The fundamentals are wrong

The fundamentals are wrong

By Dhiraj Nayyar | 29 August, 2015
The state of India’s economy is worrying.

How strong is India's economy? It's a question worth asking in the week after India (at least its financial markets) caught a frightful cold when China sneezed. Whenever things go wrong, it is common for the country's top economic managers to say that the economy's fundamentals are strong and that good time is around the corner. Unsurprisingly, Finance Minister Arun Jaitley and RBI Governor Raghuram Rajan have tried to sound reassuring. But there are reasons to be concerned about the "fundamentals".

Why else would the humble onion keep bringing tears to consumers and policymakers year after year? There is something wrong with the fundamentals of India's food economy, which results in periodic hyper-inflation of certain commodities. There is something terribly wrong with policymaking, which fails to find the right solution to a recurring problem. The fundamentals of India's food economy can be corrected only by the government. For a start, when a commodity is scarce it needs to move quickly to increase imports. Elsewhere, the government needs to end wholesale monopolies enabled by the APMC Act. It needs to end giving support prices for certain commodities, like rice and wheat, which act as a disincentive to produce others like onions. But none of that has been given priority either by the NDA or the UPA before it.

Instead, the RBI has taken over the task using the instrument of interest rates to address food inflation. The medicine is worse than the disease. While the price of credit (and liquidity) in the economy has a lot to do with inflation in general, they have only a distant link with food inflation in particular. A policy that requires a deliberate slowdown of the entire economy to tackle food inflation is harmful. It distorts the fundamentals.

For the economy to have strong fundamentals (in the current scenario) it needs to have a much lower rate of interest than it has. Growth hasn't taken off and inflation (other than in food) is the lowest in several years. But the reality of interest rates is the opposite. After the events in China (including a deliberate devaluation of the yuan), India ought to have a depreciated rupee so that exports (an important source of growth and employment generation) remain competitive. Instead, policymakers are doing their best to keep the rupee strong — in part by retaining high interest rates. That doesn't make for strong fundamentals.

The question is this: What is going to drive economic growth rates to a higher trajectory? Both investment and consumption are dampened by high interest rates. Export growth is falling because of a strong rupee and stagnant foreign markets. Government expenditure is falling because of a necessity to tighten the fisc. Fundamentally, there is no reason for the economy to take off with the current policy regime.

If the Finance Minister and RBI Governor want to be credible in their assurances, they need to take steps to correct the fundamentals. The RBI needs to lower interest rates immediately. The Finance Ministry and Agriculture Ministry need to crack down on food inflation by reforming the agricultural economy. The Finance Ministry also needs to lead the process of making the environment for investment easier. Right now, with business as usual, there is every reason to be worried about the state of the economy.

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