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What Is Wrong With The Indian
Economy?

BY
GROUP 5
Section A

13P003 Akshit Mathur
13P024 Ishita Bhatia
13P026 Abhidnya Karhardkar
13P034 Rajesh Cherukuri
13P037 Rudro Mukherjee
13P044 Saurabh Kumar

PGPM 2013-2015


Contents
Background ............................................................................................................................................. 3
Analyzing Indias GDP growth rate and GDP components ..................................................................... 3
CAD: Its components and Why a rising CAD can be dangerous?............................................................ 5
Rupee Freefall and Its Impact ............................................................................................................. 6
Inflation ................................................................................................................................................... 6
Gross Savings and Investments ............................................................................................................... 8
Banks and the Growing Problem of NPAs ............................................................................................... 8
Conclusion ............................................................................................................................................... 9
References: ........................................................................................................................................... 11

Figure 1 ................................................................................................................................................... 3
Figure 2 ................................................................................................................................................... 4
Figure 3 ................................................................................................................................................... 4
Figure 4 ................................................................................................................................................... 5
Figure 5 ................................................................................................................................................... 7
Figure 6 ................................................................................................................................................... 8














Background
The Indian Economy suddenly from being the poster boy of all the developing economies finds itself
in doldrums. The GDP growth rate of 9% has become a thing of the past and India finds it difficult to
achieve a GDP growth rate of 5% at this point in time. Inflation (CPI) is high hovering around 10% y-
o-y. The rupee depreciated on account of the fear of US Fed tapering making imports costlier.
Coupled with all this is the political climate in India. India would be going into general elections in
2014 and the government sees now as the right time to take populist measures widening the already
wide fiscal deficit. In this report we try and analyze the problems with the Indian economy in depth
but in economics there are no clear answers or should we say definite answers.
Analyzing Indias GDP growth rate and GDP components

Figure 1
From the above histogram, we can see that the Indian economy had been slowing down since
2010.Before that until the liberalization of the Indian economy in 1991 the Indian economy was said
to grow at the Hindu rate of growth i.e. at around 3-4% annually. In 1991 the Government
introduced far reaching changes in Indias economic policy which was triggered by a difficult balance
of payments (BOP) situation.
Post-liberalization Indias economic growth started to take off. Interestingly around the same time
Chinas economy also started to take off but both the countries took different paths towards
economic development. A countrys GDP can be broadly attributed to three sectors:
Agricultural Sector
Industrial(Manufacturing) Sector
Services sector
Ideally all countries pass through each of the phases in the above order. That is what happened with
China, it became the manufacturing hub of the world. China with its huge population had abundant
cheap manual labour employed it to its advantage.

Figure 2
India somehow missed the transition in that order. The highest contribution to GDP as a percentage
by industries was about 17% only in the year 1995. India achieved its poster boy image amongst the
developing economies riding on the back of the services sector. Services sector employs skilled
labour. Post 2000, IT companies in India drove the Indian economy to new highs. All of these
employed skilled workers but a country like India also have a large pool of unskilled workers for
whom there are no employment avenues. So India has to develop itself as a manufacturing hub.
At this point of time Indias service sector is also facing new challenges. A decade of growth in this
sector has led to wage inflation and now countries like Philippines are competing with India as the
new call centre hub as they have English speaking low cost workers.
The need for development of India as a manufacturing hub can also be explained in another context.
Let us analyse the current account deficit as a percentage of GDP over the years for India.
Current Account Deficit is a measurement of a countrys trade in which the value of goods and
services it imports exceeds the value of goods and services it exports.

