Flat Tyre Or Engine Failure? How Serious Is India’s Economic Slowdown?

After years of outperforming its emerging market peers, the Indian economy has been running out of steam. With five consecutive quarters of lower economic growth and a very weak GDP print of 4.5 percent for Q2FY20, it is safe to say that the economy is going through its most serious crisis since taper tantrum. The multi-crore rupee question is of course: is the slowdown cyclical or structural in nature? To illuminate our take, we make the comparison between the Indian economy and a moving vehicle. We first conduct a vehicle inspection, review the recent repairs of engineers Modi M.E. and Das M.Tech, and finally, define several options how to enhance future vehicle performance. Our goal is to determine whether India is coping with just a flat tyre (i.e. cyclical headwinds) or systemic engine failure.

Vehicle Inspection

For vehicle inspection purposes, we have developed an endogenous supply-side model for the Indian economy. This model enables us to break down our car into its vital components:

1. Labour

Without people to operate our vehicle, we wouldn’t get very far. The number of drivers is determined by the total people available in India (the working-age population), their willingness to drive (participation rates) and how many hours they are able to do so (hours worked per worker). Finally, not everyone who are volunteering to do some driving is able to find a spot behind the steering wheel and is forced to sit in the back (unemployment). There are also quite a few people driving the car without getting noticed (the informal economy), but unfortunately, we are not able to consider their contribution in our inspection.

2. Capital

To get a car running, one of course needs a set of wheels, an engine, a chassis, bodywork and a windshield. Moreover, software and IT hardware need to be installed, e.g. GPS, an electronic braking system or air-conditioning. And external capital is important: infrastructure, traffic lights, etc.

3. Total Factor Productivity

This indicator measures engine efficiency, as TFP is an indicator of the level of technology in the broadest sense of the word. For instance, people without a driving license (human capital) can try to get the car moving, but this might prove difficult if they don’t know how to operate a clutch. Moreover, TFP is dependent on foreign knowledge to enhance the performance of the car (foreign knowledge spillovers), which generally finds its way to India via foreign direct investment. Of course, Indian engineers need sufficient knowledge themselves in order to use and integrate foreign knowledge to enhance the Indian car; so absorption capacity is very important. Another factor of importance is quality of regulation (institutional quality), which enables safe travels. Of course, we take many more other factors into account.

What Are The Current Vehicle Specifications?

Based on our vehicle inspection, we think, it will be difficult for the economy to exceed 6 percent growth in the next couple of years.

Keep in mind that this chart does not illustrate Rabobank’s official economic growth forecast for India, but shows our assessment of India’s growth potential, which is stripped of cyclical movements.

If we take a closer look at the underlying components, we expect that labor contribution will be limited to one percentage point in the next couple of years due to unfavourable trends in participation rates. And although these participation rates are likely to recover over the course of time, in the medium term, India won’t be able to benefit from its population dividend the way it did in the past. The growth of the working-age population exceeded 2 percentage points in the previous decade but has already declined to less than 1.5 percentage points.

So population growth will not drive the Indian economy as it used to.

We adopt a relatively optimistic assumption that capital can contribute to GDP growth by 2 percentage points to 2.5 percentage points on an annual basis. If, however, India’s unresolved balance sheet issues weigh on investment—as India’s former Chief Economic Advisor has argued—our capital deepening scenario might be too optimistic and annual economic growth could end up somewhere around 5 percent on average.

Finally, TFP growth is expected to be relatively subdued in the next couple of years, partly caused by an expected slowdown of FDI. Between 2000 and 2018, FDI as a percentage of GDP – or FDI ratio – grew from 3.6 percent to 14.6 percent. This was achieved in the slipstream of rapid-globalisation of economic activities.

Against the backdrop of a reversed globalising trend and India’s increasingly protectionist stance —like the November withdrawal from RCEP—it is unrealistic to assume that the FDI ratio will continue to grow at the same pace as in the recent years.

In combination with weaker investment in domestic innovation, we expect an annual contribution of TFP of 1.9 ppts on average in the upcoming five years, rather than the 3.4 ppts that we have seen in the past five.

