Mitigating India’s growth slowdown
Looser fiscal policy is last available instrument
by Meghnad Desai in London
Mon 27 Nov 2017
In 2014, the year Narendra Modi became prime minister of India, the country enjoyed GDP growth of 7.5%. The economy continued to grow at a robust rate, exceeding 8% in 2015 and 7.1% last year, outperforming China on both occasions.
But 2017 has shown a marked slowdown, with the annualised growth rate for April to June falling to 5.7%. This deceleration means Modi, for the first time, has to confront a jubilant opposition faulting his economic performance, rather than on grounds of intolerance or cultural communalism. A growth rate of 5.7% is hardly a symbol of deeply damaging stagnation, but Modi has raised expectations and the problems he faces are of his own making. It is unclear if the fall in the growth rate is part of a longer-term trend or due to some special factors.
Two policy initiatives disrupted growth. One was the large-scale demonetisation of high denomination banknotes. In November 2016 Modi surprised the nation by declaring that all Inr500 and Inr1000 notes would be stricken out by the new year. This sudden change disrupted the large cash-based informal economy.
The idea was to punish those who held illegal hordes of cash – so-called ‘black money’ – to evade income tax. Cash hordes of old currency were to lose all their value. What happened instead was that the holders of such cash laundered their funds by buying whatever they could. New banknotes were slow to arrive and it took six to ten weeks before normality was restored. The demonetisation caused economic hardship for three to four months. While some of effects were exaggerated, the loss in GDP was estimated at 0.5%.
The other significant change was long-awaited tax reform. India has countless local taxes imposed on the transport of goods across state borders, and even a tax on goods entering urban areas. This variety was replaced in July by a modern goods and services tax, creating a genuine Indian single market.
The switch will continue to impact economic activity as traders get used to the new tax structure. There was some drawing down of existing stocks before the regime came into effect. Other issues have arisen – the requirement to complete online forms each month surprised business. Regardless, the long-term impact of the goods and services tax on GDP will be positive. Prices will fall, and a greater quantity of goods and services will be delivered.
The deceleration in growth rates, therefore, may not be systemic. A longer-run factor has been India’s credit famine, caused by the prevalence of non-performing assets held by nationalised banks. The government has moved too slowly on this issue. It needs to simplify bank structures, reduce their numbers through mergers, and establish a ‘bad bank’ to absorb toxic debts. Then credit may flow again. Time is short before the next election, scheduled for 2019, and voters would welcome quick, decisive action.
Another reason for the slide in growth is international. Indian growth was strongest in the first few years of the 21st century, in line with the booming global economy. Though not as dependent on foreign trade as China, India still benefits from generous capital inflows and export demand when the global economy is buoyant. The decline in energy prices over the last three years benefited India, but these have stopped falling. At least some of the growth slowdown may, therefore, be attributed to global factors.
Deep structural reforms of India’s land, labour and credit markets must be addressed to facilitate robust long-term growth. In the short term, however, the quickest and most effective boost can come only through fiscal or monetary policy.
The government has been disciplined in terms of reducing the budget deficit. The Reserve Bank of India has stayed relatively stalwart on interest rates, in spite of numerous appeals for deeper cuts. Any sizeable rise in inflation would be electorally damaging. This leaves fiscal policy and increased spending as the final available instrument to revive growth.
Lord (Meghnad) Desai is Emeritus Professor of Economics at the London School of Economics and Political Science, and Chair of the OMFIF Advisers Council.
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