India remains a supply-constrained economy where the need for investment - especially in infrastructure - is immense. However, growth in investment has slumped. Indeed, growth in gross fixed capital formation averaged 1.7 per cent year on year in the first half of 2013-14, almost half the pace of real gross domestic product (GDP) growth, and well off its pre- and post-financial crisis highs. India's investment collapse is idiosyncratic, as it is not a normal business cycle adjustment. In fact, investment was hit as the fallout of corruption scandals bred risk aversion among businesses and the bureaucracy. Investment recovery will be dictated by the pace at which corporate debt overhang eases and by the priorities of the new government.
Exports are beginning to respond to the beneficial impact of the significant rupee depreciation and improving external demand. But long-tern competitive advantage requires significant real sector reforms, including improvements to the ease of doing business. The recovery in overall economic activity is still patchy, as certain key segments remain weak. For example, commercial vehicle sales remain exceptionally weak, and the composite purchasing managers' index (PMI) readings have hardly been inspiring. Also, spending cuts by the government cannot be avoided if it has to meet the official fiscal deficit target. This will adversely affect growth in the very near term.
There are two key macroeconomic adjustments that India has to undertake while also ensuring low and stable inflation and a lasting reduction in the twin deficits. First, supply-constrained India's growth should be powered more by investment than by consumption; and, second, the virtuous savings-investment cycle needs to be rebooted. These two transitions are challenging even in normal times; they will be even more challenging because of political compulsions and the glacial pace of policy response. In fact, a turnaround in investment will be the slowest part of the uneven and gradual recovery.
The recent state legislative elections confirmed the current wave of disappointment with the ruling Congress-led United Progressive Alliance. The results bode well for a Narendra Modi-led national campaign for the Bharatiya Janata Party. How much of a spoilsport the Aam Aadmi Party will be remains to be seen. In any case, it is yet another reminder that post-election coalition arithmetic will be the decisive call on the stability and reform agenda of the new national government.
Frankly, the real issue for India's medium-term economic rise is not whether economic growth will improve to 6-6.5 per cent in the next two to three years. The relevant issue is whether growth gets stuck around that level or if it accelerates further because of initiatives by the new government - to, say, 7.5 per cent or eight per cent annually on a sustained basis.
Uncomfortably high inflation and renewed fiscal concerns remain blots on India's macro landscape. Both inflation and fiscal data improved briefly, only to reverse quickly. India has become a low-growth/high-inflation economy. Inflation has been above real GDP growth for five consecutive years, and has been stubborn despite the collapse in growth in recent years. Inflation will remain above real GDP growth for another couple of years even as the gap between the two narrows.
Some easing in wholesale and consumer price inflation is likely as food inflation declines because of a combination of a good harvest and the reversal in the recent spike in fruit and vegetable, including onion, prices. Still, inflation is unlikely to fall sufficiently to allow the Reserve Bank of India (RBI) to cut interest rates against a backdrop of tightening global liquidity. The RBI is poised to announce changes to its monetary framework, and retail inflation will play a more important role in the setting of policy rates. Consequently, even if consumer price inflation falls to 7-7.5 per cent this year, the repo rate will still need to be in the 8-8.5 per cent range. In the absence of supply-side reforms by the government, interest rates will be high for longer. The RBI is not done with monetary tightening, even though it was justified to stay on hold last month.
Aggressive spending cuts will be needed to stick to the government's fiscal deficit target of 4.8 per cent of GDP. It will also need to use all conceivable means, including pushing a part of the subsidy bill into next fiscal year. But spending cuts will take a toll on growth, especially in the first quarter of 2014.
After being caught off guard in May, India is better prepared to deal with taper. At $46.2 billion (Rs 2.8 lakh crore, or 2.6 per cent of GDP) in 2013-14, the current account deficit is now expected to be significantly smaller, thanks mainly to curbs on gold imports and still-weak non-gold, non-oil imports. Additionally, India has managed to attract significant capital inflows via the RBI's two special swap windows - including one for non-resident Indians, a segment that remains a convenient lender of US dollars. Policymakers' stop-gap measures have eased the balance of payments stress by both lowering the current account deficit and boosting capital inflows. Also, on a real effective exchange rate basis, the rupee is undervalued by 5-8 per cent.
Non-oil, non-gold imports are poised to recover as growth picks up, though its impact on the current account deficit will be partly offset by higher exports. But a risk of a reversal in capital inflows as global liquidity tightens is still a concern. India has been a significant beneficiary of global capital inflows, receiving $91 billion in net inflows from foreign institutional investors (FIIs) since the beginning of 2010. This surge is nearly 54 per cent of the total stock of FII inflow. It is hard to imagine that liquidity tightening will not affect the rupee. However, the adjustment should be significantly less dislocating than before.
In the absence of structural changes that lower the inflation differential and widen the growth differential, the rupee will return to its pre-2002 pattern of gradual depreciation. Even following the 1991 reforms, the rupee depreciated in the 1990s. The global liquidity boom that preceded the global financial crisis distorted the optics and expectations about the rupee, ensuring its stability in a less abundant liquidity environment remains a work in progress.
The writer is senior economist at CLSA, Singapore.
Views expressed are personal