Why are Indian growth rates so volatile?

Since the global financial crisis (GFC), India’s GDP growth has become highly volatile. Periods of higher growth are disappointingly short. A sharp recovery following over-stimulus after the GFC collapsed in 2011 and in the over-reaction that followed macroeconomic policy became too tight. Double deficits and high inflation did require adjustment. But the focus shifted only to structural reforms, which were expected to make possible sustainable high growth. But the disappointing yo-yo pattern continues for eight years now, suggesting that structural reforms alone are inadequate — counter-cyclical macroeconomic policy also has to be enabled.

This year GDP growth has fallen to 6.8 per cent, the lowest in five years. That growth in each successive quarter is lower than the one before, reaching 5.8 per cent in Q4 FY19 (January-March 2018-19), indicates a deepening slowdown. This is not pre-election jitters, which will reverse by itself. 

The disaggregated picture confirms policy neglect. After a slump in end 2016, manufacturing revived in Q2FY18 with a sharp jump from -1.7 in the previous quarter to 7.1. A rise in private investment by the end of the year, for the first time since a brief spurt in 2014 led to hopes that the turnaround could be sustainable. The output of intermediate goods such as cement and steel grew with the government’s push in housing and infrastructure. But manufacturing growth crashed from 12.2 in Q1FY19 to 6.9 in Q2FY19. This was the quarter in which problems at IL&FS led to a contraction of credit from NBFCs. The growth in construction, trade and hotels all slowed down in that quarter. But policy rates were actually rising in this period, although the target CPI headline also collapsed to 2.2 in Q2FY19. Real interest rates reached 4 per cent. Recently released data from the high frequency NSSO employment survey shows unemployment increased in Q3FY19, but there was no response from macroeconomic policy. The first rate cut of 25 basis points came only in February 2019. Under this onslaught, growth in private investment reversed in Q4FY19.

The fiscal stance was also tightening. A 1 per cent fall in tax growth in 2018-19 compared to the previous year needed a 4.8 per cent fall in government expenditure to meet even the relaxed deficit target of 3.4 per cent of GDP. This fall was not compensated by the rise in private consumption growth of 0.7 and of investment by 0.7. This was the drag from fiscal consolidation. It appears government expenditure crowds in more private expenditure than a cut in taxes does.

US president Trump’s trade wars had set in a global slowdown, to which also policy did not respond. Data for the current period, as well as earlier episodes, shows a clear causal sequence. First domestic demand revives, then exports and finally investment. Although world demand recovered in 2017, Indian export growth remained slack. It revived somewhat in Q2FY19 after manufacturing growth did so, only to slow again in Q4FY19 as manufacturing growth had already slowed, as had world demand. World demand alone was inadequate to revive Indian exports. It appears domestic demand that improves manufacturing growth also helps raise export growth.

Since India is dependent on oil imports, there are limits to depreciation as a strategy to increase exports. The oil bill rises. Maintaining domestic demand is essential to keep factories humming. As they achieve economies of scale, they also export. The squeeze on domestic demand since 2011 and the appreciation — as relatively higher Indian interest rates attracted more foreign capital — hurt Indian industry as well as investment and turned us into a consumption and import-led economy. 

Increasing imports of consumption goods have also widened the current account deficit of the balance of payments in recent years.  

Although the government took immediate steps to turn around IL&FS in September 2019 RBI measures to address the spillovers to the financial sector, to other industry — to consumption, investment and growth were inadequate. No lender of last resort facility was made available to NBFCs and strangely market liquidity itself was actually allowed to tighten, so that market rates rose and NBFCs found it difficult to refinance loans, aggravating distress.

All this arose from the monetarist-market fundamentalist view that dominated macroeconomic policy-making. In this view, macroeconomic stimulus cannot affect employment, markets left largely to themselves achieve the best outcome, structural reforms only aim is to unfetter markets. Rescuing financial institutions and firms leads to moral hazard and wastes resources in zombies. Weak entities are best allowed to die. It assumes a unique full employment equilibrium without allowing for the persistent losses from continued growth below potential, and falling potential, that India has had to bear since 2011.

This view bound the government in a straightjacket FRBM that does not allow it to stimulate the economy in a slowdown. India adopted flexible inflation targeting but the MPC implemented it strictly, and did not use the space it had available to stimulate the economy, although government supply-side action reduced inflation. 

Now that inflation is in the target band and growth has slowed much below potential it must act fast with rate cuts using available space. The one year ahead real rate is at 2.5 when the neutral real rate is one. Increasing the share of durable liquidity can improve transmission and reduce market rates as can special packages for NBFCs.

Else the monetary-fiscal framework must be changed to allow a better counter-cyclical balance. Imposing more unnecessary growth sacrifice can lead to a political backlash. 

The author is member, Prime Minister's Economic Advisory Council