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This piece originally appeared in the Financial Times on September 23, 2012 (gated) and is posted here with permission.

The Indian government’s recent reforms to reduce government subsidies and embrace greater foreign direct investment were unexpected and bold. Markets have rewarded them with surging stock prices and a rebound in the value of the rupee. The reforms may yet be reversed or diluted because of the political backlash. Their impact may be more symbolic than substantive. Nevertheless, they are significant in that they reflect changes in the operating assumptions of Indian politics.

For a long time, maximising electoral success required politicians to act as if there were a ceiling of about 5 per cent on inflation and virtually no ceiling on fiscal populism. The new operating assumptions all centre on growth.

It is striking that India’s economy has experienced close to double-digit inflation for more than three years, among the highest in the world, and twice as high as politics was thought to permit. Remarkably, there has been no domestic uproar. This growing indifference to high inflation seems to be the result of the rise in real incomes that has accompanied high growth. Even in rural India, wages have been rising much more rapidly than inflation thanks to government policies, including an extensive employment guarantee scheme. Moreover, a shrinking public sector means that fewer people earn the fixed incomes most vulnerable to being eroded by high inflation.

In other words, it is growth and real incomes that are increasingly important for the government and economy to deliver. Even after the global crisis of 2008, India’s growth appeared to be cruising at about 8 per cent. In these circumstances, the government did not feel obliged to undertake growth-enhancing reforms. Nor was there any serious attempt to squeeze double-digit inflation out of the system – for fear that growth, which voters had come to take for granted, would suffer.

But when growth recently began to fall below 5-6 per cent and, critically, when this deceleration began to seem more permanent, panic galvanised policy makers into action. Their resolve was strengthened by the threat of downgrading by the rating agencies, which would have further undermined investor confidence and growth. Reform was made easier by the replacement of Pranab Mukherjee, an elderly Congress apparatchik, withPalaniappan Chidambaram, a decisive reformist, as minister of finance. And while the monetary authorities did not cut interest rates to boost growth further, their inaction, given the acceleration in inflation, amounted to loosening.

If politicians are now more concerned to maintain high growth than to avoid high inflation, what about fiscal populism? Since the current government came to power in 2004, it has presided over a steady expansion in social expenditure, comprising employment guarantee schemes, subsidies for fuel, fertiliser, food and power and increases in the prices paid to farmers for key commodities. Real government expenditure per capita has doubled during the past decade.

This expansion was helped by rapid growth, which seemed to provide inexhaustible resources to finance expenditure. Moreover, the surprising victory in the 2009 elections confirmed for the Congress party its view that lavish spending also delivered electoral success. High inflation was a side effect that was overlooked as long as high growth was assured.

But as growth headed south, high government expenditure has become a problem, feeding investors’ negative perceptions about the Indian economy. Hence the recent actions to reduce government subsidies. But their modesty, the opposition they are generating, and the likelihood that any further reforms will not touch subsidies all suggest that it will not be easy to break the hold of fiscal populism.

This indifference to high inflation and the opportunistic, rather than serious, effort to roll back high government spending may yet come back to haunt the Indian economy in the future. But for the moment it is all about economic growth and the panic to prevent it from collapsing. Shrewd Indian politicians now know they have exchanged a 5 per cent inflation ceiling for a floor of about 5 per cent on economic growth.