THE year 2017 began with the Indian economy limping out of the self-inflicted disaster of demonetization. It is ending with the economy struggling to recover from the self-inflicted pain caused by the shoddy manner in which the Goods and Services Tax (GST) was introduced in July.

2017 was truly an Annus Horribilis. Through the course of the year, domestic and international agencies had to keep revising downwards their projections of GDP growth. No longer was there any talk of India being the fastest growing economy in the world; the question was more of an embarrassing one: How did India manage to start slowing down precisely when the global economy had begun to show a modest acceleration? There was no external shock and there was no drought, yet growth was slowing.

The twin disasters of demonetization and the rushed job of GST caused immense harm, but they only worsened an already poor situation. These events brought into relief the structural weaknesses in the economy that have slowed growth in the medium term.

A falling growth rate, a decline in the investment rate, erratic export growth and a poor record in creation of high quality jobs laid bare the truth that the economy registered high growth rates in 2014-16 on the back of some fortuitous circumstances. Absent these circumstances, all the weaknesses became apparent. If you discount the value of controlling the fiscal deficit, the only bright spot in the economy was the lid kept on inflation.

India is more than likely to shake off the demonetization and GST blues in 2018. Indeed, by the end of 2017, the growth statistics said the economy’s slowdown had bottomed out. But is it anywhere near moving to a high growth path, and, most crucially, delivering growth that creates quality employment? That seems unlikely. It would seem that all the attention paid by the Narendra Modi government to image-making and the desire to carry out dramatic decisions like demonetization diverted attention from working on the nuts and bolts of how to accelerate economic growth with employment generation.

 

When the Modi government took office in May 2014, global oil prices of the variety imported by India ruled at over $100 a barrel. Over the next 18 months prices drifted down to as low as $30 in January 2016, before inching up towards $45-50 a barrel. When prices were falling, central levies were not correspondingly adjusted downwards, giving the government a bonanza. This allowed the government to maintain public spending and boost growth. Growth of the Gross Value Added (GVA) at basic prices in 2014-15 and 2015-16 was 7.2% and 7.9% per cent, respectively.¹

All this while investment – which should ultimately drive economic growth – was continuing to decline from its peak in 2011-12. Private investment which accounts for most of the investment in the Indian economy was, in particular, falling. Once the continued benefits of an oil price decline were no longer to be had, the economy began to falter. Over the six quarters from January-March 2016, real growth in GVA terms fell continuously: from a high of 8.7% in the last quarter (January-March) of 2015-16 to 5.6% in the first quarter (April-June) of 2017-18. It was only in July-September 2017 that growth recovered to 6.1%, which was a modest recovery, but less than expected.

The extent of the slowdown was revealed in analysis by the Reserve Bank of India (RBI) which showed that if we excluded the expansion in the public administration, defence and related services (areas where growth is fuelled by government spending), GVA growth in the rest of the economy – which is where job creation is supposed to take place – slumped to as little as 4.5% in the last quarter of 2016-17 before recovering modestly to 5% in the first quarter of 2017-18.²

It was not as if the high growth rates in 2014-16 had delivered high rates of job creation. Accurate and timely information on employment creation is not available and this has allowed the government to claim that all was not bad on the job front. The limited amount of private and government information that was available did, however, point out that the pace of fresh employment generation was slow and the extent of creation of good quality jobs was even slower.

 

India’s investment in plant and machinery (what in technical terms is called ‘fixed capital formation’) was over 34% of GDP in 2011-12, from when it steadily drifted down to 29% of GDP in 2016-17. This is still not an investment rate to be sneezed at but not enough if one is speaking about a ratcheting up of the GDP growth rate to 7 per cent and more.

The decline in investment has been attributed to many reasons, more recently to the ‘twin balance sheet’ problem: a high debt burden of corporates affecting their ability to repay loans and high non-performing assets (NPAs) affecting the financial situation of banks and their capacity to lend for fresh investment. This was a problem known since 2014. Instead of attending to this issue, the government instead chose to come up with dramatic but ill-conceived actions like demonetization.

There was simply no economic justification for demonetization of 86% of the currency in a cash intensive economy. A year later that high profile event continues to be a subject of intense debate with the votaries (essentially government functionaries) cherry-picking both the questions to ask and the data needed to support their arguments. The government has been loath to admit a single problem with the objectives, design and implementation of Demonetization 2016. But as more and more data comes in, it is clear that demonetization caused huge disruption in the short-term affecting output, jobs, incomes and, therefore, surely consumption as well. The losses were more in the informal sector in rural and urban India, though the organized sector too was affected. The short-term impact seemed to continue well into 2017 with farmer protests in April-May signalling the disruption it caused in agriculture.

