How To Run A Growth Marathon
The first priority is healing injuries and getting fit. Then, reforms should focus on strengthening the system for the long run.
As competition heats up, India’s sequencing and prioritisation of reforms will become crucial.
Picture this. When it comes to low cost manufacturing, India’s competition is no longer China; the likes of Vietnam, Bangladesh and Pakistan are taking the lead. Ongoing U.S.-China trade tensions are leading to a relocation of production. In a survey by the American Chamber of Commerce conducted in May, more than 40 percent of the U.S. companies operating in China said they were “considering or have relocated” production facilities outside of China, with Mexico and Southeast Asia the preferred destinations; only 8.4 percent selected India and other south Asian countries.
China isn't slacking either. To prepare for the fourth wave of manufacturing (Industry 4.0), it has increased investment in research and higher education. According to the World Intellectual Property Organisation, China is now the second largest source of international patent applications filed, fast closing the gap with world leader, the United States.
Other neighbouring countries are also strengthening their economies. Over the last two months, both Indonesia and the Philippines have earned a one-notch sovereign credit rating upgrade by S&P, placing them one and two notches above India, respectively. Both countries have instituted fiscal reforms by plugging leakages and via revenue mobilisation and used the additional revenues to raise public investment in infrastructure.
The growth marathon has already begun. But where is India?
Economically, India is the injured person who hopes to one day run a marathon.
For this, India needs to both sequence and prioritise its reforms correctly. The first priority is healing the injuries and getting fit. Then, reforms should focus on strengthening the system for the long run.
Heal The System
Three immediate priorities stand out. First, financial sector fragility around the non-banking financial sector is a clear and present danger. Eight months after the IL&FS default and improved system liquidity, funding remains constrained for many NBFCs due to perceived credit risks. A default may result in contagion risks for both mutual funds and banks. Particularly stressed are the real estate developers, who depended on the NBFC sector for their funding, and the lack of working capital can result in construction delays and defaults.
A turn in the non-performing asset cycle for the NBFC sector is inevitable. The inter-linkages have created systemic vulnerabilities that require urgent attention. The solution is a mix of adequate liquidity, confidence building measures, such as asset quality review, and medium-term steps to improve the asset-liability mix of NBFCs.
Second, the banking sector is now in a much better position after having recognised non-performing assets, but the process of NPA resolution still has some way to go. If banks have to step in to fill the gap left by NBFCs, they would need both liquidity from the Reserve Bank of India and capital from the government to support credit growth.
Third, the ongoing economic slowdown is an added headache, accentuated by both global and domestic (NBFC-related) factors, and requires a counter-cyclical policy response. Since the adoption of flexible inflation targeting (FIT) in August 2016, inflation has averaged around 3.6 percent year-on-year and it's likely to stay below the medium-term target of 4 percent in the coming year as well. The timing of the move to FIT has made the process of debt deleveraging more difficult and prolonged for companies and the financial sector.
With inflation in check and no fiscal space, monetary policy will need to do the heavy lifting. However, rate cuts aren’t enough, adequate banking system liquidity and a further reduction of the cost of capital are both necessary.
But monetary policy is only a short-term counter-cyclical solution. As the injuries of the economic system are healed, further reforms to strengthen the system are needed before India can start to run the marathon. Also, a monetary policy solution will create a one-time window to heal the system; once closed, this opportunity will be lost.
Strengthen The System
The next steps involve a focused effort on reforms that raise India’s potential growth i.e. investment revival and reforms that raise labour and overall productivity. There are five priorities here.
First, fiscal space has to be created via revenue mobilisation. With the Goods and Services Tax system more stable now, the focus should shift to raising tax compliance. Direct tax reforms—lowering tax rates, removing exemptions and simplifying procedure—will improve efficiency. Privatisation and asset sales are another tool for raising revenue without crowding out private investment.
Second, equally important is a prioritisation of government spending—investment over consumption.
Conversely, spending on investment may yield benefits that can more than pay for social sector spending and leave enough for future investment.
The government has already announced a number of schemes—income transfer scheme for farmers, pension for unorganised sector workers and healthcare benefits for all. These are desirable social objectives, but without steady revenue-generation stream, they will come at the cost of other more productive spending. What we count as demographic dividend today can turn into large pension and healthcare liabilities in a few decades. We need to learn from the mistakes made in U.S. and European plans.
Third, India’s infrastructure investment needs are mammoth and will require a sector-specific public-private funding mix. Investment in transport infrastructure to reduce logistic costs is crucial to improving competitiveness.
Fourth, a bottom-up competition among states to attract investment by improving their ease of doing business will work better than a top-down strategy. Additionally, greater coordination between the centre and states is necessary for factor market reforms. This improvement in the ease of doing business needs to have a real positive impact (de facto); it can’t just be a change in process (de jure).
Finally, to prevent a middle-income trap in coming decades, education sector reforms that focus on the quality of learning need to start today. Investment in the innovation economy and in research and development are required to move up the productivity frontier.
Countries that leapfrogged from middle income to the high-income bracket followed a similar strategy. During the mid-twentieth century, governments in Japan, Taiwan, South Korea actively courted MNCs to set up factories locally, provided the necessary hard and soft infrastructure, and then used these manufacturing setups to create and build an eco-system around it.
To summarise, for India to run the growth marathon, it should first focus on reforms that heal its injuries, and then strengthen the system. The reform toolkit is well known; it's the sequencing and prioritisation that is important. The marathon has already started: ready, set, go.
Sonal Varma is Chief India Economist at Nomura.
The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.