The democracy bottleneck

By S.C. | LONDON

BUSINESS leaders in India frequently suffer China envy. If only India's political system was like China's, they reason, the government could push through much needed reforms and the economy would take off (and stay airborne). Simplistic as that prescription is, recent data from India highlight the challenges of sustaining growth in a noisy democracy. In the first quarter of this year, India's economy grew by a paltry 5.3%—the country's lowest rate in nine years. With thinning capital inflows, the rupee has also taken a beating and market sentiment is negative.

While the Indian government can blame the euro crisis for contributing to the slowdown, the current mess is largely self-inflicted. The first wave of privatisation and deregulation, begun nearly twenty years ago, has largely run its course. But the coalition government, pulled by conflicting interests and lacking clear leadership, has not pushed significant new reforms to liberalise the economy. Even in instances where it manages to reach a decision, pressure from smaller allies often causes it to rollback policies. The U-turn on opening the country's retail sector to international competition is a case in point.

Beyond the policy paralysis, the country has another problem: a growing debt burden. The Indian government's debt stands at nearly 70% of GDP and its fiscal deficit is 5.9% of GDP, up from 4.8% a year ago. Public debt in itself isn't bad, especially when private investment is low and growth is faltering. The numbers also seem manageable when compared to those in the euro zone. But in the context of India's economy it raises some questions.

First, increases in government spending aren't driven by investments needed for long-term growth. Instead, a third of the government's expenditure is spent on interest payments and subsidies. A poor country like India needs social programmes to provide basic necessities to a large number of its citizens. But there is very little evidence that subsidies on fuel and electricity actually benefit the poor. Controlled fuel prices seem largely driven by political considerations.

The continued support of loss-making state-owned enterprises (SOEs) is also hard to justify. Consider Air India, the poster-child for this policy. The state-run airline has floundered for years due to mismanagement and labour troubles. Yet the government continues to pump billions of dollars to bail out the carrier. It recently announced plans to inject $5.8 billion into Air India over the next eight years. A similar story repeats in other sectors of the economy: inefficient SOEs continue to devour public funds, at the expense of private competitors. Protection of public-sector jobs trumps any economic rationale.

This spending binge is not only misallocating resources, but also crowding-out private-sector credit. Over the coming year, the government will borrow around $110 billion to fund its revenue shortfall; it plans to front load most of the borrowing in the first six months. Since Indian banks are required to hold government notes, the success of the bond sale is guaranteed. But India's financial system isn't deep enough to absorb demand from this huge borrowing programme. Consequently, borrowing rates for the private sector may increase. Companies may also look overseas to fund their operations, exposing them to currency risk with a volatile rupee.

Unfortunately, the situation isn't likely to improve anytime soon. In the parliament no single party has a clear mandate and the largest party, Congress, is beholden to smaller regional allies for majority. Welfare programmes and populist policies that appeal to their base guarantee the support of these parties. As the government is more concerned with short-term survival, any difficult decisions are put on the back burner.

That is a shame. Continued growth promises to lift millions of Indians out of poverty. But this requires the country's leaders to take a long view and think beyond the next election cycle. Under the current electoral arithmetic, that seems unlikely.