Why did the economy slow down for five consecutive quarters? Was it structural or cyclical? The government seemed in no mood to entertain any such question. The finance ministry’s ‘State of the Economy’ (October 24) presentation focused more on an impending “take-off”, implying thereby the slowdown was a temporary dip due to structural policies such as demonetisation and the goods and services tax (GST). The swagger was understandable—strength had finally been mustered to bailout public sector banks by issuing capitalisation bonds. Let’s hope normalcy soon restores, and these banks are ready to lend if and when investors return to borrow! That is where most analysts would now focus—when will lending resume? The economy is two-paced—few segments continued healthily, their credit demand increasingly met by the bond market, non-bank financial companies (NBFCs) and few leading private sector banks. Some of that credit demand may return to public banks in the first round. But that would be pure reallocation, a fight for the existing pie. From a macro perspective, we are keen to know when net credit demand for the economy as whole will revive.
The answer surely would depend on the pace of investment revival? And if you choose to swim with finance ministry’s views, then there is nothing to worry as elements for a sound macroeconomy are in place; just fasten your seat belts as growth is about to take-off! If you still harbour doubts—because views emanating from North Block need be taken with a pinch of salt—then listen to Mint Street, where RBI Governor Urjit Patel certified that these indeed are monumental steps; the last mile jigsaw puzzle related to banking sector has been resolved in sound macroeconomic conditions for the economy on other fronts. Shun naysayers, advised the prime minister, and prepare for the joy ride!
But not everyone agrees. For example, some monetary policy committee (MPC) members expressed reservations in their October meeting. Dr Chetan Ghate suspected potential growth might have fallen, pressing for continued structural reforms to address the productivity decline. Dr Pami Dua believed growth momentums were slowing, suggesting reviving investments. Dr Michael Patra from RBI was more forthright however—all indications, said he, pointed to deeper malaise in manufacturing and advocated bold structural transformation. The lone dissenter in the herd, Dr Ravindra Dholakia, was even less optimistic as he considered the negative output gap was widening and needed urgent monetary policy support.
What’s intriguing though is that most MPC members, including Governor Patel and Deputy Governor Viral Acharya, were pleading ignorance if the slowdown was caused by transient or structural factors, but strongly believed nonetheless that growth had bottomed out, recovery would start soon!
What should worry policymakers is that deceleration is caused by near collapse in manufacturing growth where capacity utilisation remains stuck at very low levels for several years, a sure sign the economy has been demand deficient and there is very little scope for fresh investments. Such an economy would desperately require fiscal and monetary policy support. Yet, the general consensus within the government and RBI, amongst analysts, a large section of the market and editorial opinions is that fiscal-monetary policies are appropriately aligned; there isn’t policy space to support growth. And therefore, it doesn’t matter if the slowdown is structural or cyclical—the policy response has to be more and more reforms! Dr. Patra put it quite succinctly, “The advocacy for a further reduction in the policy rate is essentially a case for lowering the cost of capital or the hurdle rate to a level at which a subdued or even declining internal rate of return (IRR) becomes viable. This is not a sustainable proposition and may even be self-fulfilling: chasing a deteriorating IRR will only lead to higher inflation and no investment.”
The counter narrative is intuitive—raise the bar on structural reforms to such levels that efficiency gains would push up IRR above the cost of capital.
Easier said than done! Its proponents should realise reforms do not happen in political vacuum; every major reform goes through a process of political churn. How realistic is it to expect a government in its last 18 months of tenure to carry out labour or land reforms? What Dr. Patra ought to have explained is that if IRR has remained low or even declined after three-and-half years of consistent reform efforts, how would more reforms alter investment prospects in the short-run? The best-case scenario, it seems is to stick to macroeconomic stability and hope that reform dividends eventually flow!
So, how soon would reform bonuses kick in? Consider some big-ticket reforms of NDA government: improved power supply but the sector suffers from overcapacity, inefficiency and high costs; coal, mining and spectrum auctions are waning; GST rollout has hit a rough patch with experts even raising doubts the design structure may need modification; NPAs’ resolution has gathered momentum, but there is still uncertainty about time it could take, while more NPAs accumulate. Record FDI inflows certainly helped salvage the dire situation to an extent, but manufacturing investments remain subdued.
But if dramatic improvements in ‘ease of doing business’ couldn’t spur animal spirits and business sentiments continue falling, we must look for a proximate cause. Does parroting the ‘structural reform’ mantra overlook cyclical factors underlying the growth slowdown? Unfortunately, very few are willing to ask if RBI and MPC were overambitious in achieving the 4% inflation target in a relatively short time-span, in a structurally rigid economy, and thereby contributed to killing demand more than the economy could withstand?
We had argued in these columns (January 2016) about how steep real rates for producers vis-à-vis consumers was a textbook case of putting money in banks than risk investment because of lower IRR. Then Governor, Raghuram Rajan in his ‘Dosa Economics’ speech, January 30 2016, had suggested that needn’t be the case; lower input prices, he said, had increased corporate profitability, value addition and hence, manufacturing growth. Unfortunately, few quarters down the line the table has turned; input prices rose sharply relatively to output prices, pulling down growth. To expect efficiency gains from reforms to offset losses from higher input prices in the short-to-medium term is a tall order. For growth to recover in such a scenario, this economy would desperately need higher and higher growth in volumes, which has been lacking all these years.
Therefore, it is imperative that policymakers acknowledge the economy is woefully short of demand. Evidence in support of this is strikingly visible in persistently unutilised manufacturing capacities, about 30%. However, authorities seem persuaded by CSO’s estimates of robust consumption demand, which will eventually increase utilisation rates. But this hasn’t happened so far and, there is no convincing case why it should happen in the forthcoming quarters. To the contrary, a prudent macroanalyst would have asked: How can sustained consumption growth and lower capacity utilisation co-exist over so many quarters?
Analyse its trends in the emerging macroeconomic context: Excess capacity in manufacturing emerged following the cyclical, domestic demand slowdown after 2011-12. Weak external demand since 2014-15 further exaggerated it. But this is also a period when domestic consumption, public investments picked up sharply from large terms-of-trade benefits and lowered inflation. If that was so, then these dynamics should have adequately covered the shortfall in external demand. Capacity utilisation hasn’t budged an inch however, remaining depressed through the cycle. When the pace of fresh capacity addition has been slower, then there is something amiss, creating doubt if consumption growth is being overestimated.
Analysts often pointed to healthy motor vehicle sales, air-traffic growth as early indicators of demand revival but did not bother questioning if these reflected concentration of wealth and incomes during years of high inflation. Instead of clutching on to every single indicator straw in hope, the MPC should seriously analyse if the new GDP estimates resulted in policy errors—by underestimating a negative output gap, thereby keeping real rates much higher.
One worries on reading comments of Dr Patra, a seasoned central banker and a considered MPC hawk—a vicious inflation spiral could be developing from higher input costs; petroleum product prices, exchange rate depreciation; and inflation expectations. Let’s hope the MPC critically analyses the underlying demand conditions, assigning greater weight to the output gap instead of hurrying to reverse the interest rate cycle.
The role and urgency of more structural reforms to raise potential growth is not being undermined here. But we must acknowledge these take time to raise efficiency, can’t be hurried through. Lessons from GST should not be lost as well—repairing a ship on sail is no mean task. The burden of a cyclical recovery must fall upon monetary policy if fiscal consolidation is constrained. In its absence, any prospect of a quick recovery is less probable. Capitalising banks solves only the supply side of the problem; banks would have to wait until the demand side is equally resolved.