Challenges for Modi 2.0 as growth slips to 5-year low

The staunchest critic of Prime Minister Narendra Modi would agree that the reforms on housing, roads, toilets and financial inclusion he started in his first five years, bore fruit. But, even a die-hard fan would find it difficult to digest that such large-scale reforms failed to create jobs, eradicate rural distress, kick-start investment and ameliorate the plight of the country’s disjointed financial sector.

What went wrong, all of a sudden, to send a roaring economy into a tailspin, jobs rate to drop to a 45-year low and investment to face a massive retreat, is yet not clear. But, one thing is sure that the Indian consumer has massively lost confidence in the country’s economy. They do not expect things to turnaround immediately. A survey released by the Reserve Bank of India a couple of days ago, says so. It shows that the consumer confidence index has dropped to 97.3 in May from 104.6 in March this year. It is a disappointing signal because the RBI says that a reading below 100 on the index denotes pessimism. The survey also says that people are less hopeful about employment or economic situation getting better any time soon.

So, what should be the way out?

Well, notwithstanding a slowdown in economic growth across emerging markets, India’s problems are peculiar. In India, the GDP growth has decelerated to a five-year low of 6.8% in 2018-19 along with a decline in the credit growth for businesses. Incomes of people have slowed down, which is hurting demand and consumption, both in rural as well as urban India. The government needs to first recognise the pain points.

Financial sector reforms with a particular focus on Non-Banking Finance Companies (NBFCs) appear the most important one and should be taken up on a priority basis. Economists believe that much of the slowdown in demand conditions is because of the NBFC liquidity crisis. They are the major financiers of loans in consumer durables, auto sector and even the real estate.

A study by Elara Capital suggests that even if 15% NBFC lending towards the sectors like auto is adversely affected, it can have a 0.30% impact on the overall GDP growth of that particular year. The NBFCs have suffered the worst liquidity crisis following a spate of defaults by Infrastructure Leasing and Financial Services Ltd (IL&FS) and most of them have resorted to selling their assets to pay their debt.

Now, the RBI has ensured they do not face any liquidity crunch and remained robust to serve the economy and lobbed the ball into the government’s court. Now, the government has to ensure the pass-through is not slow and goes only to the productive sectors. It has to also ensure proper capitalisation of financial sector and bail them out before defaults turn into new NPAs.

But how will it do that? The government has limited fiscal space after it implements the post-poll promises. And that is why the monetary policy has been doing the ‘heavy lifting’. Reserve Bank of India Governor Shaktikanta Das has given three monetary policies since he joined in December last year. All the three policy decisions combined, he reduced the key interest rate by 0.75% cumulatively. But the pass-through so far has been only about 0.21%.

Small savings rate

The banks have a problem in transmission because their deposit rates are too high. They cannot bring down their lending rates until deposit rates too are reduced. But if they reduce deposit rate, there is a fear that all the deposits may fly to small savings, which have way high-interest rates. Here too, the government needs to act a bit in a disciplined way. It has to bring down the rates on small savings. Can it do that? The answer is no. That is because the government itself has increased its borrowings from the small savings to finance its deficits. If it reduces the rates, it fears it will lose savers.

Household savings rate

Official estimates suggest household savings rate, a major contributor to investment in the economy has fallen from 23.6% in FY12 to a little above 17% in FY18. It remains to be seen how the new Finance Minister Nirmala Sitharaman handles a tricky situation to ensure the fiscal policy does not become too loose at a time when monetary policy is far from being a tight one.

Given that the immediate priority of the government is to boost consumption, the finance minister will need to give more money in the hands of people, who can, in turn, enhance their discretionary spending. Together with which, she will also have to give some budgetary stimulus to sectors like manufacturing, textiles, gems and jewellery, leather and others to create more jobs. While doing all this, adequate attention is required on shoring up tax revenues. Centre’s revenue has been under stress after the Goods and Services Tax (GST). In FY19, the total shortfall of GST on Centre’s budget was to the tune of Rs 1 lakh crore. On direct taxes side, the shortfall on direct tax side was around Rs 80,000 crore. According to State Bank of India estimates, tax revenues need to expand by 30% to adjust the additional shortfall. In a year when the GDP growth has fallen to a sub-6% mark, shoring up tax revenues looks near impossible.

The finance minister also needs to see that the reduced fiscal space, due to shortfall in tax revenues, does not force her to understate government expenditures or compel her to move a significant portion to public sector enterprises. This increases off-Budget expenses and leads to financial jugglery where the fiscal deficit looks small but actual expenses are much higher than revenues. Last year, Rs 70,000 crore worth of food subsidy bill was put into off-balance sheet activities. Markets and rating agencies may be watching for a transparent Budget by the government even if it keeps the fiscal deficit slightly enlarged.

New challenges slapped on the economy due to escalating trade war between US and China, may require India to look for alternative markets for commerce. A prolonged trade war could even hit the global consumption and global growth in the long run. India needs to fire on all cylinders to reclaim the status of fastest-growing major economy, which it lost to China just last month.