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Ajay Chhibber

The author is Chief Economic Advisor, FICCI. He is also the Visiting Scholar at the Institute of International Economic Policy, George Washington University

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The Return Of Stagflation? Seven Things To Fix The Economy

Many are predicting that the downturn is cyclical - they may be right. In any case the base effect, and the lower interest rates (despite the poor transmission) may help stem the decline to some extent.

Photo Credit : Shutterstock


FY 19-20 will go down as a terrible year in India's economic trajectory. The drop in India's growth was so swift, so widespread and so large that can only be described as a crisis. India is now officially growing below   5% and with inflation reaching close to 5.4% is showing signs of a return of stagflation. Given India's needs and aspirations and a very rapidly growing young population - anything below 7% GDP growth is unacceptable and at least 9% is needed to reach the goal of $5 trillion around 2025. At this rate India will not even reach $5 trillion by 2030. 

The Indian economy has seen a decline in growth for 7 quarters - a serious growth recession .GDP growth was 8.1 % in Q4 FY 17-18 and is now 4.5 % in Q2 FY19-20 and headed downwards. Investment remains down and the consumption bump after the recovery from demonetization has turned out to be a dead cat bounce - as consumption bumps often are. People dipped into their savings to maintain consumption post - demonetization - but that bump could not last for too long without investment, and job creation .  The agricultural sector is also not doing well and rural wages are not rising as rapidly as earlier - therefore rural demand remains depressed.  This is the first time all indicators are pointing down wards - usually you get a mixed picture. 

Quarterly GDP Growth Rate (Y-on Y): India


Source: CMIE

Some of the decline is cyclical and some due to delays in addressing structural issues. It is very hard to disentangle them precisely and there appears to be no easy solutions on the horizon. The government is under huge pressure to boost demand by breaching the fiscal deficit. It is in any case going to be difficult to meet the fiscal deficit target, despite the huge transfer of reserves of Rs 1.76 lakh crores from the RBI  this year, because the revenue projections in the budget are based on very unrealistic nominal GDP projections of 12% growth - 4% GDP deflator and 8% real GDP growth. Growth projection for the year have been revised downwards and the RBI is now projecting FY 19-20 growth to be only 5% and could end up even lower. This would imply that nominal GDP growth could only be 12% if the GDP deflator grows by over 6% - a return of high inflation. CPI inflation has crossed 5%% and food Inflation to over 10%in November so it's possible that we may see a revival of sustained inflation - but that stagflationionary scenario of low growth and high inflation, would cost the government huge credibility.

If inflation  is contained at 4%, nominal GDP growth would be under 10% - so that the revenue targets would surely not be reached.  So fiscal targets are likely to be breached anyway - without any efforts to consciously breach them. And with state deficits at high levels and the PSU finances in bad shape the public sector borrowing requirement (PSBR) is in any case exceeding 8% of GDP. With declining savings it leaves very little financial savings for investment. Moreover, with low growth and higher inflation, the ratings agencies may well be inclined to cut India's ratings - something not to be taken lightly. Moody's has already signaled a downgrade by shifting from "neutral' to 'negative'. Standard and Poor has maintained ratings for now - but may shift downwards if the gloom continues.  


Source: World Bank, CMIE 

More important than a fiscal boost is to re-orient government expenditures towards a more developmental growth-oriented outcome i.e. lower the recurrent expenditures and increase capital expenditures and try to attract longer-term finance to maintain infrastructure investment. Lower borrowing costs, cuts in subsidies (by rationalizing them) could provide some space for this improvement in the quality of expenditures. Recovery in investment (Gross fixed capital formation) is key to recovery of the economy. GFCF as a share of GDP peaked in 2007-8 at 36% - just before the Great Recession and has since declined to around 28.5% - with private investment peaking at around 27.5% of GDP in 2007-08 and now slumping to 21.5% of GDP. Within the private sector, the first slump came in private corporate investment which fell from around 17% of GDP in 2007-08 to 11% thereafter - a sudden and sharp drop. Non-corporate investment remained robust for another 3 years even after the Great Recession - due to the fiscal and monetary stimulus- but then fell after 2011-12, when growth fell. 

