| Indian Economy: Reforms or Bubble | |||
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By: Dr.Dipak Basu March 18, 2007 Views expressed here are author’s own and not of this website. Full disclaimer is at the bottom. 
Feedback(The author is a Professor in International Economics in Nagasaki University, Japan) Bubble is an economic condition created by sudden influx of funds to an economy either by the shortsighted policy of the government to stimulate the economy by increased public expenditures and borrowings from foreign sources or by external factors like sudden inflows of funds from abroad. When a country is in bubble it forgets that there can be some unknown dangers lurking round the corner but it is intoxicated by thinking that the party will last forever. The questions can be raised whether the economy of India since 2004 is in such a bubble or it has experienced self-sustained growth suddenly. A number of economies of the world have experienced these bubbles and the end result is always misery. Japan has experienced it from 1985 to 1993, and then it went into a long depression from which it is yet to recover. Britain has gone through it from 1988 to 1991, and then it had severe depression until 1997. South East Asia and East Asian countries, Thailand, Indonesia, South Korea went through this bubble from 1992 to 1998 and then collapsed completely. India itself has seen a bubble from 1985 to 1990 and it went bankrupt in 1991. The newspapers from India are giving a very optimistic picture for India. The economy, which has been on a high growth path of 8-9% for the three years from 2004, is expanding faster in 2007 at 9.2%. Significantly, the 9.2% GDP growth in 2007 comes about despite the slowdown in farm-sector growth to just 2.7% in 2007 from 6% in 2006. This picture mesmerizes the analysts. “Reforms are driving growth,” Finance Minister P Chidambaram said recently, “Reforms have brought in investment, fostered competition, and enhanced productivity and efficiency.” The opinions of prominent Indian economists are the same. However, question should be raised, what is behind this glamorous picture. Is it truly a success story of the reform process or just a bubble about to be burst if the situation that created this bubble will disappear suddenly? Growth picture: The annual average growth rate, in constant price, during the 7th Plan (1985 to 1990) was 3.6 percent; during the 9th Plan of 1997 to 2002 it became 3.5 percent. India’s high rate of growth has started in 2003, when the GDP (Gross Domestic Product) grew, in constant price, grew at the rate of 8.6 percent per year followed by 7.6 percent in 2004. However the annual average for the period from 2000 to 2004 was 6 percent, which is not very different for the annual average of 5.8 percent, for the period of the earlier bubble of 1985 to 1989. In 1988 the rate of growth was already 10.1 percent. That period 1985 to 1990 was during the plan period, where ‘Reforms’ were not introduced. Thus, the source of the current high rate of growth must lie elsewhere, not on the ‘Reforms’. If we look at the source of the bubble of 1985-89 we may get the clue. A Comparison of two Bubbles can help us to understand the picture and its perspectives. The average growth rate for the period 1985 to 1989 was 5.8 percent; for the period 2000 to 2004 it became 6.0 percent, not a great advertisement for the ‘Reform’ process. Annual Rate of Growth of Gross National Product, in constant price, (in %): 1985 4.5 2000 4.0 1986 4.1 2001 5.9 1987 3.6 2002 3.9 1988 10.1 2003 8.6 1989 6.7 2004 7.6 The cause of the bubble of 1985-89: The bubble of 1985-89 was caused by unprecedented increase in borrowings from abroad and in domestic creation of money. We get the clue from the following tables. Foreign Borrowings Money Supply (Rupees Billions) (Rate of growth) 1985 13.7 16.1% 1986 19.4 19.4% 1987 32.7 16.5% 1988 25.1 18.1% 1989 29.9 11.3% Budget Deficits Balance of Payments deficit Price Increase (Rupees Billion) (US$ Million) (Annual rate) 1985 -222.5 -6953.0 8.7% 1986 -272.0 -7219.0 8.8% 1987 -278.8 -8198.0 9.4% 1988 -330.9 -9900.0 6.2% 1989 -292.3 -9896.0 8.7% Balance of payments deficits, along with budget deficit of the government, went on increasing due to increased expenditures of the government for mainly non-investment purposes. That has forced India to borrow from abroad to pay for these deficits. Foreign borrowings went up and