Monday, December 15, 2014

India's disappointing economic growth recovery

The latest IIP figures on the Indian economy makes dismal reading. It fell 4.2%, its worst performance in three years, on the back of weak manufacturing performance. This was despite the festival season and a favorable base-effect. So, despite all the "animal spirits" released in recent months, what's going on?

Madan Sabnavis of CARE Ratings captures symptoms of the malaise,
Growth in consumer durable goods for instance was 2.6% and 2.0% in 2011-12 and 2012-13 respectively, and then declined by 12.2% in 2013-14 and further by 12.6% in the first half of 2014-15. Clearly, households are not spending on non-food items. The reason is not hard to guess. Food inflation has eroded the spending power, as Consumer Price Index (CPI) inflation has been high averaging 10.2% in 2012-13, 9.5% in 2013-14 and 7.4% in 2014-15... industry has cut back on investment. This is mainly due to surplus capacity with the average capacity utilization rate coming down from 77.7% in first quarter if 2011-12 to 70.2% in the June quarter if 2014-15. Quite clearly, low consumer demand translates into lower demand for intermediate, basic and capital goods. Add to that the surplus capacity in a high interest rate environment and investment is bound to be curtailed.
For an economy where consumption makes up nearly 60% of the output and therefore critical to do the heavy lifting, this weakness is very damaging. As Mr Sabnavis identifies rightly, the prolonged period of inflation is the major culprit, having significantly eroded purchasing power among the workforce. To get a sense of the wealth erosion - the 9% average inflation over the 2008-14 period, exactly halved our purchasing power. It is reasonable to assume that incomes would have grown by far less to compensate for the loss. The steep negative impact on aggregate demand is understandable. The importance of RBI's stance on inflation has to be seen against this backdrop.

In the circumstances, as I have blogged earlier, there are two important parts to restoring economic growth - revival of credit growth and investment. Non-food credit growth, currently languishing at less than 10% has to return to atleast 15-20% levels. More importantly, infrastructure credit growth has fallen precipitously from its heady 35-40% growth rates in 2010-12 to less than 15% in 2013-14. Excluding power sector, itself weak, the infrastructure lending performance is poorer still. There are two important requirements to meet this target.

One, any rise in credit growth is contingent on the ability of banks to meet the demand. Here the weak balance sheets of the public sector banks, who supply over 80% of the bank credit, is a major constraint on lending, even if investment demand picks up. Large scale recapitalization is arguably the most urgent macroeconomic policy requirement and it is unlikely to materialize by merely divesting bank share holding. In fact, even if most of the Rs 18 lakh Cr worth projects currently stuck up in various tangles are disentangled, a very small proportion of them are likely to find the capital to start work.

Two, in the absence of investment demand - due to debt-laden corporate balance sheets, weak infrastructure investments, and the anemic consumer demand - the government becomes the engine to trigger investment revival. Unfortunately, it does not have the fiscal space to finance infrastructure investments. This is reflected in the marginal budget allocations made for even flagship projects of the government, with unrealistic hopes being thrust on private sector and public private partnerships.

The additional fiscal space come from either increased tax revenues and squeezing expenditures elsewhere. But both direct and indirect tax collections have been disappointing - 5.8% growth in indirect taxes against the budget estimates of 25% and 7.09% growth in direct taxes against the budget estimates of 15.31% in the April-September half year. This is not surprising given weak demand, low corporate investment appetite, and anemic economy. Cutting welfare spending is politically contentious and better targeting through Aadhaar will take time. Thanks to the one-step forward, half-step backward reforms, the windfall from the more than 40% drop in oil price appears unlikely to be fully reaped. Most of the measures to improve revenues and optimize expenditures are diffuse and long-drawn and unlikely to yield similar windfall.

All this highlights the adverse headwinds that the Indian economy has to navigate before it can start growing at 6-7%, leave alone the heady 8-9% rates. And I am not even talking about these long-term trends. In the circumstances, the journey towards regaining a 6-7% growth rate looks likely to be painstaking and long-drawn. Talking up the economy can only take you so far, and there are no magic reform pills available in the government's armor.

Update 1 (20/12/2014)

In its mid-term economic policy review, the Finance Ministry too comes to the same conclusion - public spending has to do the heavy lifting for reviving the economy. It points to corporate's median debt-to-equity ratio of 70%, one of the highest in the world, and posits a "balance sheet syndrome with Indian characteristics". The report's argument that household balance sheets are alright overlooks the harm done by the "income erosion effect" from persistent high inflation.

It identifies fiscal space by highlighting that the country has a debt flow (high fiscal deficit) problem and not a debt stock (reasonable and declining public debt to GDP ratio) problem. Though it finds "growing ground for hope", I am not sure.

Update 2 (4/1/2015)

Business Standard reports that the power sector pipeline for the 13th Plan (2017-22) is barren as developers struggle with a host of problems, including strained balance sheets. Highlighting this, the order book of BHEL, the primary equipment supplier, is thin for the 13th Plan period. Half the 12th Plan commissioned capacity (48000 MW till date against 88537 MW for the entire plan) are in-operational because of fuel supply issues. A plant takes 4-5 years to become operational.

Further, recent bids called by the government for the 4000 MW UMPPs in Tamil Nadu (Cheyyur, using imported coal, Case II bid) and Odisha (Bedabahal, pithead plant, Case II bid) have met with lukewarm response. It is likely that no private developer will bid for these design-build-finance-operate-transfer (DBFOT) model projects, which do not have a power purchase agreement.   

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