More thinking aloud about the ongoing problems with the Indian economy.
What to do about the Indian economy? Is the slow-down cyclical or structural? If cyclical, what are the solutions? If structural, what are the reasons? And what are the prescriptions?
Only the naive can claim there are unique answers to any of these questions. What follows is, instead, an attempt to understand the direction of enquiry and perhaps even the broad outlines of some answers.
As a starting point, let's get out of the way what is not disputed. Most people agree on the following.
Only the naive can claim there are unique answers to any of these questions. What follows is, instead, an attempt to understand the direction of enquiry and perhaps even the broad outlines of some answers.
As a starting point, let's get out of the way what is not disputed. Most people agree on the following.
One, there is an economic slowdown. Two, its immediate manifestation is the declines in consumption across a range of sectors. Three, worsening (and contributing to) it is the clogged credit markets - both the banks and NBFCs, the latter increasingly important for working capital requirements in several sectors, are struggling from NPAs and heightened uncertainties. Four, all signatures of private investment has been trending downwards, and investments in new projects are at a fifteen year low. Capacity utilisation too is very low and declining. Five, the government's ability to prime the pump is limited given the already high fiscal deficits. Six, worsening the problem, tax revenues seem to be declining, further weakening the government's ability to stimulate. Seven, external trade as an engine of growth has long since stalled. Finally, as if all this was not enough, state governments too have been reining in expenditures, as they struggle with rising fiscal deficits.
In other words, C, G, I, and NX are all sputtering. So all the constituents of output growth are struggling simultaneously.
There is of course no agreement on what are the reasons for this state of affairs. Much less on what can be done to pull the economy out of this. This should be no surprise.
Worsening the situation a negative spiral of self-fulfilling prophecies appear to have gripped the economy and its actors. Consumer and business confidence, as captured in RBI surveys, are at very low levels. The confidence fairy has disappeared.
For sure, as the saying goes, we tend to be irrationally exuberant and pessimistic when faced with good and bad times respectively. Even discounting for the doomsday predictions, we can say with reasonable confidence that the economic sentiments are very weak. The problem with such situations is that such negative loops can be self-fulfilling - consumers will cut back purchases, businesses will freeze investments, and each reinforces the other.
The economy can remain entrapped in this grid-lock for a significant time. For a country like India, with weak safety nets, this can be even more damaging in terms of the human suffering and welfare losses. The confidence fairy, therefore, has to be brought back. And this requires action in the immediate.
What can be done in terms of immediate measures to revive growth? As I prefaced, I am not suggesting any specific answers. The typical levers available to revive the economy when faced with an aggregate demand problem are fiscal and monetary policies. Both are constrained, the former due to the limited fiscal space available and latter due to transmission problems from clogged credit markets. As Andy Mukherjee wrote, the "credit and fiscal crises are joined at the hip".
Given the problems faced by banks and NBFCs, it is unrealistic to expect monetary policy on its own to be much effective. In fact, highlighting the gravity of the credit squeeze, Niranjan Rajadhyaksha writes,
The Bank of International Settlements provides a very useful data series on what it calls the credit gap, which measures the extent to which the ratio of credit-to-GDP has deviated from the historical trend as calculated by the Hodrik-Prescott filter. The credit gap has been negative for 22 consecutive quarters now, or the credit-GDP ratio has been below trend. Compare this with 55 quarters of a positive credit gap from the three-month period ended December 2000.
Therefore, only the government may have the power to break the doom-loop. This power will have to be exercised, even if it stretches its ability (in terms of the fiscal space). While the 3 per cent FRBM requirement for fiscal deficit is not arbitrary, it is also not a figure cast in stone. So, as a starting point, greater public spending, cannot be avoided.
But there has to be a very high premium associated with this public spending. It will have to acknowledged as being deployed to create the stimulus required to breakout off the grid-lock and also buy the time required to implement the necessary structural reforms. A wasting of the opportunity in terms of not undertaking the deep structural reforms will merely make the economic prospects worse.
