India’s current economic slump, accompanied as it is by a multi-decade high unemployment growth, rural wage stagnation and decline in average consumption expenditure, is in a category of its own.

This cannot be strictly seen as part of a larger global slowdown as the ruling party’s spin doctors would have us believe. Some of the dominant features of India’s economic stagnation are domestically driven and the Modi government will do well to explicitly acknowledge this in the forthcoming budget. Only then can appropriate policy prescriptions be evolved.

There are some clear features which distinguish India’s economic slump from those of other peer economies. Firstly, the extent and nature of the fall in GDP in just four quarters, the negative growth being recorded for several months in the core sector performance dominated by energy production, and the consistent decline in imports and local manufacture of capital goods (a proxy for private investment) is unique to India.

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However, the most distinguishing feature of India’s economic slump is a single piece of RBI data – an 88% fall in total credit to the commercial sector in the first six months of 2019-20 as compared to the same period in 2018-19. Mind you, this figure includes lending by banks and non-banking financial companies (NBFCs) which had been the main driver of consumer credit and housing finance in earlier years. In terms of actual amount, the total credit to the commercial sector has fallen from over Rs 7 lakh crore to a little over Rs 90,000 crore. Is there any other slowing economy in the world where credit to the commercial sector has fallen by nearly 90%? In simple terms, this is a bit like telling a marathon runner to run with the same efficiency while her diet is curtailed by 90%!

The real import of this one data point has not been fully absorbed so far. More pertinently, a fall in credit of this magnitude is not a cyclical problem because it signifies a deep rot in the financial system which is the lifeblood of any growing economy.

The second twin balance sheet problem

In my view, this is the most distinguishing feature of India’s current economic slump. In the first five years of the Modi government, the balance sheets of state-run lenders were under repair and most PSU banks were not lending at all because they were grappling with stressed loans of over Rs 10 lakh crore. But NBFCs, the firms that make up India’s shadow banking system, were lending in a robust way, especially after demonetisation brought huge liquidity in the system and enabled these financiers to access short term credit by floating 3-6 months debentures and commercial papers which were mostly bought by unsuspecting mutual funds.

NBFCs accounted for over 75% of the total incremental credit to commercial sector in the post-demonetisation period. However, in the past year or so many big NBFCs (Dewan Housing being one) with balance sheet size comparable with some banks have either collapsed or stopped lending.

They owe banks about Rs 2.5 lakh crore and most of this is turning into NPAs. The Narendra Modi government’s former chief economic adviser, Arvind Subramanian, calls this the second twin balance sheet problem – the first one was caused by PSU banks running up huge bad loans during the UPA period by indiscriminate lending.

While the Modi government holds the UPA responsible for the PSU bank NPAs, the BJP must take full responsibility for what has happened with the NBFCs in the past three years. After demonetisation, banks were flush with liquidity and they started funding NBFCs for on-lending to commercial sector. Part of this funding was also used by NBFCs to postpone repayments of bad loans made to real estate and other cronies in previous years. There is ample evidence of NBFC funds being used to evergreen loans of well-known crony capitalists who were struggling to repay PSU bank loans taken in the UPA era. The same cronies were gaming the system, but this time via NBFCs and under the Modi regime. In a way, the big NPA problem of banks was being transferred to NBFCs. That party is over now and soon a fresh wave of bad loan recognition will come.

Experts believe the NBFCs, especially housing finance companies, are still hiding the actual quantum of their bad loans. It is unprecedented that DHFL went into bankruptcy proceedings without PSU banks declaring how much lending to DHFL had actually gone bad – the figure is still a mystery. The RBI has been monitoring these bad loans but nothing is out in the public domain.

Will the Budget acknowledge this?

This is what constitutes the uniqueness of India’s economic slump. One doesn’t know whether the Union Budget will at all acknowledge this second twin balance sheet problem in India’s financial system. So even if demand recovers marginally in the urban economy, as is being speculated by some experts, it is not clear whether the financial system is in the right shape to support such demand. After all, a nearly 90% decline in total credit to the commercial sector is unprecedented and it seems as much a structural issue requiring a deeper surgery.

So, the Modi government has a lot to answer for in the way it has mismanaged the economy, especially the bleeding financial system. Again, to begin with, Modi needs to acknowledge the problems at hand. The prime minister has taken direct charge of the economy, we are told. He can start by admitting that demonetisation is largely responsible for the deepening of the current demand crisis in the economy.

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A highly regarded former RBI governor recently told me that in the last 70 years, India’s economy never slowed so sharply due to a domestic demand slump. It was always a supply-shock linked to either oil or drought in rural areas. Official documents never spoke of a persistent demand problem stretching across four-to-five years in what is still a largely untapped consumer market. This was confirmed by at least two chief economic advisors in the finance ministry in the late 1980s and 1990s. They said that the Economic Surveys of the past never made a diagnosis of a severe medium-term demand problem in an economy where even today about 800 million people are yet to access basic comfort goods like proper urban housing and consumer durables like refrigerators, air conditioners, washing machines and small cars.

So, how can we have a persistent demand crisis, which has been the dominant economic narrative over the past three years? This is understandable in the developed world where most households already possess these items but how can India have such a persistent demand issue, economists ask. If Modi seriously addresses this question, he might have some of the answers, if not all.