The intermediate-term consequences were becoming visible by 2011. Thanks to the distribution of free money, workers from poor states like Bihar refused to travel to prosperous Punjab to help in agriculture or to industrial states like Maharashtra for construction or manufacturing jobs. This undermined labour migration, an underlying strength of India’s economy.
Handing out monthly cash payments to millions of people is the time honoured recipe for inflation, structurally high inflation. Not content with giving out cash, Sonia Gandhi’s advisers planned a food security program to guarantee a minimum level of food (or its price in cash) to about 61% of Indians. The mere announcement of this program launched food inflation into a higher orbit.
The years 2009-2010 represented good times with foreign capital flowing in and everyone in the Congress looked forward to an even greater election victory in the 2012 state elections and then in the 2014 national elections.
Rise of inflation and the credit bust of 2011-2012
The combination of the credit bubble, unprecedented distribution of cash to millions of people, and the lack of critical infrastructure for food distribution led to skyrocketing food inflation in India. So the Reserve Bank of India (RBI) went into action in late 2010 with an aggressive campaign to raise interest rates. Not surprisingly, November 2010 marked the peak of the Indian stock market.
Unfortunately, that was like performing heart surgery to cure a kidney malfunction. The interest rate hikes slowed down India’s industrial production and led to urban unemployment. But the RBI and the Indian Cabinet were powerless to reduce Sonia Gandhi’s delivery of cash into the hands of millions. As a result, food inflation kept rising and industrial production began slowing as the RBI kept raising interest rates. The result is today’s stagflationary bust in India.
As the lustre of India’s growth story dimmed and the stock market stopped delivering gains, foreign capital began leaving India. This created a very serious problem for the Indian government which relies on capital inflows to make up the balance of payment deficits. When Europe’s debt problems shocked the world in late 2011, the outflow of foreign capital from India became a flood and the rupee collapsed by 20% in one single month – November 2011.
Unfortunately, India’s brains trust considered this rupee collapse as merely an accident. So did non-residents Indians and most foreign investors. To them, the fundamentals of India’s growth story were sound and secular. They sent in more than US$5 billion in capital into India in January 2012. Global investors went back into risky assets in the first quarter of 2012, the Indian stock market rose by 18% in the first seven weeks of the year, and the Indian rupee rose by 10% to recover half of its November 2011 loss. So India, ever complacent and self-rejoicing, decided the worst was over.
March 2012 elections and the May debacle
In pursuing these populist policies, Sonia Gandhi’s goal was to ensure the accession of her son Rahul Gandhi to the prime minister’s seat. The critical first step was to win the pivotal state elections in March 2012, especially in Uttar Pradesh, India’s largest state. The expectation was that the electorate, especially the poor, rural electorate, would remember the monthly cash payments delivered to them and elect the Congress Party led by Rahul Gandhi. Unfortunately, he lost and lost big. Following the defeat, Congress Party members have begun to question the power of the Gandhi lineage. The result has been infighting within the Congress and the Indian cabinet.
The anger and fury had to be directed against somebody and the government needed revenue right away. The obvious targets were foreign institutional investors. The Government targeted Vodafone despite a Supreme Court ruling in its favour. The Government raised the spectre of retroactive taxation on capital gains realised by foreign investors in prior years.