up. From 1985 to 1989 within five years foreign borrowings per year increased by more than 100 percent. The total foreign borrowing for that period was a massive Rs.120.8 Billion. Increased domestic borrowings were the results of increased budget deficits, which had the results of increased money supply and the resultant inflation. By 1990-91, when the Soviet Union, which used to absorb 20 percent of India’s exports, has collapsed and the remittances from the Indian workers in the Middle East suddenly vanished due to the invasion of Kuwait by Iraq, India found it impossible to pay back what it had borrowed and went bankrupt. As a result the ‘Reform’ process to dismantle the planning process was imposed upon India in 1991. The person in charge of Indian finance during the bubble of 1985 to 1989 is the same person who became the finance minister in charge of the ‘Reforms’ since 1991 and now the Prime-Minister of India in 2007 presiding over another bubble. Financial picture behind the upsurge of growth-rate: The recent upsurge of growth rate is the result of injections of huge funds to the economy either through increased by increasing budget deficits or by foreign borrowings. A new picture is added which was absent during the earlier bubble of 1985-89. That is the short- term borrowings from abroad and allowances for foreigners to participate in the country’s stock market and real estate developments. In 1990 non-development expenditure of the government was Rs.69.2 Billion. In 2000 it became Rs.298.9 Billion and Rs.461.9 billion in 2004. The rate of growth of non-development expenditure was 332 percent between 1990 to 2000 and 567.4 percent between 1990 to 2004. The rate of growth of development expenditure was 219 percent between 1990 to 2000 and 382.7 between 1990 to 2004. Non-development expenditure fuels both increased money supply and inflation. India has experienced both. The budget deficits that was created by these massive increases in expenditures went up from Rs.57.2 billion in 1990 to 256.3 Billions in 2004 with a rate of growth of 348.6% during that period. The tax rate did not go up to cover the expanding expenditure of the government; instead the government went on borrowing from both home and abroad. The tax to GDP (Gross Domestic Product) ratio was 15.43% in 1990; it was 16.30% in 2004. Foreign capital inflows were Rs.4.3 Billion in 1990, which became Rs.8.3 Billion in 2000 and Rs.11.7 Billion in 2004. The alarming factor is that short-term debt is increasing at a very fast rate. The ratio of short-term debt to total debt went up from 2.8% in 2002 to 6.7% in 2006. Foreign investments of short-term nature or portfolio investments went up from US$9.3 Billion in 2002 to US$12.2 Billion in 2005. Investments by foreign institutional investors in India went up from US$ 377 million in 2002 top US$9.9 Billion in 2005. However, at the same time foreign direct investment of long-term nature was increased by a much slower rate from US$3.7 Billion in 2002 to Rs.4.7 Billion in 2005. At the same time India’s deficits in the trade balance went up from US$33.70 Billion in 2002 to US$51.84 Billion. Total deficits in the balance of payments of India went up from US$2.47 Billion in 2002 to 9.19 Billion in 2005. Financing of these deficits requires more borrowings. Total foreign borrowings went up from Rs.163 Billions in 1991 to Rs.548.1 Billion in 2005 or an increase by 3.36 times. Commercial borrowings went up from Rs.197.3 Billion in 1991 to Rs.125.5 Billion in 2005 or by 6.36 times. In the mean time foreigner’s purchased shares of Indian companies went up from Rs.6.5 Billion in 1991 to Rs.61.9 Billion in 2005 or by 9.5 times. In fact that type of purchases went up within a year from Rs.42.8 Billion in 2000 to Rs.67.7 Billion in 2001 because of certain changes in the legal restrictions on such purchases that were there before. Foreign funds in the stock market: India has witnessed over a decade of portfolio flows and with each passing year, portfolio flows have gained in their significance and have played a key role in the overall Indian economy. Although investment by foreign institutional investors are typically synonymous with portfolio investments in India, investments in Global Depository Reserve and offshore funds should be included in any analysis relating to portfolio flows. The year 2002-2003 was highlighted by significant events; both locally and internationally