Addressing pre-Covid issues to be crucial for India’s recovery

Latest data suggests Indian economy has been losing growth momentum for three years; it is important to determine if it is a consequence of structural or cyclical factors

The Covid-19 pandemic has infected at least 6 million people and killed over 395,000 across the world. It has also created a huge economic disruption. An April 2020 estimate by the International Monetary Fund (IMF) said global gross domestic product (GDP) would contract by 3% in 2020. Even in 2009, the year after the global financial crisis, world GDP contracted by only 1.7%. The economic pain of the pandemic will be felt the world over. But it will play out differently. How it does will depend on three factors. First, the economic situation before the pandemic hit. Second, how the pandemic interacts with existing economic and social fault lines. And third, the policy response to the pandemic.

What will be the pandemic’s impact on India? The Reserve Bank of India (RBI) expects the Indian economy to contract in the current fiscal year. But given the recent release of GDP numbers for the quarter ending March 2020, a big-picture analysis may be needed.

In a three-part data journalism series, of which this is the first, HT attempts to do exactly that. The first part will look at the economic situation before the pandemic and dwell on its nature and causes. The second will look at the immediate effects of the crisis and their macroeconomic consequences. The third part will argue that the existing policy response may not be enough.

India’s GDP growth has been declining since 2017-18. Such a prolonged slowdown is unprecedented in India . Why did this happen? Will this affect our ability to deal with the economic disruption caused by the pandemic?

Any modern economy is a giant market. Everybody is a buyer or a seller. Workers sell their labour, businesses their products and services. Essential and non-essential spending decisions feed into each other. And everything is linked.

Consider an economy made up of shirt sellers and hoteliers. If all shirt sellers do not take a vacation, the hotel industry will face a severe squeeze. If the hotel business enters bad times, its workers will not buy shirts. This will hurt the shirt sellers. If the crisis in the shirt and hotel industry is prolonged, it will lead to a fall in demand for sewing machines (used in making shirts) and bed linen (used in hotels). If left unaddressed, this will unleash a vicious cycle of sorts. This is what makes the role of the government important.

So what should be done to prevent a cascading impact of shirt sellers’ decision to not take vacations? The answer depends on the nature of the problem confronting the shirt industry. Economists classify all such problems into two categories: demand side versus supply side, and structural versus cyclical.

In the demand-supply binary, if all people who were buying shirts suffered a pay cut, or worse, lost their jobs, they would buy fewer or no shirts at all. This is a demand-side problem. Any resolution has to be focused on boosting the incomes of those who buy shirts.

But if the shirt factory is using old machines and does not have enough money to buy modern ones; it cannot supply enough shirts to the shirt seller. This is a supply- side problem. What is needed in this case is cheap credit to make the modern machine affordable.

It is important to get the intervention right. A problem of fewer shirts being produced cannot be solved by a government payout to shirt buyers. This will only lead to more competitive bidding for shirts. Shirt prices will go up further. Similarly, availability of cheap credit will not help if shirt buyers do not have money to buy shirts. The shirt factory will either not take credit, or accumulate more debt, as revenue remains stagnant.

Then there is the structural vs cyclical aspect. A shirt seller might suffer a slowdown in sales during winters. The demand will revive once summer starts. The shirt seller might need some short-term credit during winters. However, if climate change were to lead to a prolonged winter, then annual shirt sales may suffer a permanent hit. Waiting for summer will not fix the problem. A short-term loan will only make matters worse.

Why did India’s economy start slowing? At an event in December last year, chief economic advisor Krishnamurthy Subramanian claimed that “the current (economic) slowdown is a lot more on the cyclical side”. We now have GDP data up to 2019-20. The Indian economy has been losing growth momentum for three consecutive years beginning 2017-18. GDP growth was 8.3% in 2016-17. It fell to 7% in 2017-18, 6.1% in 2018-19 and 4.2% in 2019-20. The economy has never lost growth momentum for three consecutive years since 1991-92. And it has happened only twice before. Between 1989-90 and 1991-92, and before that from 1970-71 to 1972-73. The year 1990-91 saw massive disruptions due to the first Gulf War. And 1971 was the year of the Bangladesh war. These are extraordinary shocks.

To be sure, the Covid-19 pandemic did disrupt economic activity towards the end of the last quarter of 2019-20. However, even earlier estimates had projected slower growth for the year than 2018-19. That India’s growth momentum slowed for three years without an external shock, raises doubts on the validity of claims of a cyclical slowdown. (See Chart 1)

The government’s policy response until 2019-20 was largely a supply-side response. In September 2019, the government slashed corporate tax rates. This was expected to promote investment and boost the economy. RBI has mostly either reduced interest rates or kept them stable. This was expected to reduce the cost of capital and promote investment. The investment component of the GDP, gross fixed capital formation (GFCF), has been contracting for three consecutive quarters now.

A comparison of capacity utilisation levels with GFCF shows why. Capacity utilisation levels in industry have been significantly lower since the last decade. They touched an alltime low in December 2019, the latest period for which data is available. Investment demand follows capacity utilisation levels. Firms will only invest if they can utilise the existing capacity. The trend in the last few years shows that businesses did try to invest even when capacity utilisation levels were low. Such investments have proved to be unwise. Demand did not grow and capacity utilization levels plummeted further. The fact that core (non-food, non-fuel) inflation has been slowing during this period, suggests that even with falling capacity utilisation, there is no scarcity of goods in the market. (See Chart 2)

That misplaced optimism in investing might have extracted a cost from companies. In a paper published in March in the Economic and Political Weekly, Zico Dasgupta from Azim Premji University has highlighted the deteriorating financial health of Indian companies. Dasgupta used the Centre for Monitoring Economy’s Prowess database to calculate interest coverage ratio (ICR) for India’s non-financial firms. ICR is the ratio of a company’s profits and interest payments. If profits are not enough to even cover interest payments, ICR falls below one. In December 2019, this ratio was less than one for almost a fourth of India’s listed non-financial firms. The corresponding proportion, till March 2013, was less than 10%.

The paper argues that the current policy regime has been trying to relax the solvency condition of firms through various measures such as corporate tax cuts and interest rate reductions.

Meanwhile, consumer sentiment seems to be weakening, dragging down demand. RBI’s consumer confidence surveys show that current perceptions on income and non-essential spending have collapsed in the recent period. (See Chart 3)

All this suggests that the Indian economy was likely facing a demand-driven, perhaps even structural slowdown before the pandemic. The policy response most likely misjudged it for a cyclical supply-side problem. To be sure, RBI’s Monetary Policy Committee pointed to weak demand as a problem in its resolutions last year. Unfortunately, the only policy tool available to the committee, interest rate cuts, can do little to boost demand. (This series draws from the author’s work at the Centre for Advanced Studies of India at the University of Pennsylvania as a visiting fellow. It is in the process of being developed as a working paper).