The Narendra Modi government is faced with a series of economic shocks – perhaps leading up to a ‘perfect storm’ – for the first time since it assumed power in May.

It started on Friday (December 12) with the worst factory output numbers in more than five years – minus 4.2 per cent in October. In this light, the flat wholesale price index for November 2013 (meaning zero inflation) is more a cause for consternation than relief. It brings up the problem that US economist Paul Krugman talks about in the context of austerity policies in Europe: that an excessive focus on inflation may end up creating a bigger demon – anaemic growth and joblessness.

Risk factors The fall in kharif output this year may complicate the situation for industry, dragging down rural demand for industrial goods. This is in contrast to what probably played itself out in 2013-14: of high food inflation squeezing demand for manufactured goods. Rate hikes through the last year only made matters worse for industry.

But what sits oddly with this distinctly deflationary outlook is the high trade deficit for November – at $16.9 billion against $9.6 billion in November 2013, at a time when industry and oil prices are down. Any structural distortions in our balance of payments accounts should be addressed, as the previous government did purposefully in the case of gold imports.

The whiff of degrowth in the air, combined with the usual profit-booking by foreign investors towards the end of the calendar year, led the Sensex to shed 538 points on Tuesday, and another 71 points on Wednesday (December 17). The rupee, meanwhile, has slipped from 62.5 to a dollar on December 12 to 63.6 to a dollar on December 17. This brings back memories of the currency slide of mid-2013; expectations of a fall in the rupee could trigger a further exit of FIIs from equities, in effect, dragging down the currency – a self-fulfilling prophecy.

Global headwinds What has made matters worse are global headwinds such as the slowdown in China, clouds of recession in Japan and Europe and the rouble’s fragility, despite the steep hike in Russia’s interest rates, thanks to the free fall of oil prices. Commodity prices and equities of major commodity firms have taken a hit on weak demand. In this situation, it remains to be seen how the markets take to any money tightening announcement by the Federal Reserve.

But the perhaps biggest risk of all, as the IMF’s recent Global Economic Outlook points out, is geo-political. Falling oil prices may push Russia towards desperate measures, exacerbating tensions in central or West Asia. This could lead to a supply shock in oil.

Policy dilemmas However, the Reserve Bank faces a bigger problem today than a year and a half ago. It cannot raise the interest rates to shore up the rupee as it did last time when inflation was ruling high, even as growth had started to take a hit.

Lowering the rates seems like the most obvious thing to do with industry in the doldrums, but that cannot be explored unless the currency stabilises.

Questions on whether the RBI forgot about growth in its pursuit of inflation will ring louder. But the crucial issue here is that the interest rate is also being used to manage the rupee.

Unless the RBI conceives of a distinct set of instruments to cope with the external sector, it cannot freely use the interest rate for the domestic economy.

The onus on reviving the economy lies with the Government. Finance Minister Arun Jaitley must re-examine his fiscal options. He could step up capital expenditure at the earliest, in railways and roads, and not allow the rural employment guarantee scheme to sag at this stage. He must take a bold call on whether a fiscal deficit target of 4.1 per cent makes sense in a situation where investment in the economy has stagnated.

The Government, focused thus far on creating a supply side push. Now, Keynes is back in the picture: domestic demand is the problem that needs to be fixed. If that requires another fiscal stimulus, as in 2008-09, so be it.

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