Therefore public spending has to be tailored to maximise the boost to consumption and investment. In other words, it should seek to target instruments with the highest fiscal multipliers and target population or consumption groups with the highest marginal propensity to consume.
If fiscal policy will have to do the heavy lifting to provide the thrust, the question arises about the types of fiscal spending. Accordingly, within fiscal policy, capital expenditures, have the highest multiplier. It will have to focus on shovel-ready projects, especially of the public sector units and perhaps city governments. The more promising instrument, in terms of boosting incomes, may well be transfers. However it has to be used carefully and with exit options which can be practically exercised.
There are also limits to the effectiveness of traditional fiscal policy levers like tax cuts. The conventional wisdom around middle-class spending on consumer durables, vehicles, housing etc, leading to a virtuous loop of consumption, investments and economic growth may be on shakier grounds this time. For a start, as discussed earlier, the middle class itself is very small. Second, unlike the early years of the millennium, there may be limited pent-up demand, and also given the limited broadening of the base in the last two decades, the middle-class consumption story may be in its latter stages. Finally, as the RBI survey indicates, consumer confidence is at a six-year low. It is unlikely that a small dose of "income effect" (either by tax cuts or something else), will provide a significant shot at growth revival.
This leads us to the rural consumers and the idea of taking a leaf out of the 2009-11 stimulus which largely involved transfers to them. As demonstrated by that experience, such transfers are fraught with risks and build-up of economic weakness. However, given the high MPC of such types of transfers, they cannot be avoided.
Some commentators talk about selling public assets to finance the government deficits. The idea of governments exiting certain areas should be welcomed and certain assets should be sold. However, it should also be borne in mind that the performance of the private sector in many areas has been no better. Further, for various strategic and other considerations, government may have to retain ownership in certain sectors.
But more importantly, wanting to privatise does not translate into actual privatisation, for a variety of factors, mostly on the demand-side. While some of the best performing public sector entities, especially on the petroleum and natural gas side, will naturally attract considerable foreign and domestic interest, the same cannot be said about the rest. In these cases, the market interest will be there only if there are windfall gains. In any case, the markets do not have the depth to absorb large volumes of privatisation in quick time. This too will take time.
However, in the meantime, some of the better performing public sector units may have an important role to play in the economic revival. In the absence of fiscal space within governments, these PSUs could expedite or front-load some of their planned and approved investments. This, especially from those in petroleum and gas, power generation and transmission are significant amounts. Similarly, government facilitation can possibly help expedite the planned infrastructure and capital expenditures in the private sector.
But this is hardly the garden variety cyclical weakness. There are too many signatures that the slow-down is structural. So what are these structural problems?
If we peer deep into the structure of the Indian economy, it is difficult to argue against the biggest challenge to long-term economic growth. With V Ananthanageswaran, I have argued in Can India Grow?,
The short story is that India faces acute capital deficiencies on multiple fronts as well as much under-appreciated adverse global structural headwinds which pose serious constraints to the achievement of sustainable high growth rates. High growth can be achieved only as episodes of over-heating followed by years of pain and lower growth from cleaning up the excesses. In the circumstances, the most prudent strategy may be to target a long period of moderate growth by focusing on steady economy-wide physical, human, and institutional capital accumulation and opportunistically riding on emergent global tailwinds..
Among these deficiencies, the demand-side deficiency is acutely self-limiting to growth. The middle class is vanishingly small as a share of population. And national economic growth is supposed to be underpinned by middle-class consumption. It is stunning that there has been such limited acknowledgement among the opinion makers about this problem.
This blog has written countless times about the "missing middle-class". The Economist had a cover story and briefing on this last year. Worse-still, as Rahul Jacob writes, even this small middle class seems to be shrinking.
