Moving, but slowly

Economy stalling or reviving?

The slowdown in GDP growth to below 6% in the April-June quarter of 2017 grabbed headlines. It was the sixth consecutive quarter of slowdown, and a fall of 3.5% from the January-March quarter in 2016.

It moved former finance minister Yashwant Sinha to proclaim that the economy is on a downward spiral and is poised for a hard landing. He was supported by many, countered by many others. Prime Minister Narendra Modi felt it necessary to answer critics, and he did so by interpreting data as showing economic revival. So, is the economy robustly reviving or heading for a hard landing? Actually, the truth is somewhere in-between.

It will be wrong to say that the present slowdown is entirely due to demonetisation and GST. The slowdown had started much before that. Under the UPA government, macroeconomic vulnerability had increased, with India gaining entry into the infamous ‘Fragile Five’ club. Of course, the economy was limping back to normal in 2014, but the new government accepted the interim budget projection of the previous government and subjected the recovering economy to a large fiscal consolidation.

The government was lucky as it gained a massive bonanza with the sharp fall in international oil prices. That cushioned the economy. The additional excise revenues and lower subsidy outgo helped it to plug deficit and implement reforms like market-linked oil prices. However, a gradual fiscal consolidation would have helped the government to recapitalise the banks.

It was a mistake to hope that the legacy problem of non-performing assets (NPA) of banks would disappear as growth improved. The ‘twin balance sheet problem’ of banks and corporates continued to be a drag on the economy. The share of investment in GDP fell by 5.8% in March 2017 to 28.5%, from 34.3% in March 2013.

It needs to be acknowledged that the demonetisation exercise could have been executed better in order to reduce pain in the informal cash-based sector. It also brought forth the serious governance issues in the banking sector. The structural reform of GST, so soon after demonetisation, created further confusion. Structural changes are always disruptive, with immediate teething problems, and gains are realised in the long-term. Obviously, the GST network with its forward and backward linkages will take some time to smoothen out.

This brings us to the immediate issue of what caused the first quarter GDP growth to fall to a three-year low of 5.7%. The noise about slowing consumption, poor investment and higher government spending in the GDP numbers overshadowed a few interesting points.

First, if one looks at growth by economic activity, then GDP growth without ‘agriculture’ and ‘community, social services’ (that represents government spending) actually increased by 5.5% from 3.8% in the previous quarter. This indicates that government spending, though high, has slowed and economic activity is gradually recovering, led by remonetisation. The slowdown in the manufacturing sector is primarily because of de-stocking due to the GST.

Second, a large subsidy outgo during the quarter also caused the total output to fall as GDP is calculated by adding the net indirect taxes (NIT= indirect taxes minus subsidies) to Gross Value Added (GVA). This will reverse in the coming quarter. Third, private investment emerged out of contraction and moved to positive territory in this quarter, even though it remained weak.

Most importantly, details indicate that a massive growth in imports brought the GDP down. Net exports (exports minus imports) shaved off as high as 2.6% from the headline GDP number. Imports have grown at about 30% on average in the first six months of this year, compared to 8% in the last three months of 2016. This increase in imports was across the board. It is indeed puzzling that while growth has slowed to a three-year low, imports (including manufactured products) have increased to push the current account deficit to a four-year high of 2.4% of GDP.

Of course, the appreciating rupee and problems with GST might have contributed to slowing exports. But can the import surge so dramatically in an economy with low domestic demand? According to a JP Morgan report, this occurred due to disruption in the domestic manufacturing supply chain, particularly in the SME sector, due to demonetisation. This caused lower domestic production, which was plugged by higher imports.

Recovery underway

Some of the reasons for slower growth, like GST-related de-stocking, supply disruptions and higher subsidies are expected to reverse in the coming quarters, but the drivers of growth remain weak. Though it is difficult to comment on the trend based on just one month’s data, the recent high-frequency numbers are encouraging. After a couple of months of disappointing numbers due to GST-led disruption, industrial production recovered to 4.3% in August.

Sales of cars, two-wheelers and commercial vehicles jumped in September, indicating improvement in both consumption and economic activity. Even exports growth increased while imports slowed in September. The GDP growth can be expected to pick up going forward.

Any knee-jerk reaction to give a fiscal stimulus to increase consumption can be unfortunate at this point. There is little space for expenditure in the budget in the second half of this year. However, the economy cannot afford a big fiscal squeeze, either. Moreover, we cannot have diverging fiscal and monetary policies at the same time.

The government should increase investment spending in infrastructure, including low-cost housing projects. The construction sector has the potential to have a multiplier effect on various segments. There is a need to handhold the SME sector, which was hit hard by demonetisation, to move to the formal economy.

These will help generate jobs that are of significant importance. Recapitalising the banks and resolving the stressed assets problem is essential for growth.

The economy has been slowing since the oil bounty began to roll off, even before demonetisation. The structural reforms further increased disruption. The discussion about the economy now feels like the ‘Blind men and the elephant’. The elephant has neither stopped moving nor is it dancing, it is just moving slowly.