Fiscal fallout of crossing the LoC

For the past two years India has received record inflows of foreign direct investment. The inbound FDI has exceeded foreign portfolio inflow into the stock and bond markets. This is called the FII inflow, which typically has shorter time horizon, and considered more volatile. FDI inflows on the other hand signify confidence in the longer-term growth prospects. Adjusted for their respective economic size, India received more FDI than China, relatively speaking. In these two years India’s global rank has jumped up on three different and important metrics. Its Ease of Doing Business rank, as computed by the World Bank is up. Its competitiveness rank as determined by the World Economic Forum has jumped up by 16 ranks. And its rank on the innovation index as per World Intellectual Property Organization is up by 15 ranks. These ranking may be testimony to improving health of the macro economy, its growth prospects and the progress of economic reforms. Average inflation now is half of what it was just three years ago. Foreign exchange reserves are at record highs. Fiscal deficit limits are being adhered to, indicating tight fiscal management.

In addition to these factors are five short-term positives for the economy. Firstly due to adequate rainfall, agriculture and the rural economy are expected to do well. Even the rabi crop will be better. Secondly, the award of the arrears of the seventh Pay Commission will add almost 1 percent of GDP to urban incomes (since the beneficiaries are predominantly in urban areas). This will give a boost to consumption spending. Thirdly, the continuing push in public spending on infrastructure like roads, ports and railways is beginning to manifest a stimulus impact. It will lead to increase in consumption of steel and cement and an increase in unskilled and semi-skilled employment. Fourthly, going by trends it looks likely that inflation and interest rates will drift downwards, further adding monetary stimulus to the recovering business cycle.

Of course not everything is rosy. Exports are still struggling, and nowhere near double-digit growth of five years ago. Industrial growth needs to pick up speed. Banks are still under the crushing burden of bad and stressed loans. Private sector investment in large projects is not visible. But all these specific problem areas are expected to improve in the coming months and years. The rollout of Goods and Services Tax is a net positive for the economy, and so are a slew of other reforms.

Into this relatively benign, and improving economic scenario, suddenly we have the military action of crossing the Line of Control. India’s action was retaliation to the terrorist attack on Uri camp, where nineteen personnel were killed. It was a grave provocation, which made India deviate from its dominant policy of “strategic restraint”, even if temporarily. India’s military intervention, termed as a surgical strike, was swift, decisive, pinpointed and unexpected. It was simultaneously aimed at several terrorist camps on the other side of LOC. Technically that area is disputed, and claimed by India. So it wasn’t an attack on Pakistan sovereignty, nor an act of war. Even the framing of the retaliation as a “surgical strike” was a linguistic and diplomatic coup. Hence not only was the operation a military success with zero casualty on India’s side, it was also a diplomatic success. There was worldwide support for this action against terrorists, and has put pressure on Pakistan to do something about its tacit support for such camps.

That’s where it gets complicated. The short-term tactical success has opened up longer term uncertainty. During Kargil and shortly thereafter, President Bill Clinton called this as one of the most dangerous neighborhood in the world. He was referring to the fact that two nations with nuclear arms were on the brink of war with each other.  The United States then gave substantial military support to Pakistan, and continued to do so even post 9/11. But President Clinton’s prognosis of the risk was proved too much of an exaggeration if not wrong. Just six years later India signed the nuclear deal with the US, and even the nuclear sanctions of 1998 were forgotten. Since the nuclear deal, India’s relations with the US have gone from strength to strength.

But the current hostilities add an element uncertainty in the minds of investors. This was seen on the day of the surgical strike itself. Global stock markets rallied, and Indian stock market too should have moved in sync, as always. But the Sensex actually fell by 500 points during the day. The rupee exchange rate too looked like it was going to crash. Of course this can be seen as a knee jerk reaction. Investors abhor uncertainty, be it from elections, monsoon, budget announcements, and most of all from geopolitical tensions. While FII inflows might become volatile and slow down, we need to see how the FDI flows react. India’s economic fundamentals remain strong, however much resources may get used in security operations. Investors would be more worried about how much political capital (not fiscal resources) gets diverted to solving the cross border tension. Will policy makers who are focused on development issues now get too much distracted by challenge of containing the fallout? More importantly, how will the Pakistan establishment react, since unfortunately this is seen as a zero-sum game. Wounded pride or perceived snub can have unpredictable and even irrational responses.

Ultimately, this is an inevitable economic consequence of crossing the line of control. The government officials have done well to be quiet and restrained in the aftermath, letting mostly the military brass address the press conference. The wording and communication has been well crafted. Global perceptions, including those of investors are being addressed and managed. There is much work to be done on the economy, and the ambitious GST deadline looms large. But we can’t deny that we are in uncharted territory.  Low oil prices, very good monsoon, and a remarkable nationalconsensus around GST consensus – have all been a story of good political and economic fortune for the country. Let’s keep our fingers crossed as events unfold after crossing the line.

(The writer is a senior economist based in Mumbai)