There was an interesting article in this week's Business World on what is driving the current economic growth in India by Ashok Desai (the consultant editor of the Telegraph). Mr. Desai argues that the current growth in economy has more to do with liquidity than anything else.
This is what he has to say on the current state of Indian economy -
The widespread belief that the current boom is driven by Indian companies that became efficient and globally competitive in the downturn of 1997-2002 is mistaken. It was started by the rise in liquidity and fall in interest rates that resulted from the rise in reserves. Reserves rise because people who have foreign exchange - exporters, foreign investors, NRIs abroad - sell it to Reserve Bank. In return they get Rupees. So a rise in reserves increases money supply pari passu.
If people get more money in their bank accounts, they will repay old debts and borrow less. That reduces demand for loans, and leads banks to reduce interest rates. Both lower interest rates and lower debt increase profits. That cheers up businessmen and they start investing. And more cash cheers people up and they begin to splurge on consumer goods. That is the kind of boom we are having, not the kind in which the higher profits come through a reduction in real inputs into production. The latter also happened, but it was not the cause - it happened too long ago to have been the cause.
This stimulus would go into reverse if reserves begin to fall. Money supply would fall, liquidity would decline, discretionary expenditures such as investment and expenditure on consumer durables would fall, and that would pull the economy into a downturn. The rise in reserves has virtually come to a halt; we should ask ourselves whether this is accidental and temporary or denotes a change in trend. To me, it is clearly a trend - it is driven by the rapid deterioration of the balance of trade. It is worsening at such a rate that the current account deficit must outrun capital inflows before many months pass, let alone years; then reserves will begin to fall.
Read the full article here. (one has to register to read the full article).