India Needs to Spend Smarter, Not Less
Investors have been hoping for two things from Narendra Modi's government in India: fiscal rectitude, and a return to the years of 8 percent GDP growth. To achieve the second, he may have to abandon the first.
The first calendar year of Modi's premiership is ending on an ambivalent note. Despite the huge expectations ushered in by his landslide victory in May, gross domestic product growth in the last quarter slipped to 5.3 percent, from 5.7 percent between April and June. The government is predicting growth of just 5.5 percent for the fiscal year that ends next March. Clearly, hope and enthusiasm alone aren't going to revive India's still-struggling economy.
Supporters argue for patience, at least until February when Modi's first full budget is due. Though he's pushed through only incremental changes thus far, the prime minister has been saying all the right things about sweeping, market-based reforms -- liberalizing land and labor markets, opening India to foreign investment, slashing red tape. The expectation is that he's planning a more full-throated reform push starting in February.
The key question, though, is whether even such dramatic changes will spur a renewed burst of private investment -- the key driver of sustainable growth. Between 2007-08 and 2013-14, when India’s growth rate collapsed from over 8 percent annually to 4.5 percent, private investment fell by a huge 8 percentage points as a proportion of GDP. At the same time, the fiscal deficit rose from under 3 percent to over 5 percent of GDP as the government embarked on expensive, populist schemes to provide rural jobs and waive farm loans. It was textbook bad economics: The public sector crowded out private investment.
The solution seems obvious: Trim the fiscal deficit and push reforms to encourage private investment, as Modi's government has been advocating. There are two problems with this. The first is that too many Indian companies are suffering from big debt overhangs -- a legacy of the many projects that stalled under the previous Congress-led government. Those private-sector companies simply don't have the financial capacity to invest right now, however ambitious the reforms Modi does or doesn't lay out. Worse still, many of them operate in the very same sectors -- roads, airports, power, ports -- where India needs investment the most.
The government's own mid-year review, released last week, highlighted the second problem. The review noted that public investment also fell between 2007-08 and 2013-14, by 1.5 percentage points of GDP. The fact is that politically, it's easier to battle deficits by scaling back on impersonal infrastructure investments, rather than cutting food subsidies or bureaucrats' salaries. India has paid a heavy price for this pseudo-austerity. Wasteful expenditure continues to flow; productive spending that should draw in private investment has withered.
Modi faces a political as much as an economic challenge. None of his other reforms will work unless the government also starts pouring money into power, roads and other critical infrastructure areas where the returns for the private sector are uncertain, in order to make it safer for private companies to invest. At the same time, the government cannot entirely afford to blow a hole in the budget; a chronically high deficit is inflationary (as the previous government found to its peril) and will force the central bank to keep interest rates high, dampening growth.
Between now and February, the prime minister is going to have to make a strong case for slashing populist spending, most of which rarely reaches the intended beneficiaries anyway, and redirecting that money to productive investments. Indian voters and investors have been willing to give Modi time to show results. It's up to him to be honest with them about the sacrifices that will be required.
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