Will the Reserve Bank of India's (RBI) rate cuts which are around the corner help the Indian economy move back to its 8% to 9% growth trajectory?
Is India's sustainable level of growth 7%, and were the last few years really an aberration on the upside, or is the current growth rate a cyclical downturn from a structural level of 9%?
And what will happen to the rupee this year - was the slide to 54 temporary, or has the rupee found a lower level?
Answers to these fundamental questions will shape how the next financial year pans out economically, and impact the assumptions the government makes in next year's budget.
In the past, our economic policy mandarins have usually got these answers wrong, and in doing so have ended up making budget assumptions that have been far too optimistic. As a result, most budgets end up doomed to underachieving their targets right from the outset.
Consider that in last year's budget, the finance minister assumed a 9% growth rate and inflation of 7%. Q2 delivered 6.9% and we are on track for just over 7% for the full year. Average inflation for the year is likely to be higher than 9%. The fiscal deficit will overshoot from 4.5% to perhaps close to 6% and the borrowing target will be almost Rs 1,00,000 crore higher than initially assumed.
On an earnings base of $170 billion and expenditure base of $250 billion, we will have overshot our targeted fiscal deficit of $80 billion by almost 25%! Fortunately this extra borrowing will perhaps not lead to a crowding out of private sector investments simply because corporates are not in a position to invest in this climate.
As far as our natural growth rate is concerned, it is clear that we have moved up from the 5% to 6% growth level to safely 7% and above, courtesy the earlier reforms, the higher savings rate and incremental capital output ratio (ICOR). However, the "above" is a dynamic number and depends on the continuing process of reforms (on a lagged basis), or the absence thereof.
Unfortunately, over the last few years we have not had the structural reforms at a pace needed to drive this growth. If we had actively debottlenecked supply side constraints and created more manufacturing elasticity in the economy, then automatically extra demand could have been met without a corresponding increase in inflation.
The entire economy would have been at a higher plateau of growth today. On the other hand, if we choke off investments either through crowding out or lack of business opportunities, then capacity creation suffers and the room to grow becomes limited.
In this scenario the structural growth rate of the economy drifts downwards, and any growth over this new lower level is both temporary, and leads to higher inflation, leading to the central bank stepping in with rate increases that constrain both the demand side and the investment cycle to cool the economy down.
So the first answer is that due to the absence of continuing reforms economic growth is moving down a gear. Within this medium term structural move down, we have in addition, a cyclical downturn which has been accentuated by our structurally lower ceiling.
What this means is that even if the cycle reverses through RBI rate cuts, it will likely not lead to a reversal in growth rates up to 9% plus, but rather oscillate around the 7% to 7.5% mark in the medium term.
And therein lies the tragedy of the last few years of India's economic management. Yes, we can congratulate ourselves on being at 6 to 7% when the rest of the world is struggling with zero growth. But then we do not have the luxury of per capita incomes of $30,000 to begin with.
The average Indian earns less than a 20th of what most of those in the developed world enjoy. Any chest thumping therefore is best left to the monkeys. Meanwhile, we need every single ounce of growth we can wring out of the economy, and any government that does not do its utmost in this regard is selling the country and its people short.
What of the rupee? While our foreign currency reserves are at approximately $300 billion, net of volatile foreign institutional investment (FII) flows and short term debt (up from 12.9% of FX reserves in 2006 to 21.2% in 2011), we still have about 4 months of imports cover, which appears adequate.
However, given that the RBI has always prided itself on managing rupee volatility rather than targeting a specific level, it is quite surprising that we have witnessed such a whiplash movement in.
But all things considered, I think we should see a move in the rupee back to around 50 or below as capital flows, both foreign direct investment (FDI) and FII, regain some balance, and barring unforeseen events in Europe or in the price of oil.
So what should be the finance minister's priorities for the budget? Reviving growth and controlling the fiscal deficit are the two most important tasks he can lead with.
Specific steps should include real divestment of government assets, a fundamental reform of the power sector, the government credibly curtailing its borrowing program, and allowing FDI in more sectors. Any action along any of these would greatly boost the current gloomy sentiment, and that would be half the battle won.
But the government needs to convince business that it is alive to their concerns, and not just enamoured of entitlement programs which mean wasteful expenditure of the tax payers' hard earned money.
With parliamentary elections looming in early 2014, this is the Last Chance Budget the government has to showcase its economic credentials. Let's see what's in store.
(The author runs SaVant Advisors, a financial advisory firm)