that had a bearing on the Indian economy. By end March 2003, cumulative portfolio investments totaled nearly US$16billion, which constituted nearly 11 percent of the country’s stock market capitalization. The Union Budget 2003 announced that dividends would be exempt from tax in the hands of a shareholder. Henceforth, dividends declared by an Indian company would not be liable to Indian taxes. However, the Indian company will be liable to pay 12.81% (including surcharge) dividend distribution tax. Further, long term capital gains arising on transfer of equity shares (held at least for one year) in a listed company, acquired between March 1, 2003 and February 28, 2004 would be exempt from tax. These initiatives were specifically targeted at attracting portfolio investments into India. India has emerged as the most favored private equity (PE) destination attracting $2.21 billion of private equity investment in 2006 as against just $1, 992 million in 2005. India was followed by China with $1.72 billion. Singapore came third with $1.53 billion. Foreign funds in Real Estate: India’s Foreign Direct Investment inflows have doubled to $2.9 billion during April-July 2006 as compared to the $1.5 billion during the same period in 2005. Sensing the demand of foreign investors, the Indian government has liberalized the laws relating to FDI in February 2005. Now Non Resident Indians (NRI’s) and Overseas Corporate Bodies (OCB’s) can invest up to 100% in the real estate sector. Foreign Direct Investment in real estate is now possible without the need for permission by the Foreign Investment Promotion Board. So, the liberalized FDI regime, coupled with the strong potential of the industry is going to help pump money into the sector. Currently, FDI in India is targeting township, housing, construction development projects, built-up infrastructure etc. The Indian government repealed the Urban Land Ceiling Act in 2001 and a large quantum of land is now free for construction. Investment is now also allowed for smaller projects of just 25 acres. Impacts on the Real Economy: The sudden upsurge of growth rate of the national income in India has very different effects on the real economy. The two most important aspects of people’s life are employment and food. From these points the ‘Reform’ program has little to offer during the entire period from 1991 to 2005. Index of Production of Food-Grain (1981=100) 1990 1999 2004 Rice 149 180 171 Wheat 156 217 204 All Grains 143 169 164 Net Availability Of cereals per head (Grams) 468.5 422.7 427.4 Pulses 41.6 31.8 35.9 Production of rice has improved from 1991 to 1999 but since it has declined; it is true also about wheat and all food-grains. As a result the net availability of pulses per head went down from 41.6 grams in 1991 to 35.9 grams in 2004. Availability of cereals per head also went down from 468.5 grams in 1991 to 427.4 grams in 2004. Inflation has also taken its toll. Cost of living index of industrial workers went up from 201 in 1990 to 538 in 2005. For agricultural laborers it went up from 145 in 1990 to 360 in 2005. For the urban non-manual persons it went up from 169 in 1990 to 463 in 2005. Thus, all sections of the population are affected very badly from the inflation and reductions in the availability of food. Inflation: Cost of Living (Index: 1980=100) For: Industrial Workers Agricultural Laborer Urban non-Manual Person 1990 201 145 169 1995 319 237 264 2005 538 360 463 The average rate of increase of the cost of living during the period of 1986 to 1989 was 6.38% for the industrial workers but the average annual increase during the ‘Reform’ period since 1991 is now 11.17%. For the agricultural laborers it went up from 7.6% during the planned economy to 9.88% in the ‘Reformed’ economy and for the urban non-manual people it went from 6.52% to 11.59%. Thus, the living conditions of the people the ‘Reformed’ economy does not paint a rosy picture. Employment During the ‘Reformed’Economy: Data for employment is available only up to 2003; thus we can compare the situation between 1991 and 2003 regarding employments in different sectors of the economy for the both private and the public sector. Employment in the Organized Sectors (Millions) 1991 2003 Public Sector: Manufacturing 1.852 1.260 Construction 1.149 .948 Total Public 19.058 18.580 Private Sector: Agriculture .891 .895 Mining .100 .066 Manufacturing 4.481 4.744 Construction .073 .044 Transport .053 .079 Trade .300 .360 Finance .254 .426 Social Service 1.485 1.756 Total Private 7.677 8.421 Grand Total 26.735 27.001 Gross domestic 6660.6 27602.2 Product (Rs Billion) Ratio of Employment 4.01e-6 9.78e-7 To Gross National Income As we can see from the above table, employment increase only marginally during this period of 12 years of the ‘Reformed’ economy; it has declined in the public sector in both mining and manufacturing. In the private sector too employment declined in the mining, constructions; in agriculture it increased only marginally. In other sectors it increased mainly in the finance sector. The improvements in the private sector could not compensate for the decline in employment in the public sector. The ratio of employment to gross national income declined significantly during the “Reformed” period. Thus, it proved the inefficiency of the ‘Reformed’ economy regarding the generation of employment prospects for the country. Conclusion: The “Reformed” economy has produced two India, one very tiny part of the economy, mainly the IT sector, the financial services and trading sector has prospered. However, there is a general decline in agriculture, construction and mining. The growth of the economy is fueled by increasing flows of short-term foreign investments both in the share market and in the real estate business, which has suddenly raised the growth rate since 2004. The balance of payments still has deficits along with the balance of trade. The only positive factors in India’s external account are the growth of exports of IT related services and remittances from the Indians living abroad. The real economy and employment have not responded positively yet to the so-called “Reforms”. In the case of India’s earlier bubble of 1985 to 1989 the cause was the sudden increase of government consumptions for non-development purposes financed by foreign borrowings. In the current bubble the cause is the sudden inflows of foreign funds to satisfy the appetite of speculative demands in the share market and real estate business. Borrowings by Indian companies from foreign sources are a major factor in this scene. The danger is that these speculative inflows of funds from abroad can dry up suddenly if there is any indication that due to increasing balance of payments deficits the exchange rate of Rupee mat fall. That would provoke a speculative drive against the Rupee and there would be a general exodus of foreign funds from the share market thus bring down the economy and invite serious depression in the economy destroying millions of jobs in India. A crisis of that nature has already erupted in the East Asian countries in 1978. India was protected at that time because its capital market was closed from the foreign speculators. That is not true any more. Difference between China and India is very obvious. China had put emphasis on the manufacturing industries by inviting foreign direct investments in plants and machinery. India has put emphasis on short-term borrowings to stimulate the economy artificially. China has devalued the exchange rate of Yuan in 1994 by 40 percent and kept it all most fixed since then. India has revalued Rupee and has a flexible exchange rate knowing full well that inflows of foreign funds will increase the exchange rate of Rupee thus making India’s exports increasingly uncompetitive in the world economy. China does not allow foreign institutional investors to invest in the Chinese share market or in the real estate sector, but India does. China has not relaxed its control on the capital market, but India is going steadily towards an open economy thus inviting the danger of a sudden collapse when the speculative bubble would burst. To protect the economy from the speculative bubbles, India should immediately devalue Rupee by al least 30 percent and keep it fixed by closing the foreign exchange market for Rupee, banning participations of foreign funds in the share market and in the real estate business, have very tight control on the capital flows, have control over the foreign borrowings by Indian private companies and rejuvenate public investment program in agriculture and manufacturing to promote employment. Without a vigorous public investment that feeds the private investments, the country could not be developed for the satisfaction of the people at large. Dr.Dipak Basu
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