The medium to long-term benefits of demonetization to the economy are not yet in sight. The evidence so far is that there has been no dent in the holding of illegal wealth or the generation of black money. On tax revenue, it is too early to claim that there has been or that there even will be a permanent increase in collections. There are also many questions about the pace and benefits of digitalization. The list of question marks over Demonetization 2016 is endless.

It is a measure of the government’s sense of priorities that it chose to take what must surely can only be called a catastrophic decision when the economy which was in the middle of a slowdown, was also preparing for the major switchover to the GST.

 

The GST was in the making for 17 years. Everyone knew that the design of the rate structure and the implementation had to be carefully thought through so that the disruption to producers and traders during the transition would be minimal. Despite all warnings that the infrastructure backbone was not ready, the central government persuaded the GST Council to rush through with the fixing of rates and then make the switch on 1 July 2017. It was almost as if the government was anxious to divert attention from the ill-effects of demonetization. The desire for high profile events of symbolism was also in evidence in the ‘midnight launch’ of GST in the central hall of Parliament.

Sure enough the roll-out was a disaster. For more than three months trade and industry struggled with GST, with once again the smaller enterprises experiencing the brunt. The rates had been arbitrarily set; there were too many of them; there were inconsistencies in classification, and the infrastructure for filing returns just could not handle the gigantic switchover (small industry was exempt from GST but as producers in a chain they were very much part of it.) Disruption, closures and a deep unpopularity of the new tax were the features of the first few months of the GST. Eventually, in a damage control exercise the central government persuaded the GST Council to decide on a reduction in rates on a number of commodities and services.

 

Even as the government sought to grab the headlines with its ‘bold’ measures of demonetization and the hurried switch to GST, the major problem of the health of the banking sector was crying to be addressed. Mid-year the government and the RBI finally launched a process for resolution of the bad debt problem of a small group of the largest defaulters. But the strengthening of the banks – especially the public sector banks – came much later.

Future analysts of India’s banking problem will wonder why it took more than three years for the Modi government to take steps to deal with this critical problem. For a government that prided itself on quick action and the ability to take tough decisions, the delay was inexcusable. If investment was slowing down, in part because the banks were first unwilling and then unable to lend (since they did not have adequate capital reserves), why not first attack the underlying problem?

 

It was only towards the end of the year that the government came up with a complicated package for recapitalization of public sector banks. ‘Complicated’ because while elsewhere in the world, governments step in with a large infusion of funds to prevent a banking crisis, the Modi government’s key component of recapitalization was a ‘bond-for-equity’ exchange which, in essence, was an accounting exercise. Banks would get additional equity, but a fudge in the form of the banks buying bonds to an equal value was designed to prevent the fiscal deficit from widening. The recapitalization of banks – which at a total of Rs 2,15,000 crore was still modest and not large enough given the scale of the problem – awaits implementation so that the weak public sector banks can resume lending for investment.

Indeed, in the midst of the prolonged slowdown, the central government refused to take any immediate fiscal spending measures which would pull up growth. Anxious not to upset the international markets and credit rating agencies, it did not countenance an easing of the fiscal deficit for short-term pump priming.

Yet, the government was eventually compelled to announce the Rs 5,35,000 crore five-year road building Bharatmala Pariyojana to jump-start spending on infrastructure. This was in part a repackaging of existing programmes and it was also something that would take time to implement. The Vajpayee government had in 1998 launched the major Golden Quadrilateral project which did a few years down the line give a direct and indirect (through the automobile sector) boost to the economy. It looked like the Modi government was hoping its new road building programme, along with bank recapitalization, would do a similar trick. But it was odd that the government was taking these measures towards the end of its term in office.

The only good news for the economy came by way of external ‘certificates’ and it was natural that the government’s very active PR machinery went into overdrive with the help of a pliant press to make much of these commendations. India’s ranking in the latest edition of the World Bank’s ‘Doing Business Indicators’ (DBIs) jumped by 30 ranks. No matter that the DBIs are the result of dubious methodology and of doubtful value for guiding domestic or international investment decisions.³ For a government that had made an improvement in these ranks a matter of some priority, this was a feel good moment.

Likewise, Moody’s upgrade of India’s credit rating was also something to be highlighted. The credit rating agencies may be a discredited lot after the 2008 global financial crisis and the Government of India too had openly questioned the agencies. Yet, when the Moody upgrade came, the first in 14 years, it was again made much of. The Moody’s rating upgrade would make India’s external borrowings less expensive, but beyond that it had little value for a slowing economy that was going through a medium-term decline in investment.

