Why govt will need to adopt a different economic strategy
NEW DELHI: 2020-21 is the year of largest economic contraction in post-independence India, but is not the first. India suffered a GDP contraction in 1957-58, 1965-66, 1972-73 and 1979-80. However, there is good reason to believe that the economic strategy to revive the economy from its current predicament will have to be very different from the previous episodes of contraction. This is because the macroeconomic situation which prevailed during the previous contraction years was very different from what it is now. Here are five reasons why this is the case.
No food supply constraint, but farm incomes still precarious
The first difference between the current and past instances of GDP contraction has to do with agriculture. 2020-21 will be the first year when India’s GDP will see a contraction despite positive growth in agriculture. Unlike now, India used to have a major food supply constraint before the green revolution, which started in late 1960s and led to a large increase in production of rice and wheat. In fact, the agrarian challenge facing the government is the exact opposite of what it used to be in the first two decades after independence. Faced with food shortages and high inflation, the central government actually wanted to procure more food in the 1950s and 1960s, only to face resistance from state governments and the local farmertrader nexus in various parts of the country.
Today, farmers actually want the government to procure more food grains at Minimum Support Prices (MSPS), as they find it more attractive than the market prices. This demand has been reiterated during the ongoing farmers’ protest. While the increase in agricultural production has ensured that India does not have to lead a ‘shipto-mouth’ existence, this has not necessarily translated into higher incomes for farmers. The fact that the current government has promised to double farmers’ incomes is an acknowledgement of this reality. While Indian agriculture is self-sufficient, it is caught in a viability crisis.
No obvious foreign exchange constraint but challenges remain
While India did well to alleviate its food supply constraint without large scale economic reforms, the foreign exchange problem kept worsening and ended up in India staring at a payment default in 1991. India has come a long way in the last thirty years and foreign exchange reserves have continued to reach new highs. To be sure, India’s comfortable foreign exchange situation is very different from a country like China which runs an export surplus. Because a large part of the India’s foreign exchange reserves are financial flows, and can move out at very short notice, there is an asymmetry in their costs and benefits. Prolonged outflows of such funds generate tail winds for the rupee, which can erode competitiveness of exports and extract an interest payment cost, and they cannot be invested in productive long-term activities. The last budget tried to ease the second constraint by floating the idea of issuing dollar denominated sovereign bonds – this was objected to by many independent economists – but no progress has been made on this front. Although interest rates in the developed world are at near zero levels currently, the government will have to keep in mind the possibility of a sudden capital flight like the taper tantrum in 2013.
India’s first demand driven contraction after a prolonged slowdown
While the Indian economy does not face the problems of wage goods (food) and foreign exchange which it had to deal with in its earlier episodes of contraction, it has a serious demand side problem. The pandemic’s economic shock has led to a large scale loss in employment and a consequent fall in incomes, especially of those at the bottom of the pyramid. A twopart series published in HT by economists at the Azim Premji University discussed this in detail. Research by many other economists has underlined that the pandemic is likely to increase economic inequality as the rich, both individuals and companies, have been spared the worst effects. There are many others, including this author, who have argued that India faced a demand-driven slowdown even before the pandemic, and things have only become much worse now. While India did well to boost demand in the aftermath of the global financial crisis of 2008, finances, both of government and households were in a much better situation then.
Preserving financial sector stability
If there is one sector which has been caught in a systemic crisis after the 2008 shock to the Indian economy, it is finance. The irrational exuberance led debt-heavy boom, something which the former RBI governor Raghuram Rajan termed as riskless capitalism culminated in what the former Chief Economic Advisor Arvind Subramanian described as the twin balance sheet crisis, where both banks and businesses were unable to carry on their expected tasks of lending and investment due to a pile up of bad debt. The true magnitude of the banking crisis was only known after RBI under Rajan forced an asset quality review in 2015, and some corrective action was taken in the subsequent years.
However, the banking crisis proliferated to non-banking financial companies towards the end of the last decade, one of the important reasons for the economy losing momentum once again. The pandemic’s economic disruption to companies’ earnings has the potential of creating a large pile of bad debt on its own. Because this comes in the backdrop of a pre-existing crisis, its impact will be even more severe. The RBI’S latest Financial Stability Report expects that the ratio of Gross Non Performing Assets to total advances for banks could go up to as much as 14.8% by September 2021 compared to 7.5% a year ago. Government owned banks are expected to experience the most pain. This underlines the importance of making adequate provisioning for bank recapitalisation in the budget. Any such exercise will have to be mindful of the fact that unless the larger economy sees a healthy and sustained revival, even nonstressed loans could end up in the stressed category in the future. To make matters worse, money is not the only problem facing India’s government owned banks. Experts have been pointing out that unless there are large-scale governance reforms and the government drops ad-hocism in recapitalisation of banks, things might not improve despite the government putting in more taxpayer money in the banks.
Who will pay for the fiscal boost?
The Narendra Modi government’s larger philosophy around economic policy can be summarised as a mix of welfare benefits and a push for formalisation. Efforts toward the second have come in the form of policies such as demonetisation, Goods and Services Tax (GST), and the corporate tax cuts announced in September 2019. The implicit assumption behind such a policy paradigm is that the formalisation push will increase growth and keep generating more resources for welfare benefits. With GDP growth decelerating and eventually entering a contraction zone due to the pandemic, revenue has suffered a large fall as well. Even non-tax incomes from programmes such as disinvestment have not materialized in a contraction ridden economy. The government faces the unenviable task of not just financing its welfare programmes but also generating resources for a larger fiscal push. The budget, at the end of the day, is a zero sum game and extra spending must be financed by either current incomes or borrowing. This raises the question of locating the extra resources for a fiscal boost in the forthcoming budget. One way to do so would be to rely on greater indirect tax proceeds via a hike in customs duty, raising or continuing the high cess on petroleum products or a hike in GST rates by the GST Council. None of these measures are without their adverse effects. In addition to being inflationary and regressive – indirect taxes create the same burden on the rich and the poor – there are other potential pitfalls. A hike in customs duty can increase the cost of imports required for producing export goods and chip away at export competitiveness. Continuing dependence on special cess and duties will mean that states, which have done a lot of the heavy lifting during the pandemic, will not have a claim to these revenues and might have to cut back on their spending, potentially negating the positive effects of a central boost. A direct tax route, especially through a hike in corporation tax rates runs the risk of dampening animal spirits and could generate discontent among the big-business community against the government. The government will have to depart from its established economic philosophy to provide a healthy fiscal boost to the economy. The government could also announce ambitious disinvestment targets, but given this year’s experience, these will not generate much confidence about the adequacy of budgetary resources to boost the economy.