Fixing the growth puzzle

Cyclical responses won't fix the structural constraints, and structural reforms don't address a cyclical slowdown

GDP growth slowed to a six-year-low of 5 per cent during the April-June quarter, which is weak, no matter how it is sliced or diced. Private consumption demand was hit hard, investment remains lacklustre, and export growth has slowed. This raises two issues: Reasons behind the slowdown and the solutions.

Is it cyclical or structural?

The slowdown is partly cyclical and partly structural. The cyclical slowdown is only a year old, but the structural (trend) slowdown has been ongoing for five-ten years. 

Two cyclical factors have contributed to the growth moderation over the last year: Shadow banking stress and weaker global demand.

For shadow banks, access to funding has not yet fully recovered and, while funding costs have declined for most, there is still credit risk differentiation. This has hurt sectors that are dependent upon shadow banks, such as small and medium enterprises, consumer lending, and real-estate developers.

Similarly, the synchronised global growth slowdown has spilled into the domestic economy via export and manufacturing channels.

However, there is also a structural element to the current downcycle. India's investment-to-GDP ratio has been declining since 2012, and productivity growth has stalled. This suggests that the trend growth rate has declined. 

Among other factors, the peaking of the financial (credit and housing) cycle and corporate balance sheet deleveraging cycle have resulted in lower investment demand.

In addition to cyclical and structural forces, the timing of some of the policy changes, which are intended to benefit over time, have made the process of deleveraging tougher. For instance, the goods and services tax, demonetisation, measures to curb corruption, and the move to flexible inflation targeting led to a combination of lower inflation, higher real rates, and lower nominal growth. As nominal expectations are reset lower, the transition is tougher for debtors.

The cyclical fix

Cyclical slowdown calls for a counter-cyclical policy response. Weak GDP growth suggests the negative output gap is larger than anticipated, which should open more space for monetary policy easing, given low inflation.

On the fiscal front, if budgeted targets are met, then the fiscal impulse to growth will be negative, even after accounting for off-balance sheet borrowing, due to the weak state of the business cycle.

This does not mean that a fiscal stimulus should be announced because increased borrowing would raise the risk-free interest rate and partly negate policy transmission. At this stage, the government should frontload its spending, because that would be an ideal response to current weakness in private demand. If the slowdown persists or deepens, only then should a counter-cyclical fiscal stimulus be considered. 

Liquidity is most important. The shadow banking crisis has increased financial-stability risks. While positive liquidity does not directly address the confidence issue, it is still necessary to ensure the financial system does not choke.

Illustration by Ajay Mohanty

Excess liquidity will slowly lead to a chase for higher returns and will narrow spreads across the risk spectrum. Faster transmission via the banking system requires both positive liquidity and healthier balance sheets. Until financial stability and growth risks are clearly averted, the central bank should provide a guidance that liquidity will remain in surplus.

The good news is that the shift to surplus liquidity is finally aiding faster policy transmission and the cumulative effect of monetary policy easing should aid a recovery in the growth rate cycle in coming quarters, unless the US economy falls into recession. 

The structural fix

Lower interest cost can help the leveraged corporate sector, but monetary policy is not the answer to reversing a structural "trend" slowdown.

To reverse investment slowdown and attain higher sustainable growth, a key question is: What should be India's growth model? 

India, unlike the Asian tigers, cannot rely on exports alone, given deglobalisation trends. Instead, a multi-pronged strategy is necessary, including: 1) fast-tracking infrastructure investments; 2) raising export market share via competitiveness; 3) attracting global value chains that are shifting away from China; 4) prioritising domestic production over imports; and 5) leveraging sectoral strengths.  

Six priorities will help achieve these objectives

First, law and order lies at the core of a rule-based society. Encroachment in cities, delays in land acquisition, cost overruns, etc are common complaints. Judicial reforms and ensuring timely contract enforcement are important. Compliance with the law should be made easier, while non-compliance should be tougher.

Second, financial-sector reforms need a push. We need to strengthen existing entities (shadow banks and public-sector banks), but we also need more instruments, more players, and deeper capital markets.

Third, to boost productivity and raise efficiency, bureaucratic reforms are a starting point. Tax simplification (direct tax code) and continuing down the path of factor-market reforms are medium-term necessities.

Fourth, to address funding constraints and dearth of risk capital, asset monetisation and privatisation are an option. Reorienting general government spending from consumption to capex is another. The domestic savings gap and the global environment (of low rates and low growth) all argue for tapping foreign capital both for unlocking stuck projects and greenfield investments.

Fifth, the business model of small and medium enterprises has to be scaled up by addressing the constraints that lead to threshold effects (smaller size). Leveraging technology to link small entrepreneurs to the final consumer is an option. 

Finally, many sectors in India have huge potential and there should be a bottom-up strategy to maximise their potential. These include agriculture, food processing, tourism, small cars, motor cycles, medical services, gems and jewellery, and clinical research.

To summarise

India's growth slowdown is both cyclical and structural. Cyclical responses are already in place. They will lift the cycle and create the space to implement structural reforms. However, cyclical responses cannot fix the structural constraints. Let us not mix the two.

Sonal Varma is Chief Economist (India and Asia ex-Japan), Nomura