India's Economy Hits a Very Welcome Soft Patch

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Includes: EPI
by: Edward Hugh

As the European Central Bank moves steadily and earnestly forward with its ongoing rate hike cycle -- sending one fragile economy after another along Europe's periphery drifting off towards recession -- there is at least one prominent global central banker who must be feeling vindicated in the policy stance he has taken to try and bring the rampant inflation from which his country has been suffering back under control.

Duvvuri Subbarao is governor of the Reserve Bank of India, and under his stewardship the central bank has been hard at work over the last 12 months trying to credibly fight inflation. So far rates have been raised 10 times, and the bank has managed to claw the annual rate of wholesale price inflation back from its peak of 10.9% to the current level of 9.06%. Hardly a level to be complacent about, but then Subarrao seems far from complacent.

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Obviously, there is a long way to go yet before he can reach his short-term inflation target, which is why he warned again following last week's monetary policy meeting -- when the benchmark repo rate was raised to 7.5% -- that monetary tightening in India would continue even at the cost of further slowing economic growth. In so doing, he underlined his determination to reach his inflation objective of 6 percent “with an upward bias” by March 31, 2012 and maintain the credibility of the bank as an independent entity. Be warned: When this man says "strong vigilance," he means it -- even though central bank rates are still negative at this point.



As a result of this posture, India’s economy may, he accepted, expand by only “around 8 percent” in the financial year through March ... a reduction on the 8.6 percent he previously estimated, and significantly short of those double-digit growth rates India must be aiming for in the near term. In fact, most forecasters agree with Subarrao and see India's growth dropping back from last year's sweltering 10.3% pace. Indeed, the majority of commentators agree that in the very short term, this would be no bad thing.

India's inflation is structural, and needs containing so the economy can accelerate to its full growth potential, which I personally estimate to be well into the double-digit zone. I have felt and been arguing so for some years. It is highly likely India can easily break all those earlier Chinese records when it really gets going, such is the country's potential ... but that potential can only be realized if the old phantoms that haunt the economy are hunted down and eliminated. High on the "hit list" here has to be the inflation curse.



Purging the endemic inflation out of the system is as much an attitude change as anything, and Subbarao is hard at work trying to achieve it. People need to get used to the idea that they cannot simply solve their short-term problems by raising prices and passing on their inefficiencies to customers, and that the reason they can't do this is that the central bank is there to make sure they don't.

India’s current inflation problem is largely a structural one, and is in large part due to supply-side rigidities coupled with low capacity slack in some of the key sectors. Ultimately, only government-initiated reforms and substantial infrstructural investment can get to the heart of the problem, but the central bank has a key role to play in this, especially by demonstrating to would-be investors that the financial and price environment is a stable one. The current bout of energy and food price inflation is a particular concern, given the risks that the country's supply-side deficiencies and rigidities could generate second-round effects and feedback into core prices. This is important, since unlike in many developed economies, India’s inflation is in part a demand-driven phenomenon. And since it is demand-driven, it is susceptible to the application of monetary policy.

In any event, more interest rate rises are certainly in the pipeline, and the markets are taking the central bank growth warnings seriously: Stocks peaked in November and show no sign of reviving in the short term.


If we take a look at the way things worked out in the first decade of the present century, you might want to ask how I can be so sure that India is destined to become one of the leading players in the global economy over the next decade or two. Surely up to now, the emerging markets story has been very much a China one.



My answer would be: It's the demography, silly! I am sure there will be no shortage of people lining up out there just waiting to tell me that I am wrong, that demography isn't destiny, and I don't know what else. So I am here to answer them, saying you are right; in economic terms, demography may well not be everything, but it sure as hell is a big part of the picture -- a much bigger one than many economists are willing to admit. This is the real problem, since mainstream neo-classical economics and structural-reform-oriented microeconomic analysis virtually screens demographic dynamics out of the picture.

And it is the underlying comparative demography of the two huge emerging "mega-countries" that suggests to me that while the global growth story at the present time is largely a China one, pole position could easily pass over to India at some point during the next decade. The principal reason I feel so confident in saying this is that India's demographic transition is a much more balanced one, producing a far more stable population pyramid than the one China is about to find itself landed with.



Population aging is a global phenomenon, one which has been affecting all societies and all countries since the start of the Industrial Revolution. The last 250 years have seen enormous and swift changes in the structure of our populations. During nearly roughly 10,000 years prior to the coming of modern society, population median ages and structures varied very little, but since the the end of the 18th century -- driven by movements in fertility rates and life expectancy -- populations all across the globe have been steadily aging.

Put very simply, this aging comes in two waves, which could loosely be called the first and second demographic transitions. During the first transition, fertility falls from very high levels to population replacement ones; the proportion of those in the working age groups rises constantly, while life expectancy increases so that the population in the 65-to-80 age group steadily increases. This is the time when "Pay As You Go" pension systems are introduced, since people still believe they are sustainable.

