Now that figures point to the deep contraction experienced by the Indian economy over the last two quarters and it being the worst impacted economically among all major economies, it is time to take stock of the Indian economy.
Amidst the sigh of relief due to signatures of recovery in some of the high frequency indicators, I think there are two under-appreciated concerns about the economy.
One, while the formal economy appears to be recovering, the informal economy may be much farther from recovery. The job and wage losses, savings depletion, household debt accumulation all appear to be disturbingly high. Worsening matters, as we discuss latter in the post, the prospects of recovery do not appear very promising. Besides the recovery in the formal economy appears to be happening with significant job losses and associated productivity improvements in corporate balance sheets. While the productivity improvements are good long-term trends, the associated job losses are a matter of concern, especially in an economy struggling to create good jobs.
In the context of the demonetisation and GST, Pronab Sen had written (see also this from Ananth) that GDP calculations overweight the formal economy and underweight the informal economy, and the greater impact of the two shocks on the informal economy meant that the official GDP numbers did not capture their true economic impact in the subsequent periods. The same is almost certainly true of the pandemic, and the formal GDP numbers are under-estimating the true output contraction. It is likely that this is also lessening the imperative on the government to act more forcefully.
Second, the impact on state finances may be much worse than is being estimated. Many state governments were already facing acute fiscal pressures due to accumulated power sector debts and slowing economic growth. The pandemic-induced revenue shock coupled with expenditure spike (especially on the pandemic fighting front) were a double whammy for states.
DK Joshi and Adhish Verma have an analysis of the economic impact and points to a long load ahead for recovery. They draw from the latest RBI report to highlight the expenditure compression on capital expenditures by both central and state governments and how the rising public debt ratios will make increases in the immediate future difficult. They highlight the 11.6% and 23.4% compression in capital expenditure for central and 11 state governments respectively for the first half year of 2020-21. With states undertaking more than 60% of total government capital expenditures, and their finances having been battered by the Covid 19, the need for some stabilising transfers was logical.
After all, today's capital expenditure is tomorrow's growth base. And for an economy already on a declining growth trajectory, any major cuts in capital expenditure is only pushing its growth trajectory further down, especially so with private investment and exports not well placed to be the engines of growth.
This points to the two possible problems with macroeconomic policy making during the pandemic. One, there is a case that there should have been more aggressive stimulus to boost aggregate demand, targeted especially at those in the informal sector who lost jobs and faced distress. The food and small cash transfers were only subsistence requirements to prevent starvation death, and they achieved their objective. But when you lose your entire livelihood and you don't have meaningful savings (the plight of the vast majority), there are other household consumption and investment requirements that are foregone with very damaging long-term consequences. In many cases, the damage is bad enough to push people into a lower income poverty level.
True, targeting such stimulus would have been difficult and it would have entailed leakages. But it is also not true to say that targeting is impossible, and some degree of leakages, given the extraordinary circumstances, should have been condoned.
Two, the support to state governments have been very parsimonious. At a fundamental level, India is a fiscal union, and given states' limitations on raising revenues and incurring debts, it is only natural that the central government support state governments during a shock with counter-cyclical transfers. This is the case when natural disasters hit and state governments are provided counter-cyclical transfers. Covid 19 was perhaps the biggest natural disaster in terms of economic shock since independence.
This requirement for central transfers is also borne out by the reality that state expenditures have generally been pro-cyclical. The truly exceptional nature of the pandemic, with the entire economy being virtually shut down for a quarter, also meant that the state finances were in shambles and required more transfers.
Looking ahead too, in terms of recovery headroom, states will also face a potential fiscal drop due to both the impending Fifteenth Finance Commission report as well as from the ending of the 14% GST compensation growth regime by end of 2021-22. The likely revenue losses are not easily replaced, especially on the current baseline fiscal position.
In fact, if one were to choose between these two, one could understand the union government's reluctance to bite the bullet on the former, especially given the challenges with administering demand stimulus with an acceptable level of leakages. But the transfers to state governments, if at least to limit cuts to critical growth promoting expenditures, should have been high on priority. After all the inevitable expenditure cuts by states will naturally fall on capital expenditures, the determinant of future growth.