... almost three decades after reforms started in 1991, the very notion of a middle class is more of a vague national aspiration than an actuality in India. “The middle class in our minds is actually the upper class," says Rama Bijapurkar, the well-known marketing consultant. Bijapurkar repeats the witticism that the middle class in India is “more sociological than logical." She prefers the term Middle India. That is a better description for people who are merely in the middle of the population in income terms but not at all a middle class. Those with a per capita income between $10 and $20 a day belong to the global middle class, according to a 2015 Pew Research Centre report. This would translate into the top 3% of India’s population.
This fact should be borne in mind whenever we make prescriptions about the Indian economy. It is still a country where the vast majority are very poor.
Call it the home-market problem or whatever, the real issue is that India's middle-class is surprisingly small, even tiny as a proportion of population compared to its peers. This is perhaps the single biggest structural limitation to the country's sustained economic growth. It is growth constructed on a very narrow base.
This may have multiple reasons. And it is most likely that all of them are relevant, and it will be impossible to disentangle the exact contributions of each. In any case, one of them is this,
When market forces are left to themselves, farm yields tend to stagnate or even fall. Demand for land increases faster than supply, so landlords lease out land at increasing rents. They also act as money lenders at high rates of interest. (This also adds to their holdings when debts cannot be paid and they seize the land that had been pledged as collateral.) Tenants, facing stiff rents and costly debts, with little or no security of tenure, cannot make the investments, like improving irrigation or buying fertiliser, that would increase yields. The landlords could make the investments, but they make money more easily by exacting higher rents and by usury. Land inequality leads to low long-term growth, which reduces the income of the poor but not of the rich. So, radical land reform is vital.
In fact, for those looking for a practical and actionable road-map for long-term structural reforms, one need not look farther than Joe Studwell's excellent book. How many economists could have written such a book?
The high growth period of 2003-11 were built on release of pent-up demand, massive public investments in infrastructure, and large transfers through welfare programs. As the present problem highlights, that growth did not lead to any significant broadening of the middle-class. It appears to have largely increased incomes through temporary transfers from the government, especially to rural citizens. The attendant consumption boost and investments supported the high economic growth rates. Once the transfer spigots dried up, rural incomes tanked, and household savings fell by more than six percentage points, it took the wind out of economic growth. Exogenous factors and shocks merely exacerbated the problems.
In light of above, the debate on whether the slowdown is cyclical or structural misses the point. The current slowdown has both cyclical and structural features. Further, as discussed earlier, all the major engines of growth appear to be sputtering.
This brings us to the point about specific structural reforms. The list is long. A listing of many of them are here, here, and here. The approaches to be adopted too are outlined in there.
In this context, one note of caution will be to refrain from using the sledgehammer. Like with everything else in nature, change too has to take its time. Too quick a change will do more harm than good. And unlike physical systems, we are dealing with social systems inhabited by people. And human suffering should be minimised.
Take the example of the credit market reforms. Logically, the RBI's slew of actions on recognition and resolution of banking sector problems - SMA, AQR, PCA framework, February 12 circular etc - cannot be faulted. For sure, they have undoubtedly laid the foundations for a better financial intermediation. But the question is at what cost and whether it could have been phased out more gradually? Perhaps not. But we cannot ignore the costs of such actions. This is a good analysis of the sledgehammer that RBI delivered.
In any case, I am inclined to the belief that using the sledgehammer is just as inappropriate as is ignoring the problem altogether. Both are easy responses for policy makers at the helm of affairs. Making change happen in a more thoughtful and calibrated manner is very challenging.
Such sledgehammers are most often counter-productive. In the case of China, it is now widely acknowledged that the crackdown on corruption and off-balance sheet financing entities has had the effect of squeezing spending and investments.
Another example is the idea of transitioning the economy from informality to formality. This, as overwhelming evidence from elsewhere suggests, cannot happen directly. The share of the formal sector increases not by shrinking the informal sector, but by having the formal sector grow faster and gradually displacing the latter.
