Getting the stimulus right
Smart state intervention in select labour-intensive industries can create comparative advantage and boost India’s manufacturing sector
Measures to stimulate growth are now being discussed as key parameters of growth, investment and off-take of bank credit continue to fall over successive quarters. This is a welcome development as there was the sanguine comfort of being one of the fastest growing large economies with prudent macroeconomic management combined with the optimism flowing from the expected benefits of the various reform initiatives. India did put in place a stimulus package in response to the global financial crisis in 2008-09. This worked and growth bounced back quickly enough and was good till 2011-12.
Thereafter, neither industrial production nor private investment has really picked up. The fiscal deficit was allowed to rise for longer than was necessary. Higher inflation and a tighter monetary policy with a higher interest regime followed until the fiscal deficit and inflation came down. It is useful to recall this. The global financial crisis was an external shock which caused the Indian economy to go into free fall. The IMF was then suggesting to everyone that a fiscal stimulus, even if it meant increasing the deficit for some time, was a good idea.
The situation today is fundamentally different. There is no external shock which calls for a rapid response. The internal shock of demonetisation is behind us, as cash is back in the economy. The disruption occurring as a result of the introduction of GST needs to be mitigated by addressing implementation issues. GST is a fact now. If some rates need adjustment, that should be done. Compliance problems need to be addressed. The GST Council should be quick, pragmatic and effective. There is no other factor which could be seen as a shock calling for an immediate response in terms of a stimulus package.
Nevertheless, the declining trend in terms of investment, credit off-take and GDP growth does call for reflection and action. The key fact since 2011-12 has been the weakness in manufacturing. In the peak years before the global financial crisis, manufacturing growth rates had gone up to 15 per cent. Indian industry went through a major capital investment cycle then. Since 2011-12, industry has not seen the business case for a fresh round of investment for creating additional capacity.
Aggregate capacity utilisation now is around 73 per cent. If inadequate demand for domestic industry is the problem, then further lowering of interest rates or the resolution of the NPA problem of banks are not immediate demand-creating measures. A modest increase in public expenditure by some relaxation of fiscal deficit reduction targets can be undertaken, but it is unlikely by itself to create sufficient demand to trigger a revival of private investment.
The major factor which has been at work in not generating greater demand for Indian industry, and which is only now getting the attention it deserves, has been the continuing substantial appreciation of the real exchange rate. An appreciating real exchange rate weakens the business case for value addition in the country, both for the domestic market as well as for exports. It makes imports cheaper and increases their market share. The greater the domestic value addition the greater the impact.
Growing remittances of expatriate Indians and FII inflows into a booming stock market have been driving the appreciation of the real exchange rate, which has been appreciating without any commensurate underlying increase in productivity in the Indian economy. Growing remittances have the same adverse effect as surging commodity (say, oil) exports have on industrial and manufacturing competitiveness. The RBI has had the orthodox view of letting market forces work and has not felt the need to intervene. Maintaining a stable real exchange rate is not yet seen as being central to the objective of greater value addition and job creation in the country.
After a spell of real exchange rate appreciation a few years back, the market drove a sharp correction when the rupee came down to about 68 to a dollar, with the sudden fall causing considerable disruption. Even then, many had felt that the rupee needed to go down to below 70. The non-performance of the manufacturing sector has been to a considerable extent due to the adverse effect of the large real exchange rate appreciation. If this was undone, the beneficial impact would be substantial.
Devaluations have been a part of the standard IMF and World Bank prescription for economies in difficulty. Therefore, the single most important step that is needed now is the depreciation of the rupee to neutralise the real exchange rate appreciation.
In addition, it may be useful to look at specific sectors, which have a large multiplier effect, where with some intervention additional demand can be created. Construction and housing is one major sector which is generally an engine of growth. It is labour-intensive and generates demand for a wide range of goods, from cement and steel, to electrical fittings. This sector has been in the doldrums for some time now. Can something be done for its early revival?
Demand has been booming in sunrise sectors like computers, smart phones and solar power equipment. However, significant domestic manufacturing capacities have not emerged in these areas and as a result growing demand has been met by imports. The orthodox view has been that the government should not try to create domestic capacities in specific sectors.
However, in a departure from this standard view there has been some recognition of the merit of selective state action in some key areas. For assembly of smart phones, some measures have been taken recently with surprisingly good results. Efforts are on to go beyond final assembly and have greater value addition in the country. Similarly, a package for the labour-intensive apparel sector was announced some time back.
Recent historical experience shows that comparative advantage is often created and nurtured by smart state action. The successful East Asian economies, starting with Japan, followed by South Korea, and more recently China have been very good at this. India needs to attempt this and succeed in getting higher growth with jobs.
Construction and housing, an engine of growth, has been in the doldrums for some time. Can something be done for its early revival?