India's Cycle of Recklessness and Reform

WSJ : RUCHIR SHARMA:February 28, 2013, 12:21 p.m. 

Unless Delhi holds itself accountable, it will periodically face crises.

India's cycle of crisis and reform is predictable as clockwork. Ever since it faced a balance of payments crisis in 1981, the country has found itself in some macroeconomic trouble at the start of every decade. This, in turn, has pushed its reactive policy makers into reform mode.

The same pattern has been at play over the past year, with the economy slowing sharply to 5%, inflation stubbornly high at 10% and the fiscal and current account deficits widening sharply. The threat last summer of India's sovereign rating being downgraded to junk status finally galvanized policy makers into taking some corrective measures. They liberalized foreign investment in retail and airlines, and took aim at the subsidy system.

Finance Minister Palaniappan Chidambaram's budget speech Thursday was expected to further confirm these newfound reformist urges. Unfortunately, it failed to bolster the government's market-friendly credentials.

The finance minister did seem to stick to fiscal prudence by meeting a budget deficit target of 5.3% of GDP for the fiscal year that ends this March and promised to bring the number down to 4.8% in the next. However, the math involved some Robin Hood economics of soaking the rich to pay the poor. Mr. Chidambaram hiked allocations to the government's pet welfare schemes even as evidence keeps mounting that such spending is leading to higher wage inflation and lower worker productivity.

What's more discomforting is that this budget made little provision for a food security bill, which aims to provide food grains at heavily subsidized prices to more than half of India's population. If enacted as currently planned, this welfare project could cost the country far more than the $1.8 billion provided in the budget.

To pay such bills, Mr. Chidambaram is already pinging India's companies for more revenue with a 5% surcharge imposed on their corporate tax. India already has one of the world's highest corporate tax rates, with a ranking of just above 100 out of 150 emerging markets. And it could go up higher.

Whenever the Indian government has relied on higher taxes to meet its revenue targets, the fiscal math has not worked out. A projected 19% rise in tax revenues seems too optimistic with nominal GDP growth unlikely to exceed 14% this year. Government spending is set to jump more than 16% in the coming year.

The finance minister began his speech by saying that if India has to achieve any of its social objectives, it has to return to a higher economic growth path of 8%. The problem is that last decade's growth surge deluded Indian policy makers into thinking that their economy has shifted to a permanently higher growth plane. They now conveniently blame the global downturn for much of their domestic woes without appreciating the fact that a synchronized boom across emerging markets was the only reason for India's accelerated growth last decade.

Indian policy makers believed the boom was locally manufactured and tried to counter the global downturn in 2008 by launching a sizeable fiscal and monetary stimulus. That seemed to work for a couple of years with growth outpacing the emerging-market average by an unusually large 3% in 2009 and 2010.

But in the absence of any economic reforms that could improve the economy's underlying potential, the levitation act couldn't last long. Inflation surged to double digits and for the first time in recent history, India's inflation rate climbed above the emerging-market average. India currently ranks an abysmally low 120 out of 150 on the relative inflation rankings compared to a historical ranking of 65.

Economic growth has now slipped to the emerging-market average of 5%, which is disappointing for a country with a per capita as low as $1,500 compared to the developing country average of $10,000. The only reason India has not paid an even heavier price for its spendthrift ways is that investors are still willing to keep some faith in its long-term prospects. Portfolio inflows remain strong with the country attracting around $30 billion in net inflows in 2012, helping fund the current account gap of $80 billion.

If there's a reason to be optimistic, it's that while national leaders in Delhi have been underachieving, India's many states are throwing up increasingly competent leaders. These chief ministers understand the connection between good politics and good economics. A number of states, from Gujarat to Orissa, unveiled their respective budgets over the past few weeks and have shown much greater fiscal responsibility by keeping their budget deficits within the 3% limit mandated by law. If a state violates the limit, it can lose access to funds from the central government.

The center too was supposed to show such restraint but no one can hold it accountable. It has indeed repeatedly violated the limit since launching the 2008 stimulus. What all this loose policy at the center signals is that India could do with more of a rules-based system.

For a start, a more independent central bank with an explicit inflation target will help check fiscal indiscipline by not funding the government's demands for money. Otherwise, India will have to periodically face the wrath of ratings agencies and markets to instill some discipline.

Mr. Sharma is head of emerging markets at Morgan Stanley Investment Management and author of "Breakout Nations: In Pursuit of the Next Economic Miracles" (Norton/Allen Lane, 2012).