The Hindu Business Line : Growing risks to economy

The slow process of poverty alleviation, the dismal face of Rural India and rising prices, inflation and interest rates threaten to put a damper on the India growth story.

The economy has been on a high growth trajectory in the recent past, boosted by overall superior performance. The growth story should bring cheer to millions of young Indians expect to benefit from the demographic dividend, in terms of more gainful jobs. But is this progress sustainable in the long run? Are there, in fact, signs of deceleration already? There may, indeed, be growing risks on the horizon. These could be with regard to the very slow process of poverty alleviation, the dismal face of Rural India and, most important, rising prices, inflation and interest rates.

Poverty amidst plenty

India is proud of its long list of wealthy people, some of them occupying global ranks. But the island of high wage earners is surrounded by starving millions, who lack the basic necessities — food, clothing, education, healthcare and shelter. About 27 crore Indians belong to this poverty-ridden segment.

The Human Development Report 2005 virtually condemns India for its neglect of people below the poverty line. Infant mortality rates are high due to factors such as malnutrition and inadequate healthcare. In rural India, negative growth in the farm sector has led to rising unemployment.

The agrarian economy is still heavily dependent on the monsoon. Successive years of drought and power shortages have taken their toll on the farmer. Pesticides are, more often than not, spurious. Fertilisers are costly and scarce. Quality seeds are in short supply. Farmers lack scientific storage, processing and grading facilities. They suffer huge post-harvest losses. The farm sector does not have any meaningful insurance cover, either.

Unless these inadequacies are addressed, the farm sector cannot be profitable and banks will only lend reluctantly to this sector, which contributes 18.5 per cent to the GDP and engages 60 per cent of the population.

Rising Asset Prices

A steep rise in asset prices is a cause for concern. The RBI monitors prices periodically and revises provisioning rates, risk weights, etc, essentially to ensure that its scarceresources are not channelled into speculative activities such as real-estate, equities and certain sensitive commodities. Housing finance is rising at the rate of 25-35 per cent per year. With soaring demand, real-estate and housing prices are sky-rocketing. The question is: are banks displaying prudence with regard to appraisal, follow-up, pricing and the loan-to-asset ratios? Inflated asset prices, both for equities and real-estate, could fall steeply, sucking the air out of consumer spending. Entrepreneurs could then find it difficult to raise investment funds, adversely affecting growth.

Curse or boon?

With regard to forex management, India follows the managed float system without any predefined band. In the era of financial globalisation, the central bank has been facing new challenges, following massive but uncertain forex flows, especially of short duration, in both directions.

These have been caused through FDI, FII, commercial borrowing, NRI deposits, banking capital and other short-term credit. Surging forex reserves reached a level of $200 billion recently. The RBI is facing a formidable challenge in ensuring that the reserves do not grow beyond the required levels. The regulator is not prepared to allow the rupee to find its level, as it could result in its appreciation and erosion of export competitiveness.

However, the vital question is: what is the solution to the growing global imbalances, the cause for the rise in reserves? The answer lies in enhancing domestic investments and acting in concert with other nations in facing the dollar hegemony. As reserves are essentially invested in low-yielding US treasuries, the returns are very low, often much less than the weighted average cost of funds. With the value of the dollar falling recently due to its fundamental weakness, India is losing on both counts: returns and capital value.

A recent report of the Asian Development Bank recommends imposition of tax on forex inflows, arguing that Thailand's failed experiment in this regard was due to `stringent rules'. It, however, appreciates the efforts of the Indian Government to invest part of the reserves through a special purpose vehicle for infrastructure development, without adding to the liquidity. It also recommends Singapore-type investment pattern for the reserves, in a diversified portfolio (rather than in US treasuries) for higher return.

The economy experienced a low interest rate regime in the recent past, but no longer. With inflation crossing the 6 per cent level, interest rates have also gone up by 2-3.5 percentage points. Inflation is essentially fuelled by shortage of foodgrains and other products, besides rising fuel prices. Monetary management, therefore, will not have a significant effect in arresting its rise.

interest rates, inflation

The central bank, on its part, has been trying to put in place an anti-inflationary monetary policy, in the face of rising inflow of funds, credit-led growth, rising asset prices, rising interest rates and falling dollar. Much depends on the medium to long-term solutions in the form of augmenting farm production, reducing import duties and moderating the oil price rise. Inflation risk and interest rate risk will, nevertheless, persist in the short to medium term.

The RBI's reluctance to intervene has resulted in higher flow of forex funds, and an appreciating rupee. The rupee has now been overvalued by about 10.5 per cent on real effective exchange rate basis. The regulator's dilemma in this regard is obvious: Its intervention could result in higher supply of rupee funds and, consequently, higher interest rates and higher inflation.

Higher interest rates, in turn, will attract larger short-term arbitrage funds, which will worsen the situation. With the rupee gaining ground, exports could be less competitive and imports could rise further, worsening the current account situation. The falling dollar also means erosion in the value of forex reserves. The RBI has resorted to easing the capital account convertibility restrictions in part, to correct the situation, as is evident from the relaxations it announced in its recent monetary policy statement on overseas investment limit, prepayment of external commercial borrowing, high individual limits for current or capital account transactions, etc.

These measures, though well-intentioned, may go but a short way in significantly checking the net forex inflows. The economy thus faces many risks looming on the horizon.

(The author is Associate Dean, ICFAI School of Financial Studies, Hyderabad. nrkaturi@yahoo.co.uk)