Credit to the private sector as a share of GDP also peaked in 2013 and has since fallen - contrast with Vietnam and Bangladesh where credit growth has continued to rise despite a slowdown in global trade as these economies have maintained export growth. 

Among the cyclical factors the slump has been attributed to a) high-interest rates and financial sector problems, b) demonetization, c) GST complexity and implementation as well as d) the global slowdown. 

a)High-Interest Rates and financial sector problems: 

The RBI has done its part to some extent. It has over the last year lowered the repo rate by 135 basis points to 5.15% - but only a third of this cut has translated into lower lending rates by commercial banks. The RBI's has correctly paused in December 2019  as CPI inflation has now jumped up to 5.4 % - implying a real repo rate of  -0.3 % - lower than is warranted.  The big challenge for the RBI is how to get the cuts already announced passed through. The government has announced that future lending rates will be linked to the RBI's repo rate but in practice, it's not that simple. This is not easy because banking system remains saddled with large NPA's, a 19.5% SLR, and directed lending norms.  These have led to the creation of the world's most inefficient banking system with financial intermediation costs - the difference between lending and deposit rates at over 500 basis points. The state banks are also busy dealing with recently announced mergers - which will eat up their management attention. The NBFC sector remains in poor shape after a binge in lending - but it's not clear throwing more funds at the NBFC's will not create further moral hazard. An asset quality review (AQR) will be needed to separate those that should be helped from those that may have to go under.  

Source: CMIE and RBI

*: CPI inflation available only for Oct, 2019

The RBI's MPC has reduced the repo rate by 135 basis points since last year - but it has had no effect on the weighted average lending rate (WALR).  Over the last year, the WALR has gone up by 1.9% points - not declined. In general, since the establishment of the MPC in 2013-14 the WALR has jumped from under 2% in real terms to around 7% in real terms for outstanding loans and 6% for new loans. The pressure to come clean and provision has forced banks to increase their lending rates and hurt economic growth - via both the consumption and investment channels.

The state banks have been recapitalized but demand for loans remains constrained due to high lending rates, slump in demand and still low capacity utilization in many key sectors. India's monetary transmission remains very slow about 4-6 quarters - so that past high rates of interest are contributing to the slow-down seen now. The RBI kept interest rates very high for almost 5 years since 2013 - when the MPC was formed to fight inflation through inflation targeting regime. Inflation did come down but largely as part of a global commodity price cycle. In the process - high-interest rates caused huge pain but very little gain. The RBI was fighting the wrong battle because with the revision in the GDP series - suddenly India looked to be doing well on growth - so its focus shifted entirely to fighting inflation. In hindsight they should have been equally focused on growth. 


Demonetization is still being blamed for the current slump. This is unlikely as the economy recovered from it in FY 2018-2019 when GDP growth increased from 6% in Q1 FY 17-18 to 8.1% by Q4 FY17-18. It could be that we are now seeing lingering effects of demonetization as many MSME's went under - or were temporarily hanging on by borrowing and dissaving. But the demo story has come and gone, with some damage but cannot be blamed for the continuing slump- more structural factors are involved. 

c)GST Complexity and Implementation: 

GST implementation woes have gone on much longer than was anticipated - largely due to very ambitious design and unnecessary complexity. Collections were substantially short of estimates in FY18-19. With the economy slowing down sharply - estimates for FY 19-20 also appear to be optimistic. Further simplification and widening of the base - by including petrol, real estate is also badly needed for both implementation and revenue collection. 

d)Global Economic Slowdown; Challenge and Opportunity: 

There is no doubt that the global economy is growing much slower than was projected - the IMF describes it as a "synchronized slowdown". Trade wars have added to the slow-down both from the direct effects of tariffs - but even more from the uncertainty effects. Nevertheless, the China-US trade was also seen as an opportunity for several countries. So far the biggest winner in this is Vietnam and to some extent Bangladesh - India appears to have missed the bus - due to lack of competitiveness. Vietnam's exports to the US have jumped by about 30% and it has seen huge inward investment from Hong-Kong based companies. 

