Will the Prime Minister, who now holds the finance portfolio as well, take the right steps to save economy?

Will the Prime Minister, who now holds the finance portfolio as well, take the right steps to save economy?

The prime minister is an astute and experienced politician who undoubtedly recognises the challenges facing the economy. He appears emboldened with his new duties as finance minister, willing to tackle some of the tough issues. The next couple of months will be crucial for him.

Prime Minister Manmohan Singh has made a strong start since taking over the duties of the finance minister a little over a week ago. The PM has hit the ground running and appears emboldened with his new duties, willing to tackle some of the tough issues, such as retail reform and some of the abhorrent foreign-investment rules proposed by his predecessor. There is support both within the Congress party and among the public to move forward. But is it just a honeymoon period for the country's new CFO, or the start of a more sustained period of effective policymaking and governance? And will this help lift India's economic outlook?

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Singh last assumed control of the finance ministry in 1991 when the country faced an economic crisis. Comparisons of today's situation with that in 1991 are instructive but wide off the mark. Then, the Indian economy faced a balance of payments crisis, a fiscal crisis and a collapse in investor confidence. Today the economy is troubled, but a full-blown crisis is unlikely, thanks to the freely floating rupee. In 1991, the currency was pegged to a basket of trading partners, and India at one stage had foreign reserves to cover only three weeks' of imports. Today India's reserves would cover around 6.5 months of merchandise imports, although this is down from a peak of 12 months in 2009.

Glenn Levine
Glenn Levine
The rupee, down 20 per cent against the US dollar over the past 12 months, is frequently held up as emblematic of the economy's recent woeful performance. This is only partly fair. Investors have cooled to the Indian economic story, and this is undoubtedly linked to poor governance and policymaking.

But some of the recent outflow is due to Europe's recent travails, which amplify investors' risk aversion and so are negative for the rupee. And some of it is simply the exchange rate acting exactly as expected in a country with a large external deficit. If the rupee were not declining, it would likely mean a more painful adjustment down the road.

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The rupee's performance is thus a by-product of prevailing economic conditions and the government ought not to waste time worrying about it. Pranab Mukherjee's attempts to support the rupee just prior to leaving office did nothing of the sort, and only served to confirm suspicions about the government's lack of economic expertise. The challenge now is the central government's large fiscal deficit. Indeed, this is the main factor behind the external shortfall; balance the government's books and the current account deficit disappears.

But a balanced budget is easier said than done. The government has projected a deficit of around 5.1 per cent of GDP for fiscal year 2012/13, but this relies on rosy assumptions, such as GDP growth at 7.6 per cent. Using more realistic figures, deficit ends closer to six per cent of GDP, uncomfortably high. The most effective course for Prime Minister Singh involves scaling back subsidies for fuel, especially diesel. There will be a backlash, both within the Lok Sabha and among voters, but such a move is in the economy's longterm interest. With the Congress party likely headed for defeat in the next election, the government may as well do something productive before taking leave. It could not do much worse than it has been doing so far, taking the populist path over the last three years.

The stock market's decline and the currency's depreciation over the past 18 months may be transitory, but they reflect a profound shift in thinking among businesses and investors about India. There is now widespread recognition that India's long-term growth comes with significant risks, and that GDP growth above eight per cent per year does not just happen on its own. The correct policies and the right business environment need to be in place. Investors have recognised this. The big question is whether policymakers have done so as well.

The prime minister is an astute, experienced politician who doubtless recognises the challenges facing the economy. The next couple of months will be crucial. After more than 30 years in public office, Singh's legacy may well be determined by his remaining time in office. If he treads water, as he has since the 2009 election, he will quickly become a lame duck, more than a year out from the 2014 election. In a best-case scenario, however, Singh could begin with small changes - such as a reduction in fuel tax subsidies, which would not need Parliamentary approval - to generate momentum and raise expectations for reform. This could turn around business confidence and investor sentiment, help to fund the current account deficit and support the rupee. If he can reignite the optimism that existed around the Indian economy as recently as 18 months ago, it could become selffulfilling, lifting investment and economic growth.

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Is it too late for Singh? The main difference between 1991 and now is that today's Parliament is deeply divided, whereas in 1991 there was widespread consensus that the old system had broken down. The opposition and regional parties have made the government's life much more difficult today, and there is still no widespread recognition that the current economic management has failed. GDP growth of five to six per cent is still respectable in most circles, although it is well short of what India should achieve. Most likely, the economy will continue to perform below potential, much like the prime minister himself.

The author is Senior Economist, Moody's Analytics