Anatomy Of A Growth Slowdown And Policy Implications
Hammers and other tools lay on the floor of a small metal factory in India. (Photographer: Sanjit Das/Bloomberg)

Anatomy Of A Growth Slowdown And Policy Implications


The Indian economy is going through a cyclical slowdown which also has shades of structural elements in it. At a structural level, several years of investment decline have been due to the problem of three ‘D’s; Demand, Debt (of corporates) and Default (non-performing assets of banks). While debt and default are on the mend with gradual deleveraging and partial success of the insolvency process, lack of demand is a stubborn bottleneck still. The demand problem, in turn, could be connected to two important structural issues – job/wage growth and a rural economy suffering from a lack of nominal growth.

To accentuate the domestic demand problem, external demand has also plummeted in the last few months.

India’s export growth is now averaging only 1 percent in the last eight months compared to 12 percent in the eight months before that. The point-to-point decline looks even starker – from 19 percent growth in August 2018 to de-growth of 10 percent in June 2019.

This is partly due to the rather sharp decline in global growth and partly because of a secular decline in elasticity of global trade to global growth. As a result, India is unable to compensate for the slowing domestic demand through higher external demand despite India’s share in global trade increasing marginally to 1.8 percent from 1.7 percent a year ago.

Why Was The Slowdown So Sudden?

Gross domestic product declined from 8.0 percent in June 2018 to only 5.8 percent in March 2019 which is unusual because cyclical slowdowns often take longer to manifest.

In our view, domestic consumption demand was supported in the last five years through a substantial lowering of savings (almost 8 percentage points of GDP in last eight years) and increased household borrowing (in particular, the share of these borrowings from NBFCs were consistently increasing).

The consumption growth in this period appeared to be robust but the foundations were weak in the absence of continued income growth. It was difficult to sustain this pace of consumption growth as on one hand, reducing savings rate any further became difficult and on the other, the lack of credit support from struggling NBFCs made matters worse despite banks retail lending holding up for the time being. The suddenness in the NBFC credit freeze is quite apparent when we notice that the share of NBFCs in overall non-bank credit to the commercial sector plunged to 1.5 percent in FY19 from 22 percent last year. It could have impacted not only the final consumer demand but also business demand from smaller players in sectors like real estate, construction, autos, etc.

A large part of the rural demand problem could be traced back to lower realisation for the farmers despite crop output at historic highs.

The large MSP increase of 2018 also did not change the price dynamics much as global food prices remain depressed.

The challenges in the farm sector were complicated by a lack of mobility towards non-farming jobs.

More recently, the demand shortfall was also because of government spending coming to a halt in the April-June quarter due to the elections. The expenditure growth for the central government in this quarter has been only 2 percent. However, the silver lining is that this leaves some space to boost expenditure in the second half since the full-year expenditure is budgeted to grow by 21 percent. This could especially be the case with public capex which has a much higher fiscal multiplier.

It is not a surprise that falling domestic and external demand has started impacting investment growth too, which was on a strong run for most of 2018. Even here, some of the headwinds could be taking almost structural characteristics. The dearth of equity funding, a lack of risk-taking in an uncertain policy environment and a subdued demand outlook – could all be contributing towards missing ‘animal spirits’.

Policy Response – Fiscal Space Limited

In this context, the obvious question is what could arrest this slowdown before it gets worse. Fiscal space appears to be limited as the government wants to stick to the fiscal glide path suggested by the FRBM rule and avoided announcing any explicit stimulus in the recent budget. Although the government is liberally using off-balance-sheet ways of spending and supporting public capex, its impact is not visible as yet. Another option for the government is to directly address concerns in the sectors which have been affected more by the slowdown. This strategy could have a relatively lesser fiscal cost.

All Eyes On Rates And Liquidity

The focus has now shifted on the RBI’s Monetary Policy Committee meeting announcement of Aug. 7. The growth outlook explained earlier might nudge the MPC to lower its GDP growth forecast for FY20 from 7 percent. Even if there is a marginal increase in RBI’s CPI forecast, we do not think that it will deter the MPC from reducing the policy rate by 25 basis points taking the cumulative reduction in 2019 to 100 basis points. Supporting growth is a more immediate concern and there are no signs of inflation substantially exceeding the 4 percent target.

Core inflation, expectedly, is moderating fast on the back of slowing growth and rise in food inflation has been less than feared despite an uneven monsoon. Global central banks tilting towards an easing bias would also be indirect support.

Can the MPC do more than a 25 basis point rate cut?

In a significant departure from trend, RBI has started maintaining banking system liquidity in substantial surplus from June onwards, hoping for better transmission of rate cuts. The RBI is likely to release the recommendations of the internal group that has been set up to simplify the liquidity management framework along with the MPC announcement. If the MPC proposes to keep liquidity synchronous to the monetary policy stance, then the RBI might commit to continue with the substantial surplus in banking system liquidity (more than Rs 2 lakh crore now) and allow the overnight rate to fall to reverse repo. That way the impact of monetary policy will be more than just a 25bps rate cut, with ammunition left for more. The current infusion of liquidity has only helped in reducing the risk-free rate (yield on government securities) but not so much the credit spread because of risk aversion choking the flow of credit to the non-banking system. The liquidity comfort might have to be continued patiently for growth to be supported as the RBI is not too keen to perform the ‘lender of last resort’ function as yet.

Arresting The Cyclical Downturn – Immediate Attention Required

If the MPC endorses the view in the government’s Economic Survey that the ex-ante real policy rates are too high in India (one of the highest in Asia), then it can open up the scope for deeper rate cuts. However, monetary policy works with long and uncertain lags. In the interim, the challenge would be to lift the sentiment which has sagged maybe even more than the actual activity data would suggest. The classical cyclical slowdown can be further propagated through financial institutions tightening their credit standards and fall in asset prices impacting consumer sentiment more. It is imperative that policy action tries to stem the worsening of the cycle and hope for a cyclical recovery as lower interest rates and better liquidity impact percolates through the system.

Samiran Chakraborty is Managing Director and Chief Economist, India, at Citigroup Global Markets. Disclosures

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

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