Economic Reforms: A cleansed economy needs a new credit cycle

Published: February 1, 2020 1:03:22 AM

The cleansing of the economy and financial system will have a substantially positive impact in the longer term. However, the near-term impact is deflationary.

economy, epfoEPFO has over 60 million employees on its payrolls.

By Prasenjit K Basu

The Indian economy has decelerated sharply in the past year. But, there is unnecessary confusion about the degree of deceleration. Revenues from GST are up 10.5% year-on-year (y-o-y) in April-November 2019—disappointing, but not indicative of a meltdown.

The trope about a “45-year-low unemployment rate” is being trotted out, although this refers to an NSSO survey for 2017-18. Unlike the gauge of unemployment in most economies, which begins by defining the labour force (those “willing and able to work”), and then measuring the subset of the labour force that is unemployed, the NSSO merely asked all respondents the question “are you employed?”—a thoroughly unscientific approach that would normally be laughed at by serious economists.

There is ample data on net new employment in the organised sector, as measured by the Employee Provident Fund Organisation (EPFO) for firms with over 20 employees. EPFO has over 60 million employees on its payrolls. In FY19, net new employment in the organised sector was up a further 6.11 million. Data for the April-November 2019 period shows a further net increase of 6.24 million in EPFO payrolls—a spectacular acceleration of organised-sector employment (with more jobs added in eight months of FY20 than in the whole of FY19). The surging organised-sector employment is a source of positive dissonance in an otherwise gloomy economic scenario. Either there is a surge of start-up companies whose economic activity is being missed by those measuring value-added, or the rising enrolment in the EPFO reflects enhanced “formalisation” of the economy.

There is a cleansing underway in response to the trifecta of anti-black money moves in 2016: the gazetting of the Benami Transactions (Abolition) Act in early September, the VDIS (Voluntary Disclosure of Income Scheme) at the end of that month, and demonetisation on November 8. In 2017, the introduction of the GST ensured that all transactions must be reported by both parties, making tax-evasion even more difficult.

The sharply-reduced scope for tax evasion arising from the 2016-trifecta has caused a drastic shrinkage in unrecorded transactions. The interstices of the economy—in construction/real-estate, agriculture and small-scale manufacturing—have seen financial flows contract sharply. The Real Estate Regulation Act (also passed in 2016 and notified by 2017) has added a further dose of formalisation to the greyest part of India’s erstwhile grey economy. The deflationary impact of these multiple shock therapies has been exacerbated by the operation of the Insolvency and Bankruptcy Code (IBC). The resolution of Essar Steel is the highest-profile of the recent successes of the IBC, contributing crucially to the 187% y-o-y increase in ICICI Bank’s profits in the latest quarter.

It is becoming clear to promoters that the IBC ensures they can no longer use public-sector banks as an endless source of borrowing—and escape consequences when their profligate borrowing results in business failures. Instead, promoters will lose their assets, including non-corporate assets offered as collateral for loans. While this cleansing of the economy and financial system will have a substantially positive impact in the longer term, the near-term impact is deflationary. Promoters think twice about new greenfield investments, the informal sector has shrunk, and a backlog of incomplete residential projects holds back new construction (a highly labour-intensive activity).

The July 2019 Budget proposed a rational counter to this deflationary outcome, led by a $10 billion sovereign bond issue, a Rs 70,000 crore infusion of capital into public-sector banks (after they had cleaned up their bad loans), and a support package for NBFCs. The sovereign bond issue was unfortunately shelved amidst a hail of criticism from leftist economists worried about India becoming another Argentina (or Brazil of the 1980s).
The critiques were ludicrous. India has never issued a sovereign foreign currency bond in the public markets. Consequently, there is no benchmark against which other Indian issuers can borrow in public international markets. And, the international rating agencies have no incentive to engage seriously with India, as the sovereign rating they issue for India is purely academic. The idea that India will go the “Latin American way” by becoming a serial issuer of sovereign bonds is absurd, since India is starting from zero, while Argentina has been a regular issuer for nearly two centuries—and runs into trouble like clockwork at least once a decade.
In Asia, on the other hand, regular sovereign issuers include South Korea and Indonesia; China issued over $6 billion of sovereign bonds in the months last year that saw red-hot debate in India about sovereign issuance! Moderate-sized sovereign issuance by a country with a low external debt to GDP ratio (like India or China) is perfectly rational.

The absence of extra funding from sovereign issuance, and tardiness of capital infusion into PSBs, led to a slump in bank credit growth (to just 7.6% y-o-y growth as of early-January 2020). The persistent sluggishness of bank credit has caused domestic demand to slump, with private consumption growing just 4.1% and fixed investment just 2.3% y-o-y in April-September 2019. The economy was able to eke out 4.8% growth because of strong growth in government spending (+12.3%), but also because of a strong turnaround in net exports (which improved 18% y-o-y).

With domestic demand weak, imports of goods and services declined 1.6% y-o-y while real exports increased 2.6% y-o-y in April-September 2019. Consequently, the current account deficit (measured in nominal terms) also declined to 0.9% of GDP in July-September 2019. Given the further improvement in the merchandise trade deficit in October-December 2019, the current account deficit is likely to have narrowed to 0.3% of GDP in that quarter, likely enabling 5% GDP growth in October-December 2019. The other trope that is repeated ad nauseum is that India’s exports have “stagnated since 2014”. In reality, India’s goods exports declined by 17.1% in 2015, primarily because refined-oil exports were over a fifth of India’s exports in 2014, and their value halved because of a slump in oil prices. At a time of sluggish global trade growth, India’s goods exports increase 5.9% in 2016, 12.4% in 2017, 10% in 2018 and 2.3% in January-September 2019 (based on the RBI’s data), while invisibles exports have steadily increased, rising by 36% between 2014 and 2019.

Unobtrusively the external sector is leading India’s recovery. But, it cannot carry the can alone. Sharply lower tax rates are boosting corporates’ net profits. The IBC is boosting banks’ profits, but they still need a further spur to get the wheels of credit turning. Steeliness in implementation is still needed, as it was last July.

The writer is former chief economist for India & South-east Asia at Credit Suisse First Boston. Views are personal

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