India has moved up again on the World Bank's Ease of Doing Business rankings to the 77the position - but remains behind other competitive destinations such as Vietnam, Indonesia, Thailand and Malaysia. India dropped 10 ranks to 68th on the broader WEF Competitiveness Index - which incorporates the World Bank Ease of Doing Business Index- but includes other factors as well. This suggests India will need to do more aggressive reforms in the enforcement of the contract, registering property, paying taxes and resolving insolvency as well as labour and financial sector reforms. These are needed to accompany the corporate tax cuts to boost investment. 

In the upcoming budget given the limited space for short -term fiscal policy and now having reached the limits of monetary policy its best to shift attention to structural and sectoral factors that will help drive the Indian economy over the medium term. The high real interest rates have also meant that the real exchange rate remains hugely appreciated - by around 15-20% over the last five years. Such a high real exchange rate has hurt India's competitiveness and its "Make in India" objective. 

Seven Important Measures to Help Revive Economy: 

1)Fix the Gearbox of the Economy ----Financial Sector Reforms:

 The IBC is a good reform - but it is not designed to address a systemic NPA problem. It's too slow and cumbersome. The slow recovery in NPA's through the IBC driven process is now harming the economic recovery. Since the start, only a little over Rs 1 lakh crore of NPA's have been resolved - so the remainder some Rs 7.9 lakh crore will take 7-8 years to resolve at this rate. If the RBI had used its excess reserves of Rs 3-4 lakh crore - to clean up half the NPA's in-state banks in return for serious reforms India may not have been in such a mess. Eventually, the RBI was forced to transfer those excess reserves to the government, which has now recapitalized the state banks but without any serious reforms. Bank mergers are not a serious reform and instead several state bank should have been privatized. 

Given the above what should Government, with the support of the RBI do? 

1.Establish Bad Bank and clean up the NPA's and ask state banks to reduce lending rates.

2.Privatize (at least partially) the state banking system - instead of mergers.

3.Find ways to energize the bond market for infrastructure projects.

4.Conduct AQR of NBFC's and find ways to support well managed larger NBFC's.

5.Remove priority lending targets from state banks and designate one or two for priority sector lending.

2)Take the plunge -- Labour market reforms: 

The government has announced that it is preparing new labour market legislation - clubbing all labour related laws into 4 baskets. But it is unwilling to address the most important aspect - labour market flexibility. Without greater flexibility, Indian industrial structure has a missing middle - relatively few firms in the size 100-500 workers which are often the most competitive firms globally. Given its political capital, the government needs to get bolder with such reforms and take a page from former PM Atal Bihari Vajpayee that labour reforms are not anti-worker. Existing law market rigidities are not protecting workers as unemployment rises and most workers in India do not have unemployment protection. India should ease labour flexibility at least for firms up to 500 workers. Some states have relaxed labour laws for firms up to 300 workers but in the new all India centrally directed legislation even that may be disallowed. Term contracts - up to 5 years - have been allowed but are still under-utilised. 

3)Liberalize farming -- Agricultural Sector Reforms: 

Expand PM-Kisan and MGNREGA and reduce input subsidies - such as free electricity and wasteful fertilizer subsidies. The shift to PM-Kisan - which is a broader production-based subsidy- could also be used to reduce MSP's for specific commodities. This shift could be designed to be budget neutral. It would enhance productivity - as farmers would be able to take greater risks in their crop-mix and would increase rural demand and thereby help recovery. It would put more income in the hands of farmers and landless labour - boost rural demand and give farmers greater choice in cropping patterns. It would also ensure that less paddy and sugarcane are grown especially in parts of the country where water is scarce. Groundwater depletion would be curtailed and land productivity would increase. Also, free up the APMC and stop export restrictions. 

