Our finance minister has undoubtedly made a difference in the short time since he took over. He has restored some discipline to government spending, notably on politically-contentious subsidy-related expenditures. He has managed to raise precious revenue through disinvestment in choppy markets. His commitment to fiscal consolidation has placated the rating agencies that were threatening to downgrade India’s sovereign rating. He has assuaged GAAR-related investor concerns and succeeded in improving at least the sentiment of FII investors who have poured in over $23 billion into our equity markets since April 2012. These have been purposeful and necessary steps, but as the finance minister knows, they are not sufficient to get us out from the hole we have dug for ourselves. Let’s take stock of the situation.
We are faced with a declining investment-to-GDP ratio thanks to a sharp fall in private fixed asset creation. Gross fixed capital formation is down from its peak of 34.5% of GDP in 2008 to 30.6% last quarter. This is, by far, the most important reason why GDP growth continues to decelerate, and may become even more sluggish in the coming quarters.
But growth is not our only challenge. Our savings ratio has been declining at an even faster pace than the investment-to-GDP ratio. Consequently, the current account deficit, which is nothing but the savings/investment gap, has been widening from the already elevated level of minus 4.5% of GDP in March 2012 to an estimated minus 6% in January 2013. Even in a liquidity-surplus global economy we cannot be sanguine about this. If fickle FII investors lose faith in the resilience of the Indian economy and/or should US growth surprise on the upside, we could see a rapid withdrawal of international capital from Indian markets, triggering a change in exchange rate expectations that RBI would find difficult to tackle. Financing a deteriorating external balance in a slowing economy is a tricky business. At the moment, we are flirting with potentially-serious macro instability.
To make matters worse, CPI inflation continues to rise despite an incipient moderation in WPI inflation. In fact, the gap between CPI and WPI inflation has widened significantly, implying that real interest rates are negative for households who contribute the largest share of bank deposits, and very high for corporates that are the most dependent on banks for their borrowing. As a consequence, households are deploying their savings into gold and other real assets instead of bank