India’s GDP growth dropped to 4.5% in the second quarter of 2019-20, which makes Modi’s goal to develop India into a $5 trillion economy by 2025 seem implausible. What are the main reasons for this drastic economic slowdown?
The reason for the slowdown lies largely in the financial sector. There was a boom in investment in the years prior to the global financial crisis. After the crisis, the Government of India took actions to stimulate the economy, and they succeeded in forestalling a slowdown. When the stimulus dissipated, many investments that were made during the boom period became unprofitable, especially those in infrastructure. Many of these investments were made by loans from public sector banks. As the banks’ bad loans mounted, they became reluctant to lend. At the same time, many corporations became disinclined to invest. This scenario is central to the broader slowdown of economic growth. The problems were compounded by several faulty government policy interventions; in particular, demonetization and the problematic implementation of the Goods and Services Tax (GST). It is in this context that the economic problems caused by the corona virus recently hit.
In your opinion, how much of the current crisis can be attributed to the policies of the Modi government (such as his signature reforms like demonetization and GST)? How much of it can be explained by other internal and external unfavorable factors?
Demonetization was an effort to eliminate what people who study Indian finance call “black money,” which is illicit money that comes from outside of the formal economy. The idea was that the government would suddenly invalidate all currency notes denominated in 500 and 1000 rupees. People could exchange their old notes for new ones denominated in 500 and 2000 rupees. There were two main problems with the policy. First, demonetization was based on the premise that most of the illicit wealth was held in currency; however, most “black wealth,” was not held in currency notes, so this policy was not able to capture much illicit wealth. Second, the government implemented the policy ineffectively. They didn’t have enough new currency available to replace the 86 percent of the currency that they withdrew from the economy. Consequently, the government ended up withdrawing large amounts of currency from the economy for an extended period. This imposed hardship on the many people who are dependent on currency-based transactions, whether it’s salary payments or daily purchases. Those suffering the most were from poorer socio-economic strata. Removing the currency from the economy ultimately limited the growth and contributed to the slowdown.
However, from a political standpoint, the policy was surprisingly successful. The Modi Government was able to frame the policy as targeting the corrupt and wealthy. In the spring following demonetization, there were elections in Uttar Pradesh, India’s largest state. Modi’'s BJP won an overwhelming majority. At least in the short term, demonetization appeared to be an economic failure but a political success.
Creating the GST consolidated a range of state taxes into a national value added tax. It involved a difficult set of negotiations between the central and state governments. It also required setting up a sophisticated software platform so that businesses across the country process could pay the transaction based tax on their sales and apply for reimbursement on their purchases. The government made the GST more complicated than was necessary by creating too many tax rates. It also set rates too high for the smallest businesses. Many of these businesses faced difficulties in completing the burdensome paperwork necessary for securing reimbursements. Finally, the government unduly rushed implementation of the new tax before the software platform was ready to efficiently process all the payments and reimbursements.
The problems were widespread and obvious to the public. Nonetheless, rather than viewing the implementation problems GST as showing the BJP’s poor judgement, many in the public perceived the BJP’s efforts to address the issues as demonstrating the government’s responsiveness to inevitable policy that arise when a complex new policy is rolled out. Though the political damage was mitigated, the problems of the GST struck a second blow to the economy that limited economic growth.
The overall global slowdown, without a doubt, reduces opportunities for India to export. But we shouldn’t let the global slowdown obscure the domestic factors, which I think are the most important contributors of the slowdown. To be precise, demonetization and the GST were significant short-term factors that compounded the longer-term structural problem in the Indian financial system that needs to be addressed.
The twin balance sheet problem has been a critical challenge facing the Indian economy in the past five years. How do Indian banks and companies contribute to the economic slowdown this time? What kind of constraints does the twin balance sheet problem place on domestic investments?
The twin balance sheet problem persists because of its underlying structural causes. These lie in the fact that India has a predominantly public sector banking system. This creates problems when the government tries to use the banks to achieve its policy objectives. If we go back to the boom years early in the 2000s and the effort of the government to stimulate the economy after the Global Financial Crisis, in both cases the government used the public-sector banks as means to direct investment into the infrastructure sector. Such “political uses” of public sector banking led to the bad loan problem, and this contributed to the slowdown of the investment.
Arvind Subramanian created the concept of the twin balance sheet problem when he was the government’s chief economic advisor. The twin balance sheets refer to the balance sheets of the bank and of the companies investing in infrastructure. More recently, he has decelared that the twin balance sheet problem has been transformed into a “four balance sheets challenge,” which means that in addition, there is a deterioration in the balance sheets of the Non-Banking Financial Companies (NBFC) and in the real estate sector. This problem emerged because, after the traditional banks deteriorated and became reluctant to make loans to infrastructure projects, the NBFC became a major channel of infrastructural lending. In 2018, the default of the IL&FS, India’s largest NBFC infrastructural lender, precipitated a crisis across the NBFC sector contributing to the bankrkuptcy of Dewan Housing Finance, one of the largest lenders to real estate developers and home buyers. The NBFC crisis then spread more broadly in the real estate sector. However, the underlying problem is still the same. That is, the government was trying to direct investment through public banks and NBFCs rather than permitting them to operate on a more commercial basis. Moreover, the problem of moral hazard arises. After encouraging the public sector banks and NBFC’s to make loans, when the loans go bad, the government recapitalized the public sector banks. There is moral hazard in the sense that when the banks make bad loans, they know they will survive because the government would come in and recapitalize them.