The Repairs By Engineers Modi And Das

Engineer Modi has been working around the clock to patch up the clapped-out car. Measures that for instance have been taken are the renewal of the government vehicle fleet, the launch of the Pradhan Mantri Kisan Samman Nidhi scheme of Rs 75,000 crore, the merger of ten state-owned banks into four entities, and finally the significant cut in corporate tax rates. With a contribution of government consumption of 1.9 percentage points (the quarterly average over the last five years was 0.8 percentage points), the government’s hand could already be seen in the GDP print for Q2FY20. And we do see some green shoots in high-frequency data as well, such as private consumption indicators, PMIs and a recovery of the external sector.

However, from a more structural angle, engineer Modi has only spent limited time and resources on modifying more fundamental parts of the car, like land and labour reforms.

Engineer Das’ Nitroglycerin Boost Had Little Impact

Meanwhile, engineer Das M.Tech added 135 basis points of nitroglycerin—in the form of policy rate cuts—to the fuel tank in 2019. Unfortunately, this failed to kick-start the engine, mainly because the transmission to the engine had broken down due to a ruptured fuel pipe. This rupture was partly caused by the government itself, tapping fuel from the car to plug its own fiscal deficit.

Indeed, one reason why the RBI’s aggressive cutting cycle has not translated into lower lending rates is that commercial banks are increasingly competing for savings with the government’s small savings scheme, which generally offer a higher deposit rate (8 percent) than commercial banks (roughly 7 percent).

In the current fiscal year, the small savings scheme raised 10 percent of net time deposits raised by commercial banks, which explains why banks are reluctant to lower lending and deposit rates, as this would definitely increase switching behaviour by clients.

So unless the government fixes the fuel pipe rupture, actions by engineer Das to get the fuel (credit) pumping again are likely to be in vain.

Also Read: FY20 GDP: First Advance Estimate Pegs Growth At 5%

How To Enhance Performance?

So what options are left? Money for new repairs has been depleted and both engineers basically did everything within their reach to revive short-term growth. Which is why it’s important to shift the focus to the medium- and long-term and start rebuilding the fundamentals of the car. We already touched on the need to tackle land acquisition issues and labor market rigidities. But there are many more challenges: ongoing woes in the banking sector, inefficiencies in the food and agriculture sector and problems on the housing market.

Alongside these reforms, India needs to focus on enhancing the technology of its car. The car currently is running on a heavy capital-intensive engine which is burning a lot of fuel. Adopting more enhanced technologies and at the same time switching to an electric vehicle or a cost-efficient hydrogen-powered one would not only crank up the vehicle’s performance but would also be less damaging to the environment.

How to achieve this? As 2018 Nobel Prize winner Paul Romer already argued back in 1990: start educating those engineers! Improving the level and quality of the labour force would not only enable India to adopt more advanced technologies from abroad, but ultimately is the sine qua non to generate global cutting edge innovations in all sorts of technological areas on Indian soil.

There is still plenty of room to enhance human capital, as many emerging market peers are doing much better. And of course, it is unlikely that a human capital agenda would raise much political resistance in the Rajya Sabha.

The gains are substantial according to our calculations. Raising human capital towards levels that South Korea was able to realise in the 1980s and 1990s would already push growth well above 9 percent. If India were to launch an innovation agenda as well it would create opportunities for FDI. Both elements are important to benefit from foreign knowledge spillovers which would significantly increase productivity in India.

In combination with the Korea human capital agenda, these policies would boost economic growth in the second half of this decade towards 12 percent.

Also Read: Monetary, Fiscal Policy Not Enough To Pull India Out Of Great Slowdown, Say Subramanian And Felman

The policies described above need time to feed into the economic system. Our model shows that a human capital impulse takes four years to result in higher economic performance. So, policymakers, put on your boiler suits and start engineering those policies as soon as possible.

Hugo Erken is Head of International Economics at RaboResearch Global Economics & Markets.

The views expressed here are those of the author, and do not necessarily represent the views of BloombergQuint or its editorial team.