With the world’s greatest democratic election exercise delivering a decisive victory favouring another term for Prime Minister Narendra Modi, it is time to get back to addressing the economic agenda. India’s economic health isn’t as bad as the opposition talking heads would have everyone believe, but it still warrants swift corrective policy action on multiple fronts.
Modi-led NDA-1 underestimated its dysfunctional economic inheritance and overestimated its own ability to fix things swiftly. Luckily, the significant decline in international crude oil prices was manna from heaven in the early years of the government. It substantially eased the pressure on India’s twin deficits, offered a potential booster for growth, and created policy flexibility to potentially focus on reforms that would strengthen and speed up India’s economic evolution.
However, the macro backdrop now doesn’t offer that flexibility. Still, the unwavering focus should be on addressing the cyclical and structural factors behind the recent downshift in growth that go beyond election-related uncertainty. A spike in international crude oil prices could still alter the still-palatable landscape of external imbalances. However, the best the policymakers can do is to ensure policy flexibility, including by enhancing export competitiveness and moving up the value-added segments, ensuring reliable long-term stable financing of the current account balance, and perhaps even reserving some fiscal firepower as insurance, if it is needed to absorb any oil price shock.
The Indian economy in recent years has been like a big truck with a messed-up gearbox. Several parts can be replaced, but a shift into higher gear is unlikely if the gearbox isn’t fixed. And fixing it requires nursing the asphyxiated banking system to breathe again. The NDA-1 had a delayed start on fixing this problem, and despite some unprecedented and admirable regulatory reforms, the pace of healing remains glacial.
India is a reformer’s delight because there is so much to be done. The new government will have to address several challenges, including sagging economic growth, low employment generation and weak employability, structural distress in agriculture, a fiscal ledger that is worse than it appears, unfinished agenda of delivering low and stable inflation over the medium term, unshackling factor markets (land, labour and capital), administrative reforms, and ensuring adequate internal resources for financing sustained growth acceleration. The government will have its hands full with all of the above plus some more, but the immediate macro focus should be on the trinity of growth, fiscal and inflation without risking macro-prudential stability.
The GDP data for the March quarter due at the end of this month will refocus attention on the deceleration in growth. Growth probably eased to around 6% year-on-year, a disappointing outcome that will also be slower than China’s 6.4% in the same quarter. The moderation has been broadening in recent quarters and a quick turnaround in 2019-20 that everyone assumes is a forgone conclusion is wishful thinking, in my opinion. To be sure, growth in the current fiscal year won’t be significantly better than the 7%-mark in 2018-19; it could actually even be a shade softer, if corrective policy action is delayed. The strength in domestic demand is poised to moderate further while the “pull” from external demand will soften given the worsening global backdrop. Private consumption is weakening because of both cyclical and structural factors, and investment recovery is patchy and has yet to turn up in a sustained manner.
The combination of risk aversion, hit to confidence, and the liquidity squeeze triggered by the NBFC fallout exacerbates the headwinds for growth. Investors also continue to underestimate the short-term adverse impact on capex and economic growth of the business models in several industries undergoing favourable changes from the old ways of doing business that facilitated corruption. These will take time to pay dividend.
Unlocking the growth potential requires more than just fiscal stimulus and policy rate cuts. It is high time for Modi to rely on his strong mandate to unshackle factor markets (land, labour and capital) to enhance their efficiency and mix to boost growth and employment. An ironical feature of India’s economic evolution—it also contrasts with the experience of other Asian emerging economies—is that end-product markets have been reformed substantially but factor markets haven’t been a key focus. This has to change to increase the speed limit on growth without stoking the fear of sharply higher inflation.
The first policy focus of the new government will be the full Union Budget for 2019-20. The Interim Budget’s spending initiatives will likely be broadly unchanged, but its arithmetic needs to be adjusted to make it more realistic to inspire confidence in achieving the fiscal deficit target of 3.4% of GDP. It is easy for politicians to favour fiscal stimulus when growth is slowing (the pressure will increase if the monsoon disappoints), but India’s true fiscal picture offers little scope for additional boost to aggregate demand. Admittedly, there is still uncertainty about the size of the transfer of excess capital from the Reserve Bank of India (RBI) and how it’ll be used; it could ease the funding constraint.
To be sure, the actual fiscal support to the economy is far greater than what is generally acknowledged, but that still hasn’t prevented growth moderation. Total borrowing by central and state governments, and public sector companies stands at an elevated 8.5-9% of GDP, constraining the available firepower for a strong revival in private capex. Off-budget borrowing only masks the underlying fiscal support to the economy. That might facilitate escaping fiscal scrutiny, but it, along with the pressure of other borrowings, asserts itself in the unfavourable dynamics in the bond market, as has been the case in the last several months.
It is the consolidated fiscal position (states’ deficits have offset the improvement in the central government’s fiscal deficits) and the total public sector borrowing that matter for macro management. Indian policymakers, including the monetary policy committee (MPC), routinely ignore these important metrics. In the interest of transparency, the government or RBI should clearly state and comment on the total borrowings by the public sector.
Good news on inflation cannot be based on a depressed agriculture economy. Also, the government has work cut out to ensure low and stable inflation over the medium term. While the current headline inflation isn’t a problem, there is still no effective institutional mechanism for managing food inflation in case of supply shocks. Such a framework would inspire confidence that potential spikes in food inflation won’t adversely impact inflation expectations. Even at present, questions about food price dynamics create uncertainty about the outlook for headline inflation over the next 1-2 years.
Headline CPI inflation remains well below the medium-term target of 4%. Food inflation has risen, as widely expected, but core inflation has edged down, in contrast to the fearmongering by some. That should pave the way for a 25bps cut in the repo rate, preferably in June than August. Beyond the anticipated rate cut, the MPC would need to see downward revision in the 1-year ahead inflation forecast to ease again.
India is far from being done with the macro reforms needed to ensure real GDP growth of 8-10% annually with low and stable inflation, and manageable external imbalances. It is time to avoid bluster and policy adventurism, and to use the strong political mandate to script the economic rise expected, and voted for, by aspirational India.