way of the government tackling the subsidy issue and thereby reducing the fiscal deficit.



Subsidies are up 60 per cent in the first half of this year. If these could be cut, and the level of government borrowing (required to finance the deficit) lowered, then the demand-supply balance for money would swing and the RBI would be able to continue pushing interest rates down. But with the high deficit and the high rates of interest on small savings, interest rates in the market remain high and are creating a needless dollar inflow for which there is no immediate solution. The short point is that while software exports are a great success story, they have begun to throw up new challenges to macro-economic policy.

The other solution available to the government is to encourage imports in areas where it would be beneficial to the economy, and the most obvious area would be investment in the country’s physical infrastructure. If Jaswant Singh had to focus on any one button to press so that the economic recovery gains momentum, it would be this one. Because it is what the economy needs anyway, because it creates an investment stimulus that generates fresh downstream demand with lots of forward linkages, and because it necessities the kind of policy changes that will work to build greater efficiency in the system. And of all the infrastructure areas where attention can be profitably focused, the most important is power generation and distribution. Lenin had a point when he said what he did about electricity.



This does raise questions about policy reform that is required to reduce investment risk, but not much can perhaps be expected on this as the government gets into election mode: more than half a dozen key states go to the polls in under a year, and the general elections are due in 21 months. However compelling the economic logic, no government will want to upset voters at this stage. Since reform in the final analysis is about breaking the egg to make an omelette, the time when no one wants to break any eggs is a time when you should expect little to happen. But to the credit of the Vajpayee government, it has more of an appetite for action at this stage in its life than the Narasimha Rao government had at an equivalent stage in late 1994.

Politics could intervene in other ways too, if civil strife grows or spreads, and makes the economy the handmaiden to politics in new and more debilitating ways. It is equally possible that the government will fail to capitalise on the nascent upswing by failing to make the right policy announcements or bungling on macro-economic management. While it would be prudent to factor both risks into any realistic calculus, it would still be safe to say that the Indian economy looks in better shape today than it has at any stage in the last five or six years. And that is something to be thankful for.