Why India Slowed

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New Delhi – For a country as poor as India, growth should be what Americans call a “no-brainer.” It is largely a matter of providing public goods: decent governance, security of life and property, and basic infrastructure like roads, bridges, ports, and power plants, as well as access to education and basic health care. Unlike many equally poor countries, India already has a strong entrepreneurial class, a reasonably large and well-educated middle class, and a number of world-class corporations that can be enlisted in the effort to provide these public goods.

Why, then, has India’s GDP growth slowed so much, from nearly 10 percent year on year in 2010-11 to 5 percent today? Was annual growth of almost 8 percent in the decade from 2002 to 2012 an aberration?

I believe that it was not, and that two important factors have come into play in the last two years.

First, India probably was not fully prepared for its rapid growth in the years before the global financial crisis. For example, new factories and mines require land. But land is often held by small farmers or inhabited by tribal groups, who have neither clear and clean title nor the information and capability to deal on equal terms with a developer or corporate acquirer. Not surprisingly, farmers and tribal groups often felt exploited as savvy buyers purchased their land for a pittance and resold it for a fortune. And the compensation that poor farmers did receive did not go very far; having sold their primary means of earning income, they then faced a steep rise in the local cost of living, owing to development.

In short, strong growth tests economic institutions’ capacity to cope, and India’s were found lacking. Its land titling was fragmented, the laws governing land acquisition were archaic, and the process of rezoning land for industrial use was non-transparent.

India is a vibrant democracy, and, as the economic system failed the poor and the weak, the political system tried to compensate. Unlike in some other developing economies, where the rights of farmers or tribals have never stood in the way of development, in India politicians and NGOs took up their cause. Land acquisition became progressively more difficult.

A similar story played out elsewhere. For example, the government’s inability to allocate resources such as mining rights or wireless spectrum in a transparent way led the courts to intervene and demand change. And, as the bureaucracy got hauled before the courts, it saw limited upside from taking decisions, despite the significant downside from not acting. As the bureaucracy retreated from helping businesses navigate India’s plethora of rules, the required permissions and clearances were no longer granted.

In sum, because India’s existing economic institutions could not cope with strong growth, its political checks and balances started kicking in to prevent further damage, and growth slowed.

The second reason for India’s slowdown stems from the global financial crisis. Many emerging markets that were growing strongly before the crisis responded by injecting substantial amounts of monetary and fiscal stimulus. For a while, as industrial countries recovered in 2010, this seemed like the right medicine. Emerging markets around the world enjoyed a spectacular recovery.

But, as industrial countries, beset by fiscal, sovereign-debt, and banking problems, slowed once again, the fix for emerging markets turned out to be only temporary. To offset the collapse in demand from industrial countries, they had stimulated domestic demand. But domestic demand did not call for the same goods, and the goods that were locally demanded were already in short supply before the crisis. The net result was overheating – asset-price booms and inflation across the emerging world.

In India, matters were aggravated by the investment slowdown that began as political opposition to unbridled development emerged. The resulting supply constraints exacerbated inflation. So, even as growth slowed, the central bank raised interest rates in order to rebalance demand and the available supply, causing the economy to slow further.

To revive growth in the short run, India must improve supply, which means shifting from consumption to investment. And it must do so by creating new, transparent institutions and processes, which would limit adverse political reaction. Over the medium term, it must take an axe to the thicket of unwieldy regulations that make businesses so dependent on an agile and cooperative bureaucracy.

One example of a new institution is the Cabinet Committee on Investment, which has been created to facilitate the completion of large projects. By bringing together the key ministers, the committee has coordinated and accelerated decision-making, and has already approved tens of billions of dollars in spending in its first few meetings.

In addition to more investment, India needs less consumption and higher savings. The government has taken a first step by tightening its own budget and spending less, especially on distortionary subsidies. Households also need stronger incentives to increase financial savings. New fixed-income instruments, such as inflation-indexed bonds, will help. So will lower inflation, which raises real returns on bank deposits. Lower government spending, together with tight monetary policy, are contributing to greater price stability.

If all goes well, India’s economy should recover and return to its recent 8 percent average in the next couple of years. Enormous new projects are in the works to sustain this growth. For example, the planned Delhi-Mumbai Industrial Corridor, a project with Japanese collaboration entailing more than $90 billion in investment, will link Delhi to Mumbai’s ports, covering an overall length of 1,483 kilometers (921 miles) and passing through six states. The project includes nine large industrial zones, high-speed freight lines, three ports, six airports, a six-lane expressway, and a 4,000-megawatt power plant.

We have already seen a significant boost to economic activity from India’s construction of its highway system. The boost to jobs and growth from the Delhi-Mumbai Industrial Corridor, linking the country’s political and financial capitals, could be significantly greater.

To the extent that democratic responses to institutional incapacity will contribute to stronger and more sustainable growth, India’s economic clouds have a silver lining. But if India’s politicians engage in point-scoring rather than institution-building, the current slowdown may portend stormy weather ahead.

Copyright: Project Syndicate, 2013.

Raghuram Rajan
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Raghuram Rajan became Governor of the Reserve Bank of India on September 4

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