Figure 3
17.39
25.75 56.86
Agriculture, value
added (% of GDP)
Industry, value
added (% of GDP)
Services, etc.,
value added (% of
GDP)
Indian GDP Composition - 2012
Clearly the CAD had been rising for India. From the definition of CAD it implies that India imports
goods and services of more value than it exports. So either India can decrease its imports or increase
its exports. Now the major imports for India include crude oil, coal and gold. So any decrease in the
import of crude oil or coal would essentially mean sacrificing economic growth. Interestingly the
excess of merchandise imports over exports which constitutes the merchandise trade deficit has also
been widening since 2004-05. So India if it can develop itself as a manufacturing major and starts
exporting it would help. (Of course there is also a case of global demand for the goods produced
involved.)
CAD: Its components and Why a rising CAD can be dangerous?
So a Current account deficit means that India needs to pay more than it earns from these
transactions. Now we do not pay them in Rupees because then it would not have been a problem.
India needs to pay them in dollars ($).Now we can the pay in dollars in two ways:
Draining our Forex Reserves
Foreign Capital Inflows
The first option is definitely not a viable option and is only the last resort but the second one is a
volatile and vulnerable option.
Foreign capital inflows can take place in the form of direct investments, portfolio investments,
corporate loans and deposits of non-resident Indians. Now here comes a fundamental question:
Why would foreigners invest in India? Obviously with a motive of profit maximisation (FDI) or to get
maximum returns (portfolio investments).This would happen only if the investors believe in the
Indian growth story.

Figure 4
For a developing country like India, a CAD is not necessarily a bad thing. But a burgeoning CAD as it
has been in the case for India in the recent past is a problem. As per a study conducted by the
Reserve Bank of India indicate that a sustainable CAD for India is between 2.4-2.8% of the GDP.
Recently the CAD touched an all time high of 4.8% of the GDP.
A high CAD has both long term and short term consequences. Long term consequence with a bearing
on the CAD is that with the increasing debt component of foreign capital in India, interest payouts
have also increased adding to the deficit. Immediate consequences are the volatility and rapid
depreciation of the rupee. Whenever the foreign currency reserves are used to balance the deficit
the rupee sees a sharp fall.
A major component of the net capital flows is portfolio investment or FIIs. These can be pulled out of
the capital markets very quickly and once this phenomena starts there is a domino effect and
depreciation of the currency continues unabated. Recently the rupee depreciated by over 13 per
cent in the eight weeks up to 7 July 2013, exceeding Rs 61 to the dollar, after foreign portfolio
investors started withdrawing capital from India on indications of higher interest rates in the
US.(Speculation over the US FED tapering where in the Federal Bank would stop buying back Govt
bonds)
Rupee Freefall and Its Impact
So with the rupee depreciating what does it mean for the Indian Economy? Imports become costlier
and that puts further pressure on the domestic inflation. Now the Central Banks in this case the
Reserve Bank of India have a target to control inflation and they do so by increasing the interest
rates. Increasing interest rates reduces liquidity from the system. So in a way the RBI is able to
contain the inflation but it has a trade-off.
Higher interest rates would mean investments reduce. Reduced investments, when the economy is
already sluggish do not help. Private firms that owe most of Indias foreign debt come under strain
and some go bust.
Inflation
General increase in the price level is termed as Inflation. The Reserve Bank of India wants to bring
Inflation down. So the question is whether Inflation is a bad thing? And Can the RBI being down the
inflation?
Inflation is not necessarily a bad thing. It is the unanticipated inflation which is a bad thing.
Essentially it means that too much money is after too few goods. Now Inflation can be driven in two
ways:
1>Demand Pull Inflation: This theory can be summarized as "too much money chasing too few
goods". In other words, if demand is growing faster than supply, prices will increase. This usually
occurs in growing economies.
2>Cost Push Inflation: When companies' costs go up, they need to increase prices to maintain
their profit margins. Increased costs can include things such as wages, taxes, or increased costs of
imports.
India suffers from both. The rising prices of inputs contribute to increase in the prices of the final
goods and services. Let us analyse some examples:
With the Rupee depreciating against the dollar, imports become costlier. Now India does import
rubber for the production of tyres. As a result of increased prices of the raw materials the end
product that is the prices of the tyres goes up.
Also, food inflation is a major cause for concern. Now in economics nothing can be treated in
isolation. The government introduced a policy NREGA under which the people in the rural areas who
are unemployed and volunteer to work for get guaranteed wages for 100 days. The policy is a great
move to alleviate poverty which is a matter of concern for India. Now this guaranteed employment
scheme impacts the wages. During the harvesting seasons, the agricultural sector employs several
contract labourers. These people now demand higher wages as they have no incentive to work for
the regular wages that were paid earlier. This distorts the normal wag structure and leads to food
inflation. (Food distribution and shortage is also a major problem. Rising Oil prices leading to higher
transportation costs also add to food inflation.)Notice the Food Price Index as it starts moving away
from the WPI trend line.

