Indian Economy Since 2014

The Bhartiya Janta Party (BJP) swept to power in 2019 on the back of a perhaps then-achievable goal: to make India a $5 trillion economy by 2025. The outbreak of COVID-19 in the country as well as across the globe has perhaps put that dream to rest. But was that dream ever attainable? Maybe not. Even before COVID-19 began spreading across the world, India faced a combination of structural and cyclical challenges, including a massive slowdown due to the bursting of a credit bubble (remember IL & FS?). The main issue, perhaps, is the decrease in consumer and investor confidence in the country.

What do the numbers say?

In the final two quarters of FY 2018-19, GDP growth numbers came in 4.5% and 4.7% respectively, the weakest GDP growth numbers the country has reported since around 2013. Overall, the annual growth rate of 6.1% was much lower than the previous year growth of 7%. The growth of consumer goods production has virtually ground to a halt, while the production of investment goods started declining too, with its worst showing in the last five years. The unemployment rate in the country had reached an all-time high of 8.5% in October 2019, before slowing to about 7.8% by January 2020. Indicators of exports, imports, and government revenues have all either declined or are extremely close to showing contraction. With confidence tanking, total investment declined to about 31% of GDP in 2019 (after peaking at about 40% of GDP in 2011).

What has gone wrong?

Food harvests are robust. Fuel prices haven’t gone bonkers like they had in 2010. The fiscal deficit has somehow remained in control. In fact, the government has taken many steps to revive growth. It introduced a large corporate tax cut to revive investment, and has been pushing plans to privatize the country’s major PSUs. On the monetary side, the RBI slashed interest rates by a total of 135 basis points in 2019. However, lending and investment are still extremely low. The major problem grappling the economy is that its two major key drivers, exports and investment, have decelerated, while consumption and credit stimuli have perhaps run out of steam.

Long, long ago…

Let us go back to 2000, the period after which India’s economy truly began to stir, and trace exactly what went right and more importantly, what went wrong, to understand how we have reached where we are today. Following the dotcom bubble, the world economy experienced a period of rapid expansion, growing at its fastest pace in four decades. Firms and consumers, awaiting the payoff from the post-1991 reforms, heralded India as ‘the next China’. A surge in global demand resulted in a boom for India’s exports. This resulted in increasing optimism in the country’s future, which encouraged investment, much of which was focused in infrastructure projects. This investment boom was largely aided by an expansion in credit. In 3 years, the non-food credit in the country doubled, with FY 2007-08 alone seeing capital inflows over 9% of GDP. GDP growth even neared the 10% mark.

The first Twin Balance Sheet crisis

The Global Financial Crisis caused the world economy to grind to a halt, with trade being hit particularly hard, resulting in the collapse of India’s export growth collapsed to 5% (it was growing at levels of about 15% before the GFC). The collapse of global commodity prices further damaged farm incomes, while domestic investment projects started going bust. A combination of slow growth, high interest rates, and a severely depreciated rupee wreaked havoc on firms’, with the cratering of profits hurting their ability to repay loans taken during the boom. These two engines of India’s growth flattened, with investment growth slowing down sharply 2010 onwards, while exports decelerated around 2012. This brought on the first wave of the Twin Balance Sheet crisis plaguing the economy, arriving after the infrastructure projects taken up during the investment boom began to sour, damaging firms as well as the banks which had provided loans to these infrastructure companies.

Bad things come in twos

Despite this, the economy continued to grow, even in the face of adverse shocks such as GST and demonetization, via a combination of exports, hidden fiscal stimulus, and an unexpected credit stimulus. As world demand recovered, and the rupee depreciated further, exports saw a gradual uptick following 2017. Along with this, a fall in international oil prices resulted in income gains which was translated into an increase in the “hidden” fiscal stimulus (basically, the government shifted its borrowings off the budget and onto the balance sheets of PSUs such as FCI and NHAI).

