Why has India’s growth slowed?

The slowdown in growth is primarily on account of the banking crisis

India’s economic growth is down to a crawl in recent years. The growth rate of gross domestic product (GDP) had decelerated for three consecutive years starting in 2016-17, falling to 4 per cent in 2019-20, well before the pandemic struck.

What explains the slowdown? Critics lay the blame on major policy lapses on the part of the Narendra Modi government: Demonetisation, goods and services tax and the absence of major economic reforms in the first term of the government. Their contention does not hold water.

Most experts thought demonetisation would deal a body blow to the economy because it meant a huge drop in money supply. However, a number of studies have established that the impact of demonetisation on growth was not significant.

A paper by economist Gita Gopinath and others estimated that demonetisation had caused GDP to fall by 2 percentage points in one quarter but the impact dissipated over the next few months. This translates into an annualised impact on GDP of 0.5 per cent. An RBI paper estimated the negative impact on gross value added of 33 basis points.

The Economic Survey of 2016-17 estimated an adverse impact on GDP of 0.25 to 0.5 per cent.

The implementation of goods and services tax (GST) was said to have severely disrupted smallscale businesses as they struggled to comply with the requirements of data that it imposed. As the chief economic advisor (CEA) has pointed out in a recent article (Times of India, September 6), the implementation of GST coincided with the time of demonetisation. Hence any negative impact on economic activity of GST would have been captured in the studies on demonetisation.

A third reason put forward for the slowdown is the reluctance of the government to embrace major reforms in its first term. These include labour reforms, privatisation, administrative and judicial reforms. The absence of these measures can, at best, explain why growth did not accelerate beyond a baseline of 6.5-7 per cent. They do not explain why growth dropped well below that rate.

The explanation has to be found elsewhere. The CEA points out correctly that the crisis of the Indian economy is fundamentally a banking crisis. Banks were constrained in their lending by the high level of bad loans. Companies were constrained in their investment by the high level of debt.

Banking crises are long drawnout affairs. Economists Carmen Reinhart and Kennethrogoff estimate that an economy takes, on an average, eight years to come out of a banking crisis. If we mark 201112, the year from which non-performing assets (NPAS) started rising, as the beginning of our banking crisis, we are now in the 10th year. Taking into account the Covid-19 waves of 2019-20 and 2020-21, our experience is not out of line with that of other economies.

The NPA problem was the legacy of the lending boom of the first decade of the 2000s. It wasn’t entirely the result of poor lending decisions. Many factors extraneous to the banking sector contributed to it: The global financial crisis, adverse court judgments, dumping by China, etc. The NPA problem arose from a combination of bad judgement and bad luck.

The bad loan legacy caused India’s growth to slow down. Its impact was exacerbated by policy errors on the part of RBI. Starting at 2.95 per cent of assets in 2011-12, NPAS rose to 4.27 per cent in 201415 and thereafter to 7.8 per cent in 2015-16 and 11.18 per cent in 2017-18. An NPA level of 4.27 per cent is bad but manageable. A level of 11.8 per cent constitutes a banking crisis.

The sharp increase in NPAS in 2015-16 and 201617 was not just on account of more loans of the past turning bad. The RBI’S Asset Quality Review (AQR) of 2015 contributed to the increase. The RBI was of the view that banks were concealing the amount of stress in their books and that a massive clean-up was required. In segments such as infrastructure and small and medium enterprises (SMES), loans may be past the due date for temporary reasons and can be set right with a little help from banks. In several cases, banks were denied the discretion to judge whether the loans were to be classified as NPAS or not.

Provisioning for the higher level of NPAS eroded banks’ capital. As the government was unable to quickly top up capital at public sector banks (PSBS), their ability to lend was curtailed. There was a credit crunch whose impact was felt most by SMES.

Then came the inflation targeting regime of May 2016. The RBI got its inflation forecast wrong thereafter. The outcome was high real interest rates for over two years. This again adversely impacted the demand for credit and hence growth. The figures for credit growth speak for themselves. Between 2008-09 and 2013-14, non-food credit had grown at 14-18 per cent annually. From 2014-15 to 2017-18, credit growth was down to single digits, thanks to problems on both the supply and demand sides.

A third complicating factor was the Insolvency and Bankruptcy Code (IBC) regime, introduced in 2016. The RBI’S stressed asset framework stipulated that stressed assets be resolved by banks within 180 days, failing which the assets would have to go through the IBC process. Bankers found the time frame too short to achieve resolution.

The fear of inviting action by investigative agencies meant that bankers at PSBS had, in any case, little incentive to resolve stressed assets on their own. Now, with the limited time frame provided by the RBI, bankers came to see the IBC route as the default option. The IBC mechanism got clogged as a result, there were long delays in resolution and recoveries often unsatisfactory. Getting rid of bad loans proved as much a problem as the accumulation of bad loans in the first place.

The good news is that the banking system is in much better shape today. Who would have thought that gross NPAS would come down from 8.4 per cent of loans in March 2020 to 7.5 per cent in March 2021 after the first Covid shock? Banks have substantially provided for bad loans — the average provisioning coverage ratio is now 68 per cent. Banks have enough capital to weather further shocks — the average capital adequacy is 16 per cent, compared to the regulatory requirement of 10.875 per cent.

The irrational exuberance in lending of the first decade was bound to exact a toll on the banking sector and the economy. Its impact was amplified by the regulatory response to it. There is reason to believe that we will be out of the banking crisis in the near future. More than any factor, it is this prospect that holds out hope of an acceleration in the growth rate.