During the second transition, fertility in many countries falls well below replacement level and stays there for several decades. Life expectancy rises so that the over-80 population becomes a significant part of the total population and the working-age population goes into long-term permanent decline in both absolute terms and as a proportion of the total. As this happens, people start to worry about the sustainability of those very same pension systems they have just introduced, while financial markets begin to ask questions about the posibility of sovereign default.

Again simplifying, the developed societies are now well into the second aging phase, while the so-called emerging (or "growth" economies) are at some point or other along the first one. And the big difference between India and China is the velocity with which they are passing through the first phase.

Quick Fixes Normally Don't Work

Back in the 1970s, China opted for a short-term solution to its perceived population problem by applying drastic social surgery in the form of the "one child per family" policy. Its problem was, of course, a very real one, since the underlying population explosion made it very hard to feed everyone ... but as is often the case with such drastic remedies, in the longer run the cure may turn out to have been even worse than the ailment.

Fertility in India, on the other hand, has declined much more slowly (always accepting, naturally, that there are very large differences between North and South) and as a consequence the population aging process is much slower. While the proportion of population in the under-14 age group declined from 41 percent in 1961 to 35.3 percent in 2001 (5.7 percentage points), the proportion of population in the age group 15-59 increased from 53.3 percent to 56.9 percent (3.6 percentage points). The proportion of those over 60 increased from 5.6 percent to 7.4 percent (1.8 percentage points).

In strictly numerical terms, the changes seem much larger. The increase in the 15-34 age-group population, for example, has been quite dramatic: From 174.26 million (31.79 percent) in 1970 to 354.15 million (34.43 percent) in 2000. This age group is currently projected to peak in 2030 at around 485 million.

According to UN Population Division projections, even though the 15-34 age group will only start to decline in absolute terms in India post-2030, it started to fall as a proportion to the total population last year. But for the time being, the rate of decline is marginal (being projected to drop from 35.4 percent in 2010 to 34.5 percent in 2020, to 32.4 percent in 2030). After 2030, however, the rate of decline will accelerate (dropping to 29.7 percent in 2040, and 26.6 percent in 2050, according to the forecasts). Yet even given this, there will still be a massive 441.1 million people in the age group by the time we reach 2050.

This demographic evolution will have important implications for the country's labor market. India's labor force, which was estimated at 472 million in 2006, is expected rise to around 526 million in 2011 and then grow steadily, hitting 653 million in 2031. The labor force growth rate will remain higher than the rate of increase in total population until 2021. According to Indian government estimates, 300 million young people will enter the labor force between now and 2025, by which time approximately 25 percent of the global labor force (or one worker in four) will be Indian.

Meanwhile, as can be seen in the accompanying charts, China's working-age population is in the process of peaking both numerically and as a proportion of the total population.

China is getting old far too fast. By 2040, assuming current demographic trends continue, there will be 397 million Chinese over 65 -- more than the total current population of France, Germany, Italy, Japan, and the United Kingdom combined.

The population pyramid is shifting fast (unusually fast for a country with China's income level), and the degree of aging we should anticipate, in terms of both absolute numbers and velocity, is simply staggering. It is during the 2020s that China’s age wave will arrive in full force. The elder share of China’s population seems set to rise steadily from 11 percent of the total in 2004 to 15 percent in 2015, and then leap to 24 percent in 2030 and 28 percent in 2040. Over the same period, China’s median age will climb from 32 to 44.

Thus China’s aging is characterized by the unusual speed with which it is occurring, something which should not surprise us given that the outcome is the result of a massive social engineering experiment. To give an idea, while Europe's over-65 population crossed the 10 percent threshold back in the 1930s, it is not expected to reach the 30 percent of the population mark until the 2030s, a full century later. China, on the other hand, will traverse this same distance in a single generation. The magnitude of China’s coming age wave is simply staggering. And if the economic consequences of the first (positive) part of China's demographic transition have already been large and significant, we should now be beginning to brace ourselves for the other part, the demographic downside.

So India has huge potential, including the potential to act as a sheet anchor for a global economy in a state of shock as China struggles with the enormous challenges that will face it. But will India really be able to realize the potential it has? To think about this, let's go back to the short-term economic development of the Indian economy, and back to the world of Subarrao and the battle he is fighting over at the Indian central bank.

India's Exports Are Growing Fast

First the good news: India's merchandise exports rose sharply in May, helped by a surge in shipments of engineering and electronic products. They jumped 56.9% year-on-year to reach $25.9 billion, and totalled $49.8 billion for the first two months of the fiscal year that started on April 1, an increase in 45.3% over the same period a year earlier.

