Indian economy’s illness 'severe, unusually so', situation 'puzzling and frustrating'

Arvind Subramanian, Josh Felman

Counterview Desk
In a fresh paper published by the Harvard University Center for International Development, “India’s Great Slowdown: What Happened? What’s the Way Out?”, Arvind Subramanian, former chief economic adviser to the Narendra Modi government, and Josh Felman, Director of JH Consulting, California, have said that “standard structural and cyclical factors cannot explain the long slowdown, followed by a sharp collapse.”
According to them, “In the immediate aftermath of the Global Financial Crisis (GFC), two key drivers of growth decelerated. Export growth slowed sharply as world trade stagnated, while investment fell victim to a homegrown Balance Sheet crisis, which came in two waves. The first wave -- the Twin Balance Sheet crisis, encompassing banks and infrastructure companies -- arrived when the infrastructure projects started during India’s investment boom of the mid-2000s began to go sour.”
While admitting that “the economy nonetheless continued to grow, despite temporary, adverse demonetization and GST shocks, propelled first by income gains from the large fall in international oil prices, then by government spending and a non-bank financial company (NBFC)-led credit boom”, the paper states, inflating bubble “finally burst in 2019”, as could be seen in consumption getting “sputtered, causing growth to collapse.”

Excerpt:

Seemingly suddenly, India’s economy has taken ill. The official numbers are worrisome enough, showing that growth slowed in the second quarter of this fiscal year to just 4.5 percent, the worst for a long time. But the disaggregated data are even more distressing. The growth of consumer goods production has virtually ground to a halt; production of investment goods is falling (Figure 1a). Indicators of exports, imports, and government revenues are all close to negative territory (Figure 1b).

These indicators suggest the economy’s illness is severe, unusually so. In fact, if one compares the indicators for the first seven months of this year with two previous episodes, the current slowdown seems closer to the 1991 balance of payment crisis (not in the conventional macro-economic stability sense but in terms of the real economy) than the 2000-02 recession (Figure 2a). Electricity generation figures suggest an even grimmer diagnosis: growth is feeble, worse than it was in 1991 or indeed at any other point in the past three decades.1 Clearly, this is not an ordinary slowdown. It is India’s Great Slowdown, where the economy seems headed for the intensive care unit.

The situation is puzzling and frustrating in equal measure. Puzzling because until recently India’s economy had seemed in perfect health, growing according to the official numbers at around 7 percent, the fastest rate of any major economy in the world. Nor has the economy been hit by any of the standard triggers of slowdowns, what Harish Damodaran has called the 3 Fs. Food harvests haven’t failed. World fuel prices haven’t risen. The fisc has not spiraled out of control. So, what has happened—why have things suddenly gone wrong?
Various answers to this question have been proposed; there seem to be as many explanations as analysts. Yet the very number of answers hints at the problem, namely that none of the explanations seems satisfying. Commentators point to various flaws in India’s economy, but the economy has always had flaws, and only rarely have they led to predicaments like the current situation.
At the same time, there is frustration. The government and RBI have been trying vigorously to bring the economy back to health. Every few weeks they announce new measures, some of them quite major. Most notably, the government has introduced a large corporate tax cut, perhaps the most sweeping corporate measure ever, in the hopes of reviving investment; and recently it announced a plan to privatize four major public sector undertakings (PSUs). 

Meanwhile, the RBI cut interest rates by a cumulative 135 basis points during 2019, more than any other central bank in the world over the period and one of the largest rate reductions in India’s history, in the hopes of reviving lending. But lending continues to decelerate, and investment remains mired in its slump.
Hence, the current predicament. It is not obvious what more can be done to remedy the downturn, especially because it is still unclear what has caused it. Yet one cannot just accept the current situation; a remedy must be found. Accordingly, this paper attempts to make a contribution. It offers a different diagnosis of the problem, and provides a prescription, identifying a path that could lead the economy out of the current slowdown.

Our thesis can be summarized briefly. India’s economy has been weighed down by both structural and cyclical factors, with finance as the distinctive, unifying element. India is suffering from a Balance Sheet crisis, a crisis that has arrived in two waves. The first wave -- the Twin Balance Sheet crisis, encompassing banks and infrastructure companies -- arrived after the Global Financial Crisis (GFC), when the world economy slowed and the infrastructure projects started during India’s investment boom of the mid-2000s began to go sour. These problems were not addressed adequately, causing investment and exports, the two engines propelling rapid growth, to sputter.

*For the period April-October 2019 compared to the same period in 2018

But the economy was still able to achieve reasonable growth, on the back of a series of temporary expedients: initially, a large windfall from the precipitous fall in international oil prices; later, an NBFC credit boom accompanied by a large but hidden fiscal stimulus. It is the end of this credit boom beginning late 2018 that has led to the current predicament. All major engines of growth, this time also including consumption, have sputtered, causing growth to collapse.
With growth collapsing, India is now facing a Four Balance Sheet challenge -- the original two sectors, plus NBFCs and real estate companies. In this situation, the standard remedies are no longer available. Monetary policy cannot revive the economy because the transmission mechanism is broken. Fiscal policy cannot be used because the financial system would have difficulty absorbing the large bond issues that stimulus would entail. The traditional structural reform agenda -- land and labour market measures -- will not address the current problems.
Yet something must be done to get India out of its current vicious cycle, in which low growth is further damaging balance sheets, and deteriorating balance sheets are bringing down growth. In fact, there is only one way out, difficult and slow as it may be. The Four Balance Sheet problem must finally be addressed decisively. Until and unless this is done, the economy will not really recover on a sustainable basis. This argument is not new; it has been made before, in the Economic Survey 2017. But it is even more true today. 

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