Sharp slowdown: Solutions will need to go beyond interest rate cuts

The gross domestic product (GDP) data, released by the National Statistics Office (NSO) last week, has surprised analysts. While most anticipated the slowdown in demand to reflect in the GDP data, no one expected the economy to expand just 5.4 per cent in the second quarter — a seven-quarter low. Economists at the Reserve Bank of India (RBI) are likely to be particularly disappointed, having projected a 7 per cent growth rate for the quarter in the October monetary policy review. With the economy growing only 6 per cent in the first half of the financial year, the RBI needs to revise its full-year growth projection of 7.2 per cent. During the second quarter, growth was constrained by the manufacturing sector, which expanded 2.2 per cent, year-on-year, compared to 7 per cent in the first quarter. Activity also slowed in the construction sector while the mining sector registered a contraction during the quarter. The agricultural sector, meanwhile, grew 3.5 per cent compared to 1.7 per cent in the same period last year.

 

A growth rate lower than expected has increased complications for policy managers and raised several questions. It is worth noting that this is the last GDP number before the presentation of the next Union Budget. Although the NSO will release the first advance estimate for this financial year in early January, the inclusion of additional information in these estimates would be limited. Economic performance in the first half of the year poses at least two big policy challenges. Fiscal management is the first challenge. Notably, nominal growth in the first half of the year was 8.9 per cent. The Budget projections for the year are based on a nominal growth assumption of 10.5 per cent. If the trend continues in the second half, the fiscal deficit in absolute terms will need to be contained at a lower level to meet the target of 4.9 per cent of GDP. This would mean lower government expenditure, assuming that revenue targets hold. According to the latest data, as of October, receipts of the Union government were at 53.7 per cent of the Budget Estimates. The comparable level last financial year was 58.6 per cent. On expenditure, while there is time to make adjustments, a slower pace of capital expenditure should worry policy managers. In the first seven months of the financial year, the government spent only 42 per cent of the allocation, which partly explains the slower growth.

 

The second policy challenge is to revive the pace of economic activity in a sustainable manner. Some economists believe that a pickup in government capital expenditure will help accelerate growth. The assumption may materialise to an extent in the second half of the year. However, the question is how long the Indian economy can depend on higher government capex for growth. Given the fiscal constraints, it would be difficult to push up capex consistently. The allocation is worth 3.4 per cent of GDP this financial year. To sustain higher growth, other drivers, particularly private investment, will need to pick up. From a medium-term perspective, external uncertainties will make things difficult. The victory of Donald Trump in the United States presidential election has increased complications. In terms of policy, pressure on the RBI’s Monetary Policy Committee (MPC) to reduce the policy interest rate will only rise. The MPC would do well to stay the course in its meeting later this week. A knee-jerk reaction can complicate matters, particularly given the latest inflation reading of 6.2 per cent. In any case, solutions to the slowdown will need to go well beyond token policy-rate reductions.