But So Too Are Its Imports

In fact, India runs a trade deficit. May imports surged 54.1% to $40.9 billion, touching the highest level in four years and only adding to concerns about the widening trade deficit. India's goods trade deficit was $15 billion in May -- the widest level since August 2008.

Governance Is a Problem in India

So here we have the first sign beyond inflation that all is not entirely well in the Indian economy. If India has a trade deficit, this means that someone somewhere is borrowing money. And indeed they are, since while private sector indebtedness in India is low (despite rising consumer credit), government debt is high; indeed, it is very high by emerging economy standards.

But when you have an economy expanding at 8% a year, and set to accelerate to over 10%, so much government debt is hard to understand, especially since all the evidence suggests that it is not being used to finance a massive, and much needed, infrastructure overhaul. And at the present time, India's general government deficit is running at near to 10% of GDP. Part of the problem here are India's state governments, but even the performance of the central government leaves a lot to be desired.

Finance Minister Pranab Mukherjee has promised to marginally reduce the central government budget component to 4.6 percent of GDP in the current financial year, down from 4.7 percent in the previous 12 months, but even this minor correction now seems to be in some doubt, since Chakravarthy Rangarajan, chairman of the Prime Minister’s Economic Advisory Council, told reporters in Mumbai recently that the target would be “difficult to achieve."

With a fiscal and a trade deficit, it is hardly surprising that India's current account position has been deteriorating in recent years. India reported a current account deficit equivalent to $9.7 billion in the fourth quarter of 2010, down from $16.8 billion in the third quarter, and the situation may have even improved again during the first quarter given the strong export performance -- but the IMF is still forecasting a small increase for 2011, up to 3.7% of GDP from 3.2% in 2010.

At the present time, the deficit is being financed by short-term capital inflows; India's reserves stood at $313 billion at the start of June, up from $271 billion a year earlier (a rise of 15%).

Net private capital inflows to emerging market economies can be expected to keep growing this year (provided there is no financial accident in Europe) and could even reach $1.1 trillion in 2012, according to a recent estimate by the Washington-based Institute of International Finance. As the IIF says, “The strength of capital flows is still presenting policy challenges in a number of emerging economies, especially those already facing pressures from rising inflation, strong credit and asset price growth and rising exchange rates." India's case precisely.

Just as importantly, many of the inflows are short-term, and are primarily used to fund bank loans and equity purchases. The share going into infrastructural and other projects is comparatively small.The Bank For International Settlements (the central bank of the central banks) highlighted just this problem in its latest quarterly report, drawing attention to the extent to which the rapid growth in lending to emerging market economies might be “hot” money, subject to withdrawal at short notice.

According to the bank, most of the growth in lending to EMs between the second quarter of 2009 and the end of 2010 was driven by short-term lending, and an estimated $418 billion, or 79 percent, of the increase consists of loans with maturities of less than one year. This compares with the 49 percent of lending to EMs falling into this category between the start of 2006 and the middle of 2008. And the bank also highlighted just how the trend of increasing reliance on short-term lending was highly concentrated among borrowers in the Asia-Pacific region, which accounted for 84 percent of the recent rise.

These proportions look horribly like what we were seeing entering emerging economies in Eastern Europe in the run-up to the Lehman debacle, which means if we do have a sharp reversal in risk sentiment on the back of the euro zone debt crisis, emerging Asia would look to be very exposed -- a point which is not lost on central banker Subbarao, who warned on precisely this topic in a recent speech in Zurich.

After the U.S. announced its second round of quantitative easing in August 2010, “the prospect of easy liquidity in the U.S. seemed to prompt a large increase in capital flows to emerging market economies, threatening domestic price and financial stability,” he told his audience. Since the U.S. quantitative easing policy had also put pressure on global commodity prices, the "combination has put some emerging market economies in a policy bind, but higher interest rates will only intensify capital inflows, potentially putting more pressure on exchange rates and domestic stability. In India’s case, the concerns on this account currently are less acute since capital flows are needed to finance our current-account deficit.Yet even for us, the composition of the inflows remains an issue,” he said. “About three-quarters of the current-account deficit has been financed by volatile capital inflows.” And those inflows, in situations of stress could easily reverse, as he knows only too well.

Don't Forget India Is Still an Emerging Economy

Having said all this at great length, we should never forget that India is still an emerging economy, one which has made great strides forward in recent years. And despite many difficulties, India has remained a democracy since independence. It is a country where human rights are by and large respected, and where institutional quality is gradually improving. As I am suggesting here, the central bank is becoming more and more independent. Corruption is still a big problem, but eventually this has solutions. At the same time India is a country of individuals, of creativity and strong entrepreneurial spirit.

This post first appeared on my Roubini Global Econmonitor Blog, "Don't Shoot The Messenger."