Indian economy: that 2002 feeling
It is usually better to drive with an eye on the road ahead—but an occasional look into the rear view mirror can prove to be useful. So it is with the state of the Indian economy right now.
The economic situation now has striking parallels with that in 2002. There is macroeconomic stability, weakening economic momentum, balance sheet stress. A more detailed look at how the stars seemed aligned 15 years ago can offer many important clues about the current situation.
First, economic growth was coming down over many sequential quarters. There were calls for fiscal expansion to boost domestic demand even as the government seemed committed to keeping its deficit under control.
Second, inflation had come off its recent highs. There was a vibrant debate about whether India was flirting with deflation. The Reserve Bank of India was under pressure to cut interest rates.
Third, the costs of an investment boom funded by a credit bubble were being felt in private sector balance sheets. Banks were weighed down by bad loans as project economics went awry. A new law had given lenders teeth to go after loan defaulters.
Fourth, the economy was highly dependent on consumer demand for its incremental output. New investment activity by companies had almost collapsed. Public investment— especially in road construction—was CONTRIBUTION TO ECONOMIC GROWTH an area of focus.
A few more factors can be thrown in as well: farmer distress, an appreciating rupee, corporate restructuring.
That was then. Few now perhaps remember how quickly the Indian economy jumped out of the 2002 trough. Was the recovery unexpected?
There were two important cases of optimism amid the overall gloomy atmosphere. Arvind Subramanian and Dani Rodrik wrote a research paper for the International Monetary Fund where they put down a host of reasons why India could begin growing at 7% a year on a sustainable basis. Vijay Kelkar said in his K.R. Narayanan lecture at the Australian National University that the Indian economy was on a growth turnpike, and that it would accelerate in the decade ahead. All three economists proved to be prescient. The Indian economy was then moving into its best run, before the global financial crisis provided a bitter (and much needed) dose of reality.
The splendid recovery from the 2002 trough is worth remembering at a time when many economists fear that India is now trapped in a new normal of slower growth. There is no guarantee that what happened in the past will be repeated with karmic certainty. However, there are some useful clues for policy makers today. The data here encapsulates the structural changes that took place after 2002, and tells us a bit about the factors that need to be in place if the Indian economy is to break out of its current trap.
First, the savings rate as a proportion of gross domestic product went up by almost 10 percentage points between 2002 and 2007—from 24.8% to 34.6%. The splendid rise in domestic savings was led by fiscal consolidation as well as an improvement in corporate financials. Higher savings meant that the subsequent investment boom could be largely financed from domestic sources. The savings rate has come down after 2007—though thankfully not all the way down to the levels of 2002.
Second, the Indian economy in 2002 was like a plane running on one engine. Almost all the growth was coming from consumer spending. Net exports made some contribution, but there was almost nothing coming from investments or government spending.
Now look at the situation in 2007. The process of economic growth was far more balanced. In fact, the contribution to economic growth from investment activity was higher than the contribution from consumer spending. The contribution from government spending was modest since fiscal consolidation was being driven by strong tax collections. And even while net exports had a negative contribution, the strength of the global economy provided ample scope for exports.
The current situation is more like 2002 rather than 2007. Economic growth is again being driven by consumer spending, though government spending is also playing a small role this time around. The contribution of investments and net exports is modest.
The Indian economy has been served two large exogenous shocks over the past 10 months. There was demonetization. And then there was the transition to the new goods and services tax. The economy should pick up some momentum once the effects of these two shocks dissipate.
But there is an important lesson to be learnt from history as well. India cannot raise its potential growth rate without three driving forces: a strong private sector investment recovery, robust export growth and a higher rate of domestic savings. That is the key to those elusive extra two percentage points of sustainable economic growth.