The NBFC crisis is ultimately tied to another underlying structural problem of India’s financial sector: the underdevelopment of its private debt market. The lack of a healthy bond market places the burden of long-term finance on the banking system to begin with. As I mentioned before, when the loans of India’s public sector banks went bad, infrastructural lending was taken up by India’s NBFC’s. The NBFC’s were funded by investments from fixed income mutual funds, banks, and short-term corporate paper. It created a classic asset-liability mismatch. Thus, the crisis of the NBFC sector threatens the development of India’s fledgling corporate debt market, which is ultimately the best means of long-term investments like infrastructure.
The Indian Financial Minister’s recent package (support the rural economy, boost infrastructure spending, corporate tax cut etc.) has been criticized for focusing too much on the supply side. Are his critics correct?
The problem lies in both the demand and supply sides. What really needs to happen is a stimulation of demand and investment. There have been two sets of reforms that are important, one is tax cut for the corporations, and the other is designed to facilitate FDI. Those in and of themselves won’t be sufficient to stimulate the type of investment necessary to get India’s economy growing again. There’s also the need to stimulate demand, but the government is now in a tricky situation because both the central and state governments bear large deficits. Attempting to be fiscally responsible for the deficits places constraints on how much it can encourage demand.
What are the primary causes of demand contraction in India? Why hasn’t construction of rural assets and infrastructure projects translated into a significant increase in income and employment, which would lead to consumption growth?
It is true that in terms of the rural sector, the Modi government has made a number substantial new policy inititatives, but they haven’t been able to stimulate demand in ways that are needed. Here also there are structural problems – in particular, the fragmentation of landownership the growth in the number of agricultural laborers and the slow generation of industrial employment that might absorb excess labor from agriculture. Until these formidable problems are addressed, it will be difficult for India to sustain rapid and equitable growth.
Sluggish export growth is another major concern for the Indian economy. What kind of reforms are required to make India an attractive investment destination and its exports more competitive?
Some of the policies that the Modi government implemented have made India less attractive. Under Modi, there has been an increase in tariffs, which made it more difficult for the Indian economy to link up with the global value chains. India is missing an important opportunity resulting from the diversion of global value chains from China as a consequence of the increase in Chinese wages and US trade war with China. India needs more investment to build up its infrastructure and to make exporting more efficient. It is a shame for India to miss this opportunity because at a time when more and more Indians are entering the labor force, the economy is not generating enough jobs to provide employment.
India’s economic development differs from many other developing countries in that its fastest growing sector is services, not manufacturing. Some of the most dynamic sectors in the Indian economy are business processing outsourcing (BPO), software development and financial services. These services provide a limited number of jobs for highly skilled workers, but they offer few employment opportunities for unskilled or semi-skilled workers. At the same time, India is faced with a relatively slow-growing agricultural sector that is not able to absorb all the people living in rural areas. Therefore, there is a need to create more entry-level jobs -- even if they provide low-wages – in order to absorb people from the agricultural sector. For many developing countries, the first step is to get into the bottom of the value chain and gradually work their way up. This is the opportunity India is missing, and as time goes on, India is less able to compete with other low-income countries such as Bangladesh and Vietnam.
What needs to happen for India to reinvigorate its growth?
There are some reforms that the Modi government has passed which are important. One is the new bankruptcy law passed in 2016. It gives a one-stop solution for financial institutions that had made bad loans, but it still doesn’t address the underlying problems. I have another concern. The current government is trying to suppress and manipulate information about the economy. This has contributed to growing uncertainty which discourages investments and the inability of policymakers to adequately analyze the problems and come up with solutions. Therefore, taking care to ensure that there is accurate and reliable information is a very important first step that can be done with very little cost in terms of helping India to move beyond the current problems. There also need for reforms that restore both the solvency and the confidence in India’s financial system, not only the banks but also the bond market. Only after this is done will the financial system become an effective channel for investment in the economy.
Finally, India has been hit hard by the coronavirus. We don’t know the exact extent of the spread of the virus because there is little testing relative to the total population. What we do know is that the spread of the COVID-19 illness has obliged Prime Minister Modi to declare a three-week national lockdown. The virus and lockdown will reduce economic growth and cause widespread suffering, especially among the poor, a large number of whom, after losing their jobs in the cities, are migrating back to their homes in the countryside. It is too early to predict the overall impact of COVID-19, especially since it is clear that it will remain a problem after the initial lockdown is over. In any case, it will present a serious problem for the welfare of Indians for some time to come.
Prime Minister's Office, Government of India / GODL-India (https://data.gov.in/sites/default/files/Gazette_Notification_OGDL.pdf)