Figure 5
Indian economy also suffers from what people now call as supply constraints. Supply side constraints
simply mean that production in the economy is unable to keep pace with rising demand due to a
variety of factors such as inadequate infrastructure, lack of credit, availability of labour and
availability of technology.
Now we come to second question, Can the RBI influence or control inflation?
RBI can control inflation only if it is demand inflation. If there is too much liquidity in the system then
by affecting the monetary base which in turn affects the money supply thus reducing liquidity from
the economy .But as we have seen inflation in India is also due to cost push inflation. So the effect of
RBI taking measures to curb inflation is questionable.
Inflation also has a bearing on the Gross savings of an economy which in turn affects investments
which in turn affects growth. We analyse the same in the next section.
Gross Savings and Investments
Banks are an important part of an economy. Banks function in layman terms by accepting deposits
from the public and lending the same to the corporate for investments. The depositors get interest
paid upon for the money they have deposited. These interest rates are nominal interest rates and do
not take into account the inflation.
Real Interest Rate = Nominal Interest rate Inflation Rate
So once the inflation rate goes beyond the nominal interest rate there is no real incentive for the
depositors to keep their money with the banks. (They start buying gold to hedge against inflation
leading to high Import Bills.) This affects the gross capital information for the economy and this
affects investments as it affects the availability of credit for the corporate.

Figure 6
Based upon the data available with the IMF we can see that Total Investments and Gross National
Savings almost follow the same trends indicating that they are correlated.
Banks and the Growing Problem of NPAs
Banks are a very important institution for any economy. They act as an intermediary between people
who deposit their money and people who take loans various purposes. Banks earn interest on these
loans and the main source of their revenue. As per the data available the highest loans is granted to
the industries followed by personal loans, services and agricultural sector.
In India, financial inclusion is a challenge. Financial Inclusion implies making the banking facilities
available to the people living in the rural parts of India. Financial Inclusion is important mainly due to
three reasons:
0
5
10
15
20
25
30
35
40
45
0 1 2 3 4 5 6 7 8 9 10 11 12 13
Total investment(% of GDP) Gross national savings(% of GDP)

Figure 7
1. Inculcating Saving Habits into the people of India: People in rural India who do not have any
access to the banks live under financial duress as they do not have saving habits. They also
tend to park their savings in the form of gold or land. Access to banks would not only help
them but also boost capital formation in India.
2. Providing formal credit avenues: Access to banks would also lead to easy availability of
loans for the people. Easy availability of loans to farmers is an important issue.
3. Plug gaps and leaks in public subsidies and welfare programmes: Direct Cash transfer
schemes have been introduced and they make the presence of banks and bank accounts for
the poor people a necessity. This would also lead to elimination of corruption.
Banks give away loans and earn interest on these loans. But all of these loans do not get repaid and
are known as Not Performing Assets. In India some of the sectors are classified as priority sectors
and they come under the purview of priority sector lending. This rising NPA are becoming a cause of
concern. Shocks in the banking sector can have far reaching consequences as witnessed in the
banking sector crisis of 2008.
Conclusion
The above discussion only highlights the problems in the Indian economy from an economists point
of view but the above problems are not the only problems. Corruption, bureaucracy, political
instability adds to problems. In fact as per the book Faulty Lines by our present governor Dr.
Raghuram Rajan most economic issues or problems find root due to political/economic decisions
taken by the government which are taken not because they are correct or thr right thing do but
because they are populist in nature.

The End




References:
1. http://www.rbi.org.in/scripts/PublicationsView.aspx?id=14349
2. http://www.indiatogether.org/2013/aug/eco-deficit.htm
3. http://www.rbi.org.in/Scripts/PublicationReportDetails.aspx?UrlPage=&ID=662
4. http://www.imf.org/external/pubs/ft/weo/2013/02/weodata/weoselser.aspx?c=534&t=1
5. http://www.countercurrents.org/ksingh291013.htm
6. http://www.allbankingsolutions.com/Articles/Articles-AB-Financial-Inclusion.htm