A testing time

The dominant narrative about India's current economic slowdown can be summarised in two words: bad timing! Just when the global economy entered its strongest cyclical lift since 2010, India was beset by the unfortunate but unintended consequences of a series of policy decisions- demonetisation, teething problems of the Goods and Services Tax, and the restructuring of bad debt in banks- that have temporarily disrupted domestic supply chains. Once these fade, the global tide will lift India to higher growth. Meanwhile, reforms should continue focusing on easing the cost of doing business, while monetary and fiscal policies should provide short-term relief to ease the burden of adjustment. Thus the call for cutting the policy interest rate, a weaker currency and tolerating a higher fiscal deficit for this year and next. Given the languishing private investment, the fiscal expansion should target higher infrastructure spending and subsidies for low- and middle-income housing, but with elections around the corner, some support could be set aside for farmers too.
Prima facie, the logic appears impeccable, except that it has little to do with reality. Let's start with global growth. Since the second half of 2016, the global economy has witnessed a massive synchronised cyclical lift: developed economies have fired on all cylinders, ie, both consumption and investment, while emerging markets have recovered smartly. 2018 promises to be even better. Both the Euro area and the US should grow much faster than trend, while emerging markets continue to recover apace despite a policy-induced slowdown in China. Importantly, even with labour markets tightening and commodity prices recovering, inflationary pressures remain mild. Thus, central banks in developed economies will continue to tighten monetary policy at a measured pace keeping financial conditions benign.
However, underlying this cyclical bounce is a global economy mired in structural malaise. Measured productivity almost everywhere has declined since the financial crisis in the absence of any meaningful supply-side reform anywhere. Even the much-touted tax reform in the US will likely only boost near-term demand without increasing medium-term supply. With capacity increasingly strained after eight years of expansion, and productivity flagging, eventually wages will rise, pushing up inflation and forcing central banks to tighten more aggressively. Alternatively, growth will need to slow sufficiently to take off the pressure on wages and inflation. In either case, this goldilocks world of high growth and low inflation is unlikely to last for long.
Beyond the developed economies, the only other source of material global demand comes from China. At the recently concluded 19th Congress, the ruling Communist Party formally acknowledged that China was no longer a low-income economy challenged by the need to generate millions of jobs, but a rising middle-income country aspiring for a better quality of life. Back in 1981, Deng Xiaoping identified increasing growth to replace class struggle as the principal objective of the Party. For the next three decades, officials at the provincial and lower levels of government focused solely on achieving high growth by any means necessary, even if it meant circumventing efforts by the central government to cool the economy and contain growing vulnerabilities. If the previous three decades are any guide, this alignment of objectives between the state and the Party could have just as dramatic an impact with officials at all levels working to rebalance the economy. This most likely will slow growth in China in the coming years.
Turning to the India-specific factors, much has been blamed on the adverse impact of demonetisation, GST and bad debt as the culprits behind the growth slowdown. While it is undeniable that these were disruptive, perhaps even more than appreciated today, it is hard to pin the entire blame on them. The reason is obvious: India's growth has been sliding since the second quarter of 2016, six months before demonetisation and a year before the introduction of GST. While the bad debt problem hit headlines in 2016, over-leverage had already begun to tighten bank lending since 2014.
So what caused the decline in growth since 2016? It was the reversal of what drove growth up in 2014-15, namely oil prices. Global oil prices after peaking in the second half of 2013 fell nearly 70 per cent over 2014-15 to bottom out in the first quarter of 2016. This outsized decline was a massive positive shock to India that is estimated to account for almost the entire growth pick up over 2014-15. Since early 2016, oil prices have nearly doubled, imparting a large negative shock that has driven down growth since then. The demonetisation, the GST and the bad debt just made a bad situation worse; they did not cause it. Understandably, many will argue that this narrative underplays the importance of the tectonic shift in politics during this period and the attendant changes in public sentiment and government decision-making. I am not. I am just stating that factually global oil prices played a much bigger role in quantitatively explaining India's growth dynamics since 2014 than any of these other factors.
To know where we might be headed in 2018 and beyond, we need to better understand how we got here first. Once we reject ad hoc and coincidental explanations, we wade into a world of inelegant and complex answers that often require discarding long-held misconceptions. I am going to begin with one such misconception. India is, and has been, for a long time far more open to the global economy than believed. There is virtual consensus among analysts and policymakers that the dramatic rise in investment drove much of India's vaunted 9 per cent growth over 2003-08. The liberalisation of 1991-92 coupled with the corporate restructuring in the late 1990s spurred corporate investment to rise from 5-6 per cent of GDP in the early 2000s to 17 per cent of GDP by 2008. But it takes two to tango. The increase in investment also produced a lot of things that someone had to consume. Despite the explosion of shopping malls in every nook and corner, it wasn't domestic consumption that absorbed the rise in production as is widely believed. It was exports. It grew at an astonishing pace of nearly 18 per cent per year. Private consumption, on the other hand, grew at 7.5 per cent, even less than the growth rate of the economy such that its share in GDP fell from 62 per cent to 57 per cent. To put this in perspective, even after declining over the past few years, export's share in GDP in India at 20 per cent is the same as in Indonesia and twice that in Brazil.
The subsequent decline in investment, from its peak of 37 per cent of GDP in 2012 to below 30 per cent of GDP at present, is also widely accepted as the key reason behind the slowdown trend in growth. But corporate investment had plunged way back in 2009, flat-lining at around 12 per cent of GDP since then. Meanwhile, private housing and SME investment have fallen from 15 per cent of GDP to around 10 per cent in the past five years.
These have crucial implications for India's medium-term growth. India's 9 per cent growth over 2003-08 was on the back of exports surging at 18 per cent per year. In the past five years, exports grew at just 3 per cent annually. Even if exports were to grow at double the pace in the coming years, it is hard to see overall growth exceeding 7 per cent. Private investment in India has wallowed not because funding costs are too high or banks are hamstrung with bad loans or the exchange rate is too appreciated as is generally bemoaned today. It is because there isn't sufficient demand to justify large investments. In other words, with global growth likely to slump back to mediocrity, 7 per cent will be the new 9 per cent unless we find offsetting domestic drivers to induce corporates to raise investment.
This is easier said than done as it requires rethinking a framework that has been the basis of policies and reforms since India's independence. As long as one cares to remember, India has been a supply-constrained economy with a structurally high inflation and a nagging current account deficit. Policies and reforms, almost exclusively, have been geared to ease supply constraints across the economy: from infrastructure spending to recapitalising banks and, most egregiously, forcing households to keep increasing savings (for retirement income, children's education, healthcare, and housing) through a web of financial repression, regulatory distortions and public spending choices.
To be fair, this single-mindedness was the right approach as long as there was sufficient foreign demand to absorb the goods and services produced by the country. Not any longer. The hard bit is to question and rejig a 70-year-old framework and then to build consensus across central, state and local governments for the need to change. Recasting policies and reforms is less arduous and it starts with redesigning India's infrastructure to look more inward and less outward, increasing public provisioning of healthcare and education, reforming insurance regulations to reduce forced savings for old-age care, and eliminating financial repression to raise returns on retirement savings.
While no country with $1,800 per capita income has managed to sustain high growth without relying on exports, it is also unlikely that global trade will return to anywhere close to its pre-crisis growth rate. Thus, the prudent choice would be to shift the balance of policies towards generating more domestic demand. Will this happen? One hopes so. Because 7 per cent growth may not be good enough: growing at this pace for the next 25 years will raise India's per capita income to just about 15 per cent that of developed countries and half that of its Asian peers.