Business Line, November 3, 2019
Slowdown: Aligning responses to causes
There is a need to address immediate issues, such as collapse in credit following the NBFC crisis. A fiscal boost is also needed
Many of the controversies on responses to the current economic slowdown can be traced to ideological positions that obscure a clear diagnosis of the causes and the required alignment of policy.
Different ideologies
The Rightist view is that the cause of the slowdown is inadequate reforms, and the solution is more reforms. Since the ideology says that markets work, any slowdown is due to impediments (largely created by the government) that need to be removed. So the cause is structural and the solution is also structural. Since remedies proposed are largely supply-side and long-term, they cannot reverse a demand-led slowdown that can become entrenched and persistently lower potential growth.
A remedy the Economic Survey proposes, for example, is to raise exports. But this is difficult to do during a global slowdown, and is not going to give quick results. The data clearly shows the slowdown since 2018 is due more to a consumption slowdown than an export deceleration. Then why not address the immediate cause?
The Leftist view is that transfers to the poor are inadequate and the solution is more transfers, since the poor have a larger propensity to consume. The MGNREGA and PM-Kisan schemes have been pumping money into rural areas without visible effect. The call is for more of the same, financed by taxes on the better off. But reforms just got India out of a stagnation caused partly by high taxes. They go on to suggest structural causes such as a rise in inequality on a market-led growth path that has slowed job and income growth and emasculated consumption. But market reforms have been going on for 30 years now. Why would it lead to a slowdown in 2018 specifically?
It is necessary to identify and respond to the immediate causes of the slowdown. It is also necessary to distinguish between short-run polices that act on demand and long-run policies that improve supply. The market view neglects demand and the Leftists neglect long-run supply capabilities. Demand stimuli consistent with reform need to be identified and implemented. Reform measures that improve consumer and investor sentiment need to be acted on first; those that impose short-run costs can be avoided for now. Corporate tax cuts with removal of exemptions are an example of the former. They are also strategic, since they increase opportunities for India with respect to the current US-China trade war and decoupling.
Immediate causes
Real interest rates became high as inflation fell with soft oil prices after 2014, but nominal rates were not lowered adequately. Liquidity conditions became extra tight in 2018, because foreign outflows were not compensated for. After the 2015 AQR (asset quality review), lending from banks slowed. NBFCs picked up the slack propelled by all the liquidity coming into the formal financial system after demonetisation. As a result, output growth remained robust until mid-2018.
But with the problems in IL&FS in the second half of 2018, extreme risk aversion set in and credit to NBFCs slowed. They lent long-term on the basis of short-term borrowings, and were particularly vulnerable to rollover risk. Since they had no access to a liquidity window, even the better NBFCs began hoarding credit, resulting in a large fall in credit growth. Both consumption and investment slowed. Export growth also fell due to global slowdown and excessive appreciation.
India’s dependence on oil imports also rules out too much currency depreciation. Therefore, export competitiveness must come largely from long-run supply-side reforms that lower costs of doing business. The limit to depreciation implies domestic demand must take priority in the short term. A conservative squeeze on domestic demand since 2011 has already hurt domestic industry, jobs and investment and led to over-reliance on imports. While macro-economic stability is important, policy must also be counter-cyclical.
While interest rates are coming down and durable liquidity is in surplus, not enough has been done to revive credit delivery and compensate for the drying up of formal and informal channels. Complaints continue of poor liquidity in rural areas. M3 growth has not risen. Only banks have access to the RBI liquidity, as lender of the last resort. Relying on them to provide liquidity to other institutions has not worked well, since they have become extra cautious. More AQRs will not add much, since asset quality is dynamic, and only staunching the negative spiral can prevent further deterioration.
Linking the cures
The view that the slowdown in consumption is a result of slow income growth, and that consumers have borrowed too much and have therefore retreated, too does not explain the recent credit and growth slowdown. Wage growth has been slow since 2012. It rose sharply only during the high-growth period in the mid-2000s. An alternative explanation is the breakdown in inclusive credit supply-channels; more likely, since the slowdown directly followed snapping of such channels. Credit share and growth in India is much below other peer economies.
It follows that liquidity windows and refinance based on good collateral or effective restructuring based on market principles, as well as bridge financing to complete viable housing projects, are more likely to revive confidence. Surplus has to continue for some time — with complementary policies — to counter the long drought. Government spending, transfers and tax cuts can also help put money in pockets.
There is a view that interest spreads continue to be high because government borrowing is high relative to shrinking household savings. But savings are not a constraint, since there is excess cash with firms — households are not the only source of savings now. In the past, savings have risen with incomes. If the combined fiscal deficit is too large, it should be creating excess demand. Why is there no inflation? Why is income growth slowing? Spreads are more likely high due to rise in credit risk. If so, fiscal-monetary stimulus by reviving activity can help reduce the spread.
Even then, to restrict the government borrowing requirement, fiscal stimulus should largely come through fiscal restructuring. The share of spending that has higher multipliers, such as infrastructure (railways if roads are slowing), low income housing, and other non-tradable goods — including health and education facilities — should rise. Funds can be raised by asset sales, cutting unproductive subsidies, and tightening up administrative processes. Tax cuts must be accompanied by a reduction in exemptions.
Rural pluriactivity, which is anyway rising, must be further encouraged to raise rural incomes. The rural real wages rise during the mid-2000s was not based on productivity and thus sustained food inflation, since demand for food rose at a time when its supply was constrained. These constraints have relaxed and a rise in rural incomes would now support growth and counter the liquidity squeeze. But to be compatible with reform, it should come through asset creation, empowering expansion in local heath or education facilities or transfers such as income support schemes compatible with the WTO; not through a distorted rise in prices.
Land and labour reform should focus on legal and administrative simplification, encouraging competition and coordination among States, using technology to create databases of vacant land and property titles. Supply-side improvements with compatible short-term demand boosts would complement each other and sustain growth.
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