India will only have fiscal blanks to fire in a downturn

There’s a chill wind blowing around the world, which is heading into an economic downturn, and although India appears to be immune to its effect, it really is very vulnerable - and has few weapons in its armoury to defend itself.

The fact that the US and Europe are headed for a near-certain slowdown has been known for a while now . More recent data coming out of both places only confirms that earlier downbeat assessment. Scott Mather, managing director at PIMCO, the world’s biggest bond-fund manager, notes that credit markets are flashing warning signs of a lengthy economic slump in the US.

“Credit markets are basically telling us that there is an economic slowdown that is coming, and it will likely persist for the foreseeable future,” Mather told Bloomberg Television.

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And over in a heavily indebted Europe, economic data from Germany shows that Europe’s economic engine is virtually stalling. Germany’s economy grew by just 0.1 percent between April and June, even lower than the low estimates that economists had drawn up. And since Germany is at the heart of Europe, it’s a sign that Europe is at risk of a cardiac arrest.

Analysts are increasingly assigning a higher weightage to their base-case scenario of a global economic slowdown. A few economists are also drawing up “what-if” scenarios to test the potential impact of the more extreme possibility of a global recession.

On the surface of it, India appears to be relatively better placed to withstand the shock of a global economic slowdown. “India presents a unique combination of largely domestic-driven economy that has an active and open equity market for foreigners,” reasons CLSA senior economist Rajeev Malik. “This, the economy has built-in shock absorbers to cushion the hit from, say, downshifts in global growth.”

However, adds Malik, given the high correlation across equity markets, especially during periods of high global risk aversion, “any significant and lasting collapse in capital inflows and/or in local equity prices can cause dislocation of the economic cycle, as happened in 2008.”

India is worst-placed

In fact, Credit Suisse economist Kun Lung Wu estimates that in the event of the global economy experiencing another sharp downturn, India will be among the countries most badly positioned to respond with fiscal policies to ease the pain.

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India, notes Wu, stands out as having the least fiscal space to stimulate its economy, given its relatively high government debt-to-GDP ratio.

Indicatively, India’s GDP growth slowed from an average of 9.5 percent in the three years preceding 2009 to about 6.8 percent. That effect was compounded by a sharp fall in the equity market, which too affected the growth dynamics.

Malik says that it was only a combination of aggressive fiscal and monetary measures and a recovery in financial markets globally that positioned the Indian economy for an earlier and stronger-than-expected recovery growth to 8 percent in 2009-10 and 8.5 percent in 2010-11.

The Sixth Pay Commission payout in 2008-09 in particular played a significant role in lending resilience to India’s growth during the crisis. “Interest rate cuts by the RBI and fiscal measures helped, but the initial meaningful swing factor was the increase in disposable income following the Pay Commission payout,” reasons Malik.

No fiscal room this time

This time around, India doesn’t have the luxury of resorting to fiscal expansionism of the sorts it unwound in 2008.

Based on the IMF’s estimate in April 2011, Wu believes that India will have to improve the ratio of its cyclically adjusted primary balance to GDP by 8.1 percent between 2011 and 2020, and then keep the balance unchanged until 2030, to reduce its debt to GDP ratios to 40 percent of GDP by 2030, which is the median pre-crisis level for emerging economies.

Even in normal times, those are difficult targets to meet. But in the event of a sharp downturn in the global economy or even a period when trend growth level is substantially below par, that problem is compounded more severely. Carrying such a heavy debt burden is a drag on growth going forward, given the high cost of servicing it.

As we noted here , successive Indian governments have had a notorious track record of living beyond their means and blowing up the budget. The current UPA government has, with its well-intentioned but unfunded welfare projects like NREGA and the proposed Food Security Bill, built on that legacy of fiscal profligacy.

As a Moody’s analyst told Firstpost, the only saving grace for India is that it has the potential to grow out of its debt - “so long as the government does not steer too far away from the fiscal path.” It is only the prospect of high growth that has thus far saved India from its spendthrift governments.

Successive finance ministers have been blind to the risk of not easing the debt burden when times were good, and instead adopted a Micawberish attitude to balancing budgets. For far too long, they’ve placed their faith on good fortune - that “something will turn up” and bail them out.

But, as policymakers will soon learn, hope is not a strategy. The coming global economic downturn, from which India is far from immune, could show up the folly of their ways.