India’s growth is a chimera

From recent statements by policymakers, it would appear that New Delhi is responding adroitly to the personality-driven debate on the relationship between growth and equity.

What recent pronouncements of the ministers charged with articulating conviction and decisiveness in policy wished to show was the UPA’s faith in both redistributive justice and growth. So the Prime Minister held up the Food Security Bill as his government’s USP; at another podium the Finance Minister used his usual evangelical earnestness to “talk up” the market promising to further liberalise the FDI policy, loosen external commercial borrowing norms further and, in the same breath, promising to bridge the CAD (current account deficit).

Elsewhere, the Commerce and Industries Minister, an unfailing supporter of India’s exports, echoing the Finance Minister’s commitment to narrowing the CAD gap, promised Rs. 2,000 crore of interest “sops” to exporters sobbing at the sink. It’s not clear how this will help India’s exports or the CAD, but India’s diverse constituencies have to be addressed as elections loom.

With ears cocked for the sounds of global ratings’ approval, New Delhi seems to be suffering some sort of amnesia, as it tailors policies it thinks will get the private sector singing under the shower once again. You cannot learn where you have to go, if you don’t know how you got here. A look at the best years of the economy, between 2003 and 2008, at India’s Dream Run and the actors that made it possible, will enable us to understand whether they can repeat it. Policymakers seem to think they can. But the evidence seems stacked against that possibility.

Fragile base

They might start with the Economic Surveys; the one for 2011-12 showed us the trend growth for the three sectors and the dramatic expansion of the Services sector overshadowing the sorry decline of agriculture. In fact, that Survey noted the reversals of fortunes with a celebratory air, a trend to be welcomed as a sign of economic maturing.

The Economic Survey of 2011-12 also highlighted the main drivers of the Services-led expansion: IT (chiefly business outsourcing), hotels, trade, real estate and construction.

How was this dream run financed?

A recent paper by R. Nagaraj titled ‘India’s Dream Run 2003-2008” ( Economic and Political Weekly, May 18, 2013) addresses this question and the results show just how leveraged that growth was; that’s the legacy India has to bear.

India’s economic expansion was financed not just by a boom in domestic credit boom but by a dramatic surge in foreign capital inflows. In five years, by 2008, the combined sum of FDI, foreign portfolio investments, external commercial borrowings, constituted 10 per cent of GDP compared to 1 per cent in the five years before 2003-04. Since the government’s own external borrowings had reduced substantially, policymakers saw the spike in private debt as vindication of their reformist policies.

Welcome all and sundry

What helped was the US Fed’s easy money policies following the dotcom bust and Japan’s a few years later. But it was the policymakers’ loosening of rules defining FDI, raising the debt cap for FII, and generally taking a lenient view of the form in which FII and FDI funds were coming in, that really scripted a debt-driven growth.

In 2005, 100 per cent foreign equity was allowed in real estate and construction and in SEZs. Dilution of FDI norms also allowed private equity (PE), venture capital (VC) and hedge funds (HFs) to be considered “FDI”.

Nagaraj is not alone in pointing out that globally, these are counted as elements of shadow banking and that by including them as FDI, India has not been following international best practice. But who cared? The dilution, or as we were told “reforms” in FDI norms, led to a nine-fold rise in inflow in the five years to 2008.

Various studies have questioned the benefits of such a massive inflow of foreign capital. One 2011 work by Rao and Dhar cited by Nagaraj dissected 2,748 FDI projects---88 per cent of the total till 2009---of $5 million and above.

Short-term bubbles

Nearly 40 per cent of the flow was short term in nature --- portfolio, VC, PE and hedge funds; another 10 per cent was “round tripping”, domestic funds routed back into India via tax havens to earn tax-free returns. Less than half of the total inflows went into manufacturing, energy, telecom or ITES; the better part of the funds poured into financial services, construction and real estate and “other services”.

India’s FDI profile and the domestic bank credit boom fed a Services-led growth that largely resulted in a surge in asset prices, not in the creation of “productive potential.” The rise of real estate as a form of economic activity based on “land banks” rather than a factor of production, fostered a distinctive pattern of “industrial” activity that was geared to rent-seeking rather than manufacturing.

After 2008, the organised economy’s magical run sputtered, and continues to slide after a brief burst in 2009-10. The latest output numbers are none too good; after four years output has shrunk. But asset prices in India, both in construction and equity markets continue to reign high, the latter more volatile. In large part they are still fuelled by foreign capital. This includes the urge for debt that drives corporate houses, not least the smaller ones, now exposed to the influx of various types of inflow, mostly short term.

End of boom?

So has the boom ended? Yes and no. It’s over for exports, and the Commerce Ministry would do well to think up of other ways to spend public money than on interest subventions. But the “boom” in asset prices isn’t over. It’s become more volatile for the equity markets where FIIs control 40 per cent of freely traded stocks, and remains high in real estate and housing despite falling sales.

Perversely, high asset prices in construction and equity transmit a sense of well-being and provides New Delhi with the inspiration for more loosening of FDI. This, despite the persistent inflation whose primary source might lie in supply constraints, but is actively fuelled by high asset prices.

Among the policymakers, it’s only the RBI that has been alive to the threat of such inflationary pressures since 2006-07 when the then Governor, Y.V. Reddy began to raise key rates. Private firms simply went abroad for funds since the magic was still working.

This would be the right time to reassess the norms for foreign inflows to ensure commitment to the long haul. But by mistaking the froth of asset prices for the substance of productive potential, policymakers may actually further the debt burden of companies and erode their own growth prospects.