It is therefore a fair point that in an economy where broad-based demand is depressed and government capital expenditures are severely compressed, and both are likely to remain so for the foreseeable future, and corporate investment prospects remain muted, any talk of recovery is at least premature. On reflection, the case made here in this article with Ananthanageswaran for more aggressive stimulus appears even more compelling.
There is another important complicating factor on the long-term economic growth prospects. A deeper and surprisingly less discussed (in mainstream commentary in India) complicating factor in terms of the consequences of the pandemic is its possible impact on human development indicators. There are several global level macro-studies which argue that the pandemic may have not only pushed hundreds of millions back to poverty but also reversed the momentum on poverty eradication. Its legacy on education, especially on a generation of early learners, may well be long-lasting and irretrievable. It's for this reason that the continued school closures are perhaps the most damaging aspect of responses of developing country governments. Similarly, the disruptions on primary health care side will not be easily reversed and many losses may be permanent.
For an economy in which arguably the biggest drag on long-term growth prospects arise from its human development performance, these are disturbing factors.
Even less discussed are the social effects in terms of things like rises in trafficking, early marriages, and so on. The reverse migration cognitively aroused the country to the plight of migrant labour. But it did not do enough to expose the deeply inter-twined nature of trafficking (or the point about modern slavery) with the modern industrial labour supply chains. Data on all these remain acutely deficient, thereby limiting meaningful engagement or even awareness about these problems.
In terms of negative shocks, the Indian economy has now been subjected to three major episodes over the last four years - demonetisation, GST roll-out, and Covid 19 pandemic. It is futile to question their merits, since something like GST was unavoidable and a significantly better initial design impossible. All the three were faced by an economy which was already on the downward trend and whose credit system had become completely clogged. It did not help that there was a regulatory overkill from multiple directions. And the brunt of all the three appears to have been borne by the informal sector and lower income groups. Their resilience, even in rural areas, in being able to recover is far less than that of those in the formal economy. Besides the time required for recovery too is higher. It does not require any research to takeaway that the cascade of three such shocks and that too over such short duration have been catastrophic.
One can understand the government's logic behind eschewing higher stimulus spending. After all, it suffered from large revenue losses, which, together with the small direct stimulus measures, already meant almost double the budgeted fiscal deficit. Besides, the economy entered Covid 19 with a slowing economy and higher flow and stock of debt, and a deeply clogged credit system. The institutionalised discrimination in global bond markets with developing country debts and deficits, only meant that the country faced the serious risk of a ratings downgrade with all its consequences. The border problem with China also added layers of complications to taking head-long plunge with stimulating the economy.
These are all compelling considerations, made to look even more so given the encouraging indicators on the formal economy. These would have been fine as a reasoning to rationalise a measured response in case of normal shocks. But this was an exceptional shock, one which has not happened since independence. In the sense of entire economic segments being shut down for long periods. In theory at least, it's hard not to argue that it demanded a proportionate response.
It could also be argued that given the extraordinary circumstances and given the near universal breach of normal fiscal deficit ranges across countries, an additional 2-3 percentage points increase in fiscal deficit for direct stimulus would not have left us significantly more worse off fiscally. Continence when expansion was required is no virtue. Biting the bullet and living with whatever the consequences may have been better.
The points about household demand and state expenditure compression are important because of their likely drag on the future economic growth trajectory, not just for a quarter or two, but perhaps for at least 3-4 years. They are likely to depress the potential output levels by keeping demand below what should have been the case and through the capital expenditures foregone by governments due to the absence of counter-cyclical transfers to state governments.
Having never experienced them, we may also be under-appreciating the consequences of such growth contractions. Even at a conceptual level of the S-curve of poverty traps and Engel curve on household income and expenditures, for an economy with the largest share of population at the margins of poverty, their consequences and recovery prospects may not be very encouraging.
In addition, we should also keep in mind the changed circumstances today when we are assessing the prospects of the Indian economy. Our cognitive selves are still anchored around the economic environment of the first 15 years of the millennium and the associated narrative about economic growth. That was a period of favourable domestic and global economic factors, and we have come to take for granted a near 15% nominal GDP growth rate.
