Abheek Barua: The long term versus the short term

The bottom line is that for long-term expansion, the economy cannot afford to lose its short-term momentum

I was in Europe recently and was quite overwhelmed by the attention that India got in the European press, courtesy the Davos jamboree. While the Financial Times carried a special supplement on India, the mainstream British, French, Dutch, and German papers all had India-related stories on their front pages at least a couple of times that week. India seems to have replaced China as the flavour of the season, a view endorsed by most of the fund managers and analysts I met. Investors and other India watchers seem convinced that the economy is on the threshold of a phase of long-term "structural" expansion.

The problem is that their conviction about the short-term prospects for the economy is somewhat more muted. They have broadly three sets of concerns. First, there are the usual apprehensions that infrastructure shortages could constrain growth. Second, the economy depends a bit too heavily on short-term portfolio flows to fund its current account deficit. If global liquidity were to dry up, so would these portfolio inflows. This could mean currency depreciation and potentially trigger an interest rate shock. Third, the knock-on effects of the increase in oil prices are yet to be transmitted fully, and were this to happen, monetary policy could tighten further and impede growth. It is reasonable to expect that domestic investors would also have similar apprehensions.

I think that there is a fundamental fallacy in the notion that short-term economic dynamics can be viewed as being independent of long-term structural change. If indeed the economy was to lose traction in the short term, it could affect long-term "structural" expansion and set the process back by a few years. Take the case of the mid-nineties. With the economy having opened up just a couple of years earlier, one would have expected the potential for structural expansion to be enormous.This should have offset the impact of a short-term correction in the growth momentum. Yet, the combination of high interest rates, overinvestment, and the Asian crisis (all essentially short-run problems) pooped the party for the long term. It took a good six to seven years for India to get back on the global economic map.

The bottom line is that for the long-term expansion the economy cannot afford to lose its short-term momentum. I, for one, do not believe that near-term conditions warrant a significant correction in momentum. In fact, there is much to be said in favour of India's short-term macro parameters, especially in comparison with the mid-nineties. With foreign exchange reserves at 20 per cent of GDP, tiding over a couple of years of a largish current account deficit should not be too difficult. I am aware that the ratio of portfolio inflows to foreign exchange reserves is high at almost 70 per cent. However, to expect a large bit of these investments to disappear at the slightest whiff of economic stress would be a little cynical and completely unrealistic.

What are the other short-run buffers? The domestic savings rate has climbed up significantly and is at roughly 29 per cent. Some of the rise has come from better fiscal balances and, with these likely to improve further, the savings ratio should go up quite a bit. Despite an increase in oil prices and healthy domestic demand, headline inflation is below 5 per cent, which to me suggests that we are in a much more competitive pricing environment. The improvement in roads, telecom connectivity, better port infrastructure, and rail operations has led to significant efficiency gains for the economy and made a 7-8 per cent growth rate possible even over the medium term.

My apprehension is that negative signals from the political and policy-making establishment could obfuscate these short-term comforts and affect investor expectations adversely. This might just tip the economy into a downturn not because of real bottlenecks but merely because expectations are not managed well enough. In that context, I see the following short-term risks:

First, I see the initial signs of the central bank turning from cautious to plain alarmist. Last fortnight, the RBI raised its signal repo rate despite remarkably benign headline inflation numbers. This came in the wake of a severe liquidity crisis that banks are facing following the repatriation of the India Millennium deposits. The RBI chose not to speak of a comprehensive solution to this liquidity problem, nor did it even recognise the fact that the problem of (potentially inflationary) excess liquidity has, quite dramatically, disappeared. This stance has left the money markets so bewildered and jittery that any further adverse news flow could suddenly ramp up interest rates. Instead of a "soft landing" or a mild moderation in growth, the economy could fall flat on its face if borrowing costs spiral up sharply.

Second, the elections in critical states are in the offing and the principle of competitive populism that drives election campaigns in India could mean that our recent efforts at fiscal consolidation will get the short shrift. The Prime Minister's announcement of instituting yet another pay commission for government employees and the decision to postpone the food subsidy cut are examples of this.

Finally, over the past months, the finance minister's public comments on interest and exchange rates have often been at variance with the central bank's statements or actions.

Having an independent central bank is healthy but increasingly market players and investors are getting the impression that the government does not speak with one voice and this makes them nervous about the business environment.

John Keynes apparently once said that the short run was all that mattered since in the long term "we are all dead". I hope India's economic managers and politicians use it as their guiding principle.

The author is chief economist, ABN Amro. The views here are personal.

abheek.barua@in.abnamro.com