Past policies constrain economic recovery

Sorting out the flaws in GST, exchange rate depreciation and avoiding fiscal slippages should be the top priorities for the government

Ever since the publication of the 2017-18 Q1 national income estimates by the Central Statistics Office (CSO) on August 31, the media has been buzzing with commentary and debate on the decline of growth in Gross Domestic Product (GDP) at market prices to below 6 per cent. Both inter and intra political party debates have heated up on the causes of the slowdown and the need for correctives. The government too seems to have at last woken to the gravity of the situation. It is mystifying as to why this all-round concern and debate was not sparked four months earlier, when the 2016-17 Q4 data were released. After all, as I pointed out in my article “Economic slowdown and revival” (Business Standard, August  10, 2017), the May 31 CSO press note clearly showed that the growth of real Gross Valued Added (GVA) had shown “steady and sizeable decline” from 8.7 per cent in 2015-16 Q4 to 5.6 per cent in 2016-17 Q4. GVA is almost identical to “GDP at factor cost”, the concept most commonly used to track economic growth until 2015 when the new GDP series was started. And the GVA number for 2017-18 Q1 has remained unchanged at 5.6 per cent. Indeed, it is significant that the entire first half of calendar 2017 has recorded only 5.6 per cent growth in GVA. And that too is probably an overestimate, since early national income estimates have the least direct information on the informal/unorganised sector, which was disproportionately hit by the November 2016 demonetisation (henceforth Demon).

Before outlining recommendations on what should (and should not) be done to foster an early growth recovery, it is useful to understand the background and causes of the recent slowdown. First, on background:

• The exceptional 8.5 per cent plus average economic growth of 2003-4 to 2007-8 was mainly fuelled by the fruits of wide-ranging reforms of the Vajpayee government of 1998-2004 and the liquidity-propelled global boom of 2002-07. In the absence of comparable global growth and of a strong tailwind from earlier reforms (the Gandhi-Singh government of 2004-14 did little by way of reform), India’s potential, sustainable growth (with reasonably good policies) is probably around 7 per cent, if not lower.
• True, the unprecedented fiscal profligacy by finance ministers Chidambaram and Mukherjee in 2008-9 to 2010-11 achieved an extra couple of years of high growth, but at the cost fuelling a long bout of record high consumer inflation and a mini balance of payments crisis in 2013. Growth in 2012-13 and 2013-14 slumped to average below 5 per cent, according to the old national income series, and below 6 per cent, according to the new (using GVA as the yardstick).
• The subsequent pick-up in GVA growth in 2014-15 (7.2 per cent) and 2015-16 (7.9 per cent) is mostly attributable to the large terms of trade windfall that India enjoyed as international prices of oil and other commodities crashed in late 2014 and 2015 (estimated at 1-1.5 per cent of GDP). The pace of economic activity might have also been spurred by an improvement in business confidence after the Narendra Modi-led Bharatiya Janata Party and its allies won a substantial majority in the Lok Sabha in May 2014, but it is not reflected in the rate of economy-wide gross fixed investment, which fell from 31.3 per cent in 2013-14 to 29.3 per cent in 2015-16.

Illustration: Binay Sinha

Against this background, the principal proximate causes of the recent economic slowdown have been:

• The vanishing of the one-time terms of trade windfall from the commodity price tumble.
• The ill-advised, ill-timed and badly implemented Demon shock of November 2016, which slammed production and employment in the cash-intensive unorganised sector, including nearly all small producers of goods and services, and which had deleterious feedback effects on the organised sector. Estimates suggest a negative impact at 1-2 per cent of GVA growth over the three quarters of October 2016 to June 2017.
• The significant overvaluation of the rupee over the past 18 months, which discouraged both exports and import-competing production.
• The increasing, cumulative drag of the unresolved “twin balance sheet problems” of (mainly) public sector banks and borrowing corporates on credit, investment and growth.
• The transitional stresses of the poorly-designed and weakly implemented Goods and Services Tax (GST) initiated from July 2017. These stresses have been especially severe for small businesses (including many exporters), already reeling from the Demon shock.

So, drawing on the above, what can be done to boost economic recovery in the short-run? The challenges are daunting and the prospects highly constrained by the past:

• There is no new terms of trade windfall in sight. Demon has happened and the economy just has to grin and bear its toll.
• The overvaluation of the rupee can and should be corrected as soon as possible. There are some signs that the government and the Reserve Bank of India (RBI) are waking up on this.
• Work on resolution of the twin balance sheet problem is proceeding but it is likely to be a long and arduous process, before credit growth and investment demand rebound. Simply telling banks to lend more won’t help and may even compound the problem.
• Sorting out the flaws in design, software, procedures and administration of the well-intentioned GST reform is a paramount government  priority. It is heartening that top echelons of the government are “seized of the matter”. The task is not easy and significant growth-retarding effects of the GST are likely to continue for several quarters.
• The clamour for more “fiscal stimulus” is wholly unjustified in a context where state finances are weak, the centre’s fiscal deficit is on track to exceed the budget target by more than half a per cent of GDP and the revenue yield of GST is hugely uncertain. With the current account deficit in the balance of payments rising sharply, the so called macro-balance “fundamentals’’ are flashing amber. The RBI has rightly warned against more fiscal stimulus.

All things considered, and if action along the above lines is taken swiftly, GVA growth might recover to 6-6.5 per cent by the final quarter of 2017-18. As for the RBI’s recent projection of 7.7 per cent by 2017-18 Q4, hope has clearly trumped realism.

The writer is Honorary Professor at ICRIER and former Chief Economic Adviser to the Government of India. Views are personal