Credit was perhaps the most surprising and robust pillar of recent growth. This growth in credit was largely via NBFCs, which had become an important source of credit after traditional banks, which were still struggling from bad loans accumulated after 2010, restricted their lending. Instead, they loaned their money to nonbanks, who then further lent out the money at a higher rate. Much of this NBFC lending had been channeled towards the real estate sector, which was already in a fragile situation. Aggressive launching of projects in the mid-2000s by developers, who assumed that the emerging middle class would want better homes, was hit heavy by the GFC which had cratered demand. Not only did projects remain unfinished, it resulted in the piling up of a huge inventory of unsold houses. Cutting prices seems like a straightforward solution to tempt buyers, but is not practically feasible as lower prices would decrease the notional value of the collateral (the homes themselves) which the developers had pledged in order to secure their lending. The failure of IL&FS not only resulted in the crash of a behemoth with a loan pile of Rs. 90,000 crores, but made everyone take a closer look at the NBFCs.

This has resulted in the onset of a second Twin Balance Sheet crisis, resulting in India facing a Four Balance Sheet challenge, with banks, NBFCs, infrastructure firms and real estate companies all in the mix. The country is now trapped in a vicious circle, where risk aversion and loss of confidence has led to high-interest rates, which will further depress growth and ultimately increase risk aversion.

The big bad banking problem

India’s banking sector is heavily saddled with non-performing loans, with public banks in particular bearing the brunt of it. NPL ratios have more than doubled over the past five years, jumping from around 4% to more than 9%, and the debt issues have caused a huge shortage of credit, resulting in a slowdown of loans to small businesses and consumers, causing these sectors to slow. The lack of credit has resulted in consumers holding back on purchasing automobiles and residential property, with car sales hitting their lowest-ever level in the third quarter of 2019.

Tackling the TBS problem

The government has tried to attack the TBS problem in many ways. It has injected about Rs.2.8 trillion in the past five years into public sector banks. These capital injections have allowed banks to write off over Rs. 7.2 trillion of their bad loans loans since 2014, slashing their nonperforming asset (NPA) ratio by 2%.

The Insolvency and Bankruptcy Code (IBC), introduced in December 2016, aimed to resolve loans promptly and commercially. However, it has been much slower than initially expected. While the law states that cases must be resolved within a maximum of 270 days, completed cases have actually taken an average of about 409 days to be resolved. Progress is naturally even slower in the cases accounting for the major chunk of the bad loans. It has been over 2 years since the RBI referred 12 large debtors to the IBC, but by now only half of these cases have been resolved, most of which were in the steel sector.

What’s the way forward?

Monetary policy cannot revive the economy because the transmission mechanism is broken (cuts in the repo rate by the RBI are not being translated into cuts in bank lending rates, who are increasing risk premiums). Fiscal policy cannot be used because the financial system would have difficulty absorbing the large bond issues that stimulus would entail. The traditional structural reform agenda – land and labour market measures – are not suitable for addressing the current problems.

A further reduction of corporate tax rates, especially on new investments, may incentivize foreign investment. Fiscal measures such as the removal of the dividend distribution tax would result in an increase private sector savings, some of which will perhaps be translated into investment. Incentivizing manufacturing firms to reinvest such savings to substitute imports and integrate the country into global markets and supply chains will go a long way in reviving growth in exports.

Simplification and streamlining of the income tax code would result in higher domestic savings, which would aid domestic consumption. Rural consumption can be targeted via an expansion of schemes which result in direct cash transfers to a targeted section of the population. Spending on rural roads, irrigation, warehousing, and transportation, would increase domestic incomes by raising demand for low-skilled labour while also improving the long-term productivity of the economy.

Most importantly, the government needs to encourage banks and NBFCs to increase lending. The IBC perhaps needs changes to result in swifter resolutions. The creation of a bad bank, one each for the real estate and power sectors, could aid this process. The asset quality review of banks and NBFCs should be revamped to strengthen oversight, especially of NBFCs.

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