4)Announce New Strategic Trade and Industrial Policy : 

 The target of $ 1 trillion exports for a $5 trillion economy that has been recently adopted is excellent - but must now be matched by an ambitious industrial policy and a reform agenda. India should review its FTA policy boost exports and curtail unnecessary imports; as well as inverted duty structures. India needs a light-touch industrial policy by selecting 8-10 strategic industries to promote- but with an export-oriented incentive structure not just protect domestic markets. Port-led development (revisit EPZ's) could be pursued more aggressively. Many countries have used trade agreements to induce domestic reforms - India could do the same with RCEP - if it has clear objectives to enter GVC's, but without that RCEP could prove harmful to Indian industry in the short run. Instead of setting up huge new bureaucratic structures - as is being proposed in the HLAG report it may be easier and more cost-effective to add trade promotion offices to India's embassies abroad and consider how best to establish a strategic trade office reporting to the PM. It must also address the real exchange rate appreciation    - which taxes exports and subsidizes imports. This is more effective than import tariffs - which must be used very selectively.

5)New Tourism Initiative "Swagat India" : 

Tourism and related mobility services can be a huge source of job creation for India as India is a major under-performer in this key area, with less than 10 million visitors (not counting NRI's). India could more than double these to 20 million if it pursues this goal through a "Swagat India" campaign to match a "Swatchh Bharat" campaign.  But India will need to focus on tourism infrastructure, air and water pollution and safety-related issues. 

6) Direct Tax Reforms - build on the Corporate Tax Cut

The corporate tax cuts are welcome - and global experience shows that their short-term revenue effects are often exaggerated and more than made-up in the medium term. There is now a clamor to cut personal income taxes to boost demand. Instead of ad-hoc changes - such as the increase in exemption to Rs 5 lakhs announced last year - it would be better to have a more comprehensive reform based on the expert committee report which would widen the base and provide the right level of progressivity and international benchmarking.  

7)Consummate Strategic Disinvestment and Open Up FDI even further :

 The GOI's plans for strategic disinvestment and targets for disinvestment income are ambitious but laudable. Even partial disinvestment improves PSU performance - as it has to follow listing requirements. But achieving these targets by mergers - as often done in the past - should be re-examined. The sale of the marquee Air-India will be seen by markets as a sign of resolve - its failure will once again put a huge question mark on the government's reformist intent. Follow-up in the next budget on even more aggressive disinvestment will also be critical. Questions are being raised about the proposed merger of MTNL and BSNL - which will cost $6 billion - rather than sale or liquidation. The decision to sell Bharat Petroleum, Container Corporation and Parts of Shipping Corporation - all told worth around $15 billion - will be a good test and will hopefully be done in a transparent manner.  India could also further ease FDI into the country - with more relaxed financial requirements. 

Concluding Thought- Get Ahead of the Curve: 

Many are predicting that the downturn is cyclical - they may be right. In any case the base effect, and the lower interest rates (despite the poor transmission) may help stem the decline to some extent. But it's possible as Fitch and other rating agencies, and now even the RBI are predicting that the down turn maybe prolonged at least until 2021. India should prepare itself for another slow year. No amount of temporary demand booster will help as it will be just that - a temporary boost. 

The Finance Minister Nirmala Sitharaman's - who basically inherited the previous budget - has promised to do more in the upcoming budget. Given that the last budget was poorly received - and the FM had to take on a series of quick strikes to address the disappointment this time it would be better to get out in front and announce a set of coherent, comprehensive bold reforms along the lines outlined above. It would also be wise to stick to a glide path of fiscal consolidation to leave more financial savings for the likely recovery in private investment - which can be further encouraged by bolder reforms to accompany the corporate tax cut. Small tweaks and fixes will no longer be enough.

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