 

The Indian economy is now much more connected to the rest of the world than before. So the external sector does play a part in contributing to growth (likewise external shocks can affect domestic growth much more than before). The unfortunate aspect is that India’s exports have not been doing well.⁴ They contracted in 2014-15 and 2015-16 but grew in 2016-17, before they slowed down again in the first half (April-September) of 2017-18. One reason is that an appreciation of the rupee has made Indian products more expensive abroad. The other – in 2017 – was the GST roll-out. A good proportion of India’s exports in the garments and light engineering move up the value chain from the small-scale sector, and it was this sector that suffered a major dislocation during the introduction of GST.

If the export sector was not showing any buoyancy, then the economy had to depend on domestic demand. Here the growing dependence on private consumption and the failure of investment to recover began to cause problems.

 

With a decline in investment over the past few years, the share of private consumption spending in GDP has been rising. The rise in consumption has not been driven by a faster growth in income but by credit. Analysts of income and consumption growth point out that consumption driven growth, which is not being supported by investment, but is based on retail credit, may be exhausting itself. There are also danger signals: (i) retail consumer confidence is declining, and (ii) retail NPAs have started to edge up, the result of difficulties in micro-finance institutions and housing finance companies.⁵

There are other signs as well that consumption demand is not growing as fast as before. The problems in rural India – especially in agriculture – of low farm prices means that incomes are being affected and with that consumption. All this calls for a greater and better balance between investment and consumption, as the RBI too has pointed out. But there is no sign of investment perking up and until the announcement of bank recapitalization there was no sign that the government was doing anything to facilitate an investment revival.

 

The concern with maintaining the fiscal deficit and the need to fire-fight the fallout of demonetization and GST has meant that the government has had little time for other important sectors in the economy. Agriculture for one was recovering in 2016 from the drought of 2015 when it was hit by demonetization. There was a record harvest in 2016-17, but prices of different farm products in different parts of the country collapsed. The state governments responded with farm waivers (which the Centre said it would not support), but that has left them with little resources for capital spending in the rural areas.

Fiscal fundamentalism at the Centre and resource constraints in the states have meant that the social sectors of health and education have been ignored. It is difficult to think of a single major initiative by this government in health care or (school and university) education. The infant deaths in Gorakhpur in mid-2017 were a stark reminder about the collapse of the primary health care system. Safety nets too have been neglected. The Economic Survey pointed out that there was a surge in demand for work under the Mahatma Gandhi National Rural Employment Guarantee Act (MGNREGA) in early 2017. However, by mid-2017 wage arrears had piled up and so too unmet demand for work under MGNREGA.

 

The 2014 campaign promise of ‘Acche Din’ for the economy has been long forgotten. What we have instead is the promise of medium and long-term benefits of structural reform once these are fully implemented. Some of these reform measures are of doubtful quality (demonetization) and others either need to be corrected (GST) or need time to work themselves out (the Indian Bankruptcy Code).

By late 2017, the economy was showing signs of a modest recovery from the misadventure of demonetization and the poorly planned GST, though the rate of investment in the second quarter (July-September) of 2017-18 was still low (26.4% of GDP). But will the recovery be to the old normal of mid-2016 when growth had begun to slow down? Will this time round private investment pick up and deliver quality employment after bank recapitalization is completed and the resolution of the corporate debt problem picks up pace? With a government that is forever in electioneering mode preparing to enter the last year of its five-year term in office, it is impossible to see any innovative decisions being taken.

The economy also cannot function in a vacuum.⁶ The social environment is extremely tense with violence just under the surface. With the rule of law under strain, with free speech under threat, with vigilantism of various kinds on the streets and with communally polarization constantly being stoked by hate speech and actions by political functionaries, it is difficult to see a major jump in investment in productive activities.

 

* C. Rammanohar Reddy is the author of Demonitization and Black Money. Orient Blackswan, Delhi, 2017.

Footnotes:

1. In Indian statistics, GDP is now best measured by the gross value added in basic prices.

2. ‘Monetary Policy Report’, October 2017, RBI.

3. Mathew Lillehaugen and Milan Vaishnav, ‘Doing Business in India: Myths and Realities’, Ideas for India, at www.ideasforindia.in, 25 October 2017.

4. If the export sector has not been doing too well, it was the opposite on the capital account front. Foreign direct investment (FDI) in 2016-17 was a mammoth $60 billion and net capital inflows were $35 billion. Yet, these large inflows seem not to be contributing to capital formation. A good part of it seems to go into either hiking brand valuations of start-ups or to finance retail operations (as of Flipkart, Amazon, Uber and Ola). There is also reason to believe that India may be used as a conduit for treaty shopping. See R. Nagaraj, ‘Is FDI the New Engine of Growth?’ Mint, 1 September 2017.

5. Ritika Mankar Mukherjee and Sumit Shekhar, ‘India’s Credit-Fuelled Consumption Boom’, Mint, 4 October 2017.

6. Kaushik Basu, ‘Where India is Ahead of China’, Indian Express, 10 November 2017.