India's Growth On A Slippery Slope

Posted in Finance Articles, Total Reads: 1885 , Published on 30 October 2012

Nature and Magnitude of India’s growth

India’s growth story has attracted global attention for its volatility and variety. Aftermath 1991 reforms in banking, tax system, labor, production, legal system, India never treaded on the path of Hindu growth rate and accelerated with renewed vigor. Especially in the last decade it has displayed its prowess and proficiency in “Services” sector and even today claims world attention. Almost all economies have undergone the transition from “Agrarian to Manufacturing” and “Manufacturing to Service” economies. But India stands as an odd-man-out with a direct transition from Agrarian economy to Service economy with a marginal amount of time spent on developing manufacturing capabilities. In spite of this India has shown a phenomenal growth with the onset of 21st century and Indian IT muscle flexed in the global context catapulting economy to a higher pedestal.


The impressive line of growth in banking, insurance, IT, pharmaceutical, automobile, retail, and telecom has lured the foreign investors. FDI inflows between 2007 and 2008 were $41.5 million and ranked 13th in the world for FDI inflows. The “financial recession” has set in during this time and has shaken the foundations of global economy. But it didn’t deteriorate India’s growth prospects by a greater magnitude as it affected other economies. In fact India’ banking system was hailed for its robust structures and rigid policies. The aforementioned lines testifies India’s growth story but abruptly India has hit so many roadblocks and failed to overcome them. Consequently growth stagnated, GDP plummeted, inflation and unemployment soared, and rupee depreciated and brought whole India to a grinding halt.

This article attempts to dissect and diagnose the major reasons for its growth on a “Slippery Slope” and ensuing consequences.

Increased Government expenditure – ill effects

From the financial economics we know that government’s expenditure have to be financed from private savings (S-I), foreign savings (Sf) and Net taxes (T). Please see the below equation.

G = Net taxes (T) + Private savings (S-I) + Foreign inflows/savings Sf

Rs in crores







Revenue receipts of Government







Revenue expenditures of government







From the above table we can say that government revenue has not kept pace with government expenditure. Government expenditure has doubled from 2006 to 2012 and most of it financed from private savings and foreign inflows. As aforementioned net FDI to India was the highest during 2007-08 and it helped in funding government’s spending that time. But today (2011-12) net FDI flows are decreased and government’s expenditure is hardly met by private savings and it is leading to widening CAD and fiscal deficits. Please see the below table.









Fiscal deficit(% of GDP)









Current account deficit(% of GDP)









Net FDI ($US billion)









Though increased government spending leads to income multiplier effect, this is not we wanted. Increased income leads to inflation which in turn keeps the interest rates high and again crowds out private investment. This is a vicious cycle.

Dwindling Investments – Why and How?

The most visible signs for India’s growth to fall on a slippery slope are declining GDP and investments. As said before government finances its some part of its expenditure from the private savings. To have more private savings the interest rates have to be higher so as to discourage investments and “crowd out private investment”. Lower investments in the country lead to lesser expansion of the businesses and lower production and subsequently lower GDP. All of this finally culminates into attracting less foreign investments as foreigners are keen into invest in the countries which have best infrastructure and potential investments in various sectors. Lack of investments in the upcoming sectors is leading to poor foreign investments.

Y, national income = C (consumption) + G (government spend) + I + (Exports, X – Imports, M) à(1)

Also Yd (disposable income) = Y – TA (Taxes) + TR (transfer payments)

Yd is spent on consumption (C) and private savings (S)

C+S = Y – TA + TR ----> (2)

From (1) and (2)

Thus C + S = C + G+ I + X – M+TR- TA

I = S + (TA – (G+TR)) + (M-X)

[TA – (G+TR)] is called as government savings, which is negative always due to persistent fiscal deficit. It is also called as internal imbalance, if negative.

[M-X] is called trade deficit. But this trade deficit is usually covered by foreign inflows or foreign savings, Sf. It is called as external imbalance.

Thus I = Private savings + government savings + Foreign inflows

I = S + Sg + Sf

If we can infer the above equation we can say that investment depends on private savings (which is encroached by government spending), government saving (which is always negative) and Foreign savings (which is again encroached by government spending). Investments will not soar up in India unless government reduces its spending (on subsidies, welfare schemes, bailing out ill-managed public firms, crude oil, gold imports) and consequently brings down Current account deficit (CAD) and fiscal deficit (FD).

Increased Liquidity – Is it a boon or bane?

Increased income will lead to more imports and less exports i.e. reduction in net exports. To cover dip in net exports we need foreign inflows. To attract foreign inflows Indian banks should keep the interest rates high. Higher interest rates lead to more savings and lesser investments. Lesser investments further stoke the cost-push inflation.

From the logical flow in the block we can interpret that India is facing a very strange situation in current economic context with a higher inflation and lower growth, GDP violating the basic principle that “High inflation accompanies higher growth”. While the headline inflation is 7.25%, the GDP growth is 6.5% by the end of the FY2011-12.

CAD is mostly due to trade deficit on the account of increased imports of crude oil by government and d by public. Governments move to increase import tariffs on gold ($507 to $531 for 10 grams of gold) has led to small decrease in gold imports. Please see the below table to see the surge in imports and how it is stoking CAD.


Money spent on Crude oil imports($ billions)

Money spent on Gold Imports($billions)

Inflow of FDI($billions)

NRI remittances to India ($billions)

FY 2001-02





FY 2011-12





Demand-Pull inflation transforming into Cost-Push Inflation

Inflation in India started as a demand-pull inflation where too much money is chasing little quantity of goods. In order to absorb this excess cash, RBI has been increasing the repo and reverse repo rates. Despite these measures by RBI, we have not seen any progress in reducing inflation. Most of the excess liquidity which RBI is chasing is black money. Despite higher interest rates, the black money holders wouldn’t deposit money in banks due to the fear of disproportionate assets case. They can neither invest this money in the capital markets as Income tax department keeps tracking their PAN transactions. On the whole it seems that there is no logical reason or a rational approach for RBI to keep interest rates high when they can’t suck the illegal liquidity from the actual culprits. Thus we can say that individuals with black money, high disposable income, higher wages, and fake currency are stoking the demand-pull inflation.

For apparent reasons, watching the widening gap between demand and supply of goods, producers would like to produce more in the pursuit of good profits. But due to demand-pull inflation RBI raises the interest rates. Now the industrial producers though have the desire to produce more by expanding their business, can’t access the money in banks for higher interest. Even if producers are ready to pay higher interest for loans, government draws this money to meet its deficit and causes “crowding out of private investment”. Please observe that government spending is not sensitive to trade deficit or inflation or depreciation. Even if producers expand their production with their savings they will inflate the prices to gain profits. In case producers get access to money at higher interest rates, it will automatically increase the cost of production. These increased costs get translated to increased selling prices. This is where cost-push inflation comes in and persists.

Recently RBI blamed the government for the Cost-push inflation for not taking care of supply chain bottle-necks and for crowding out private investment

Conclusion: India’s growth can’t be revived until government reduces its spending and introduces big reforms in the ailing sectors. Higher inflation and lower GDP can only be tackled with increased investments and reduced costs of production. Government should also focus on black money circulation with stricter laws and increased surveillance.

This article has been authored by Krishna Chaitanya & Manu AR from SJMSOM.



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