It was also a period of one-off growth boost arising from both the pent-up demand of the stock of middle class in a liberalised era and the series of low-hanging first generation reforms undertaken by governments. The resultant near two decades of high savings rate, high gross fixed capital formation and investment rates, especially on the private sector side, may well now be structurally tapering off. Sample this about the new normal on industrial growth,
“There was a time when IIP used to grow 8-9 per cent per annum. Now we rejoice if it grows above 3 per cent. Since 2014, IIP growth has rarely crossed the 4 per cent mark,” says Madan Sabnavis, head economist at CARE Ratings According to him, the industry faces a demand problem, which has led to lower production, lack of fresh investment, and fewer jobs all of which again leads to lower demand.
As we have documented extensively in Can India Grow, the Indian economy did not do enough during the post-liberalisation high growth years to broaden the physical, human, financial, and institutional capital base required to generate sustainable high growth for long years. Indicators like the limited size of the Indian middle class and the stagnant credit to GDP ratios are clear signatures of this.
In light of all these, there is nothing that prevents us from today being stuck in a trajectory of lower economic growth (say, 4-5%) and middling inflation (5%), with nominal GDP growth struggling to hit 10%, and that too for long periods. This situation then surfaces a new set of challenges about the government's stimulative capacity, public debt sustainability, wage growth, household savings rate, private investment demand, maintenance of fiscal balance and so on. The knock-on effects on poverty alleviation, job creation, and human resources development are likely to be negative.
It does not help that unlike the first generation ones, the second generation reforms are not low-hanging and easily implementable ones. They require persistent effort at changing collective practices and behaviours and mobilising political support for effective implementation. And a binding constraint on them is the weakness of state capability.
This not-so-bullish narrative is based on several assumptions. But it can be argued that each of these assumptions are at least no less compelling than those used to construct a more bullish narrative drawn from indicators that point to a V-shaped recovery. Besides, it takes a more comprehensive and longer view of the country's growth and development trajectory.
It is hard not to feel that the consequences and prospects for the economy may not be anywhere as close to what we have come to expect for several years. We may be staring at a long and difficult road ahead. Global factors too point in the same direction of new normals. It's also important to qualify that the Covid 19 response is not the reason for this trend which had been apparent for several years now, but the response may not be doing anything to help.
This will be one case where I'll be very happy to be proved more wrong than right!
Update 1 (05.12.2020)
Latest on state government finances and Covid recovery,
A new study of top 18 states, which account for 90 per cent of aggregate output, by rating agency CRISIL shows that states’ indebtedness is likely to increase to about 36 per cent of gross state domestic product. Revenues are expected to decline by 15 per cent in the current year. This, along with the increase in indebtedness, is bound to affect government expenditure in the near to medium term. As the study notes, states are likely to reduce capital expenditure by about 30 per cent to remain within the borrowing limits. Despite the moderation in capital expenditure, the gross fiscal deficit is expected to expand by over 60 per cent in the current fiscal year, which would significantly increase borrowing needs.
From Sajjid Chinoy, some numbers on the post, as well as inequality widening effects,
In India, the net profits of listed companies grew 25 per cent (in real terms) last quarter. This despite revenues shrinking because firms aggressively cut costs, including employee compensation. Indeed, a sample of about 600 listed firms reveals employee costs (as a per cent of EBITDA) was the lowest in 10 quarters. Think of what this implies. If listed company profits are growing 25 per cent, and yet GDP contracted 7.5 per cent, it reveals (by construction) significant pressure on profits of unlisted SMEs, wages and employment... Household demand for MGNREGA remains very elevated, suggesting significant labour market slack. The employment rate (a more holistic measure since participation rates have bounced around sharply) in some labour market surveys still reveal about 14 million fewer employed compared to February, and nominal wage growth across a universe of 4,000 listed firms has slowed from about 10 per cent to 3 per cent over the last six quarters... Private consumption was increasingly financed by households running down savings and taking on debt pre-COVID-19. Consequently, if job-market pressures induce households into perceiving this shock as a quasi-permanent hit on incomes, households will be incentivised to save, not spend in the future.
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