In his statement after the MPC meeting which concluded on Wednesday, RBI governor Shaktikanta Das is categorical on the need to revive aggregate demand in the economy. (Reuters photo)

What’s common to the Reserve Bank of India and a telemarketer offering a Rs 40 lakh personal loan?

Odious as the comparison may seem – RBI, after all, is a respected and credible institution – the chances of RBI’s interest cuts providing a stimulus to growth are probably the same as a random recipient of a telemarketing call proffering a loan accepting the offer.

Thus far, RBI has cut policy rates by 110 basis points so far in 2019. One basis point is one hundredth of a percentage point. However, it has also been downgrading its forecast of projected GDP growth in the current fiscal year. This figure has been brought down by 50 basis points between the February and August monetary policy committee (MPC) meetings. Simply speaking, lower interest rates have not been able to stimulate economic growth so far.

What explains this?

Is there a problem with the fundamental premise of inflation targeting, which suggests that interest rates can be used to strike a balance between inflation and growth in an economy?.

Whatever the explanation is, the fact simply is that economic activity is not responding to cheaper interest rates – and that could be because there’s a problem of either need or affordability.

In his statement after the MPC meeting which concluded on Wednesday, RBI governor Shaktikanta Das is categorical on the need to revive aggregate demand in the economy. “In today’s meeting, the MPC judged that with inflation projected to remain within the target, addressing growth concerns by boosting aggregate demand, especially private investment, assumes the highest priority at this juncture”, Das has said in his statement .

To be sure, there is a difference between aggregate demand in an economy and an individual customer. A lot of demand in the economy is actually what is termed as derived demand.

An example can make this clear. A consumer’s decision to buy a car is usually a function of need and affordability. If incomes fall, so will demand for cars. Interestingly, this will also mean less credit demand by the car maker and others in the supply chain.

Demand may be better revived by either increasing discretionary income in the hands of consumers, or making the cars themselves cheaper.

Aggregate demand in an economy, which is simply the total demand for all goods and services, is reflected in the overall growth rate of an economy.

If it is weak aggregate demand which is holding back economic growth, then lowering interest rates can only have a limited role in economic revival.

But why is aggregate demand low?

There are several plausible explanations.

One is the so-called reversal of terms of trade against agriculture, which has put a squeeze on rural incomes. Global growth has slowing, adversely affecting the Indian economy, which has also been suffering from the twin balance sheet problem of high non-performing assets in banks and credit stress in companies. But none of these are enough to explain the drastic fall in GDP growth rate in the last one year.

Lower food prices, which have led to a worsening of terms of trade against farmers, should have kept the bulk of the economic slowdown in rural areas. That’s not the case anymore. Between 2016-17 and 2018-19, the latest period for which GDP data is available, there is a peculiar synergy between growth of gross value added (GVA) in agriculture and non-agricultural sectors of the economy, with both moving in the same direction. This is not seen in the earlier period during 2005-06 and 2015-16, rest of the period for which GDP numbers are available in the 2011-12 series. The Indian economy was increasingly outperforming the global economy during the period from 2012 to 2016. This trend has reversed since 2017.

The other is the crisis in banking.

The argument against this is simply that the situation in the banking sector has actually improved. The June 2019 (latest available data) Financial Stability Report of the RBI notes that share of NPAs peaked in March 2018 and has been coming down since then.

That a resolution of the banking crisis should lead to an economic slowdown is counter-intuitive.

So, what explains the current problem? There could be an X-factor which would not lend itself to conventional economic analysis.

In its first term, the present government aggressively pushed policies which were aimed at formalising the Indian economy. Demonetisation and Goods and Services Tax (GST) both achieved this. The result is a widening of the tax-base i.e. increase in number of tax payers. The government has cited this as one of the biggest successes of these policies, and believes that, even if not immediately, in the long-run, this will result in a significant increase in tax collections.

This formalization has increased the cost of business for the informal sector, and, as one would expect, for small businessmen who were simply not paying all their taxes For instance, a small property developer might have been selling five flats every year and taking 25% of the price in unaccounted cash to avoid paying taxes. He might have been using this unaccounted income (having shown it as legitimate after some fudging in accounts) to buy a car every two-three years. This option might not be available now because of better tax compliance, as it has become far more difficult to fudge expenses due to GST and post-demonetisation directives have prohibited large-business dealings in cash. This squeeze might have prevented the property developer from buying a new car.

It is difficult to prove or disprove such arguments with certainty, because there’s no data on unaccounted incomes. However, unaccounted incomes are likely to be spent in cash, lest there is a money trail which can be used by tax authorities. And there is data on electronic retail transactions (credit and debit cards, pre-paid instruments such as wallets, and mobile banking). Comparing this data to car sales provides some interesting insights.

Until mid-2018, which is exactly a year after GST, these two metrics followed the same trend even if their magnitudes varied. This is not the case anymore, as the two show a drastic divergence now.

The period which shows such divergence includes a good part of the phase when liquidity was restored after the demonetisation shock, which rules out an artificial boost to non-cash transactions. This trend supports the thesis of squeeze in unaccounted income leading to weakening of demand. Findings from the RBI consumer confidence survey also corroborate these arguments, as they show a sharp fall in both current and year-ahead perceptions on non-essential spending from June 2018.

The Indian economy cannot go back to the weak tax-compliance regime which existed before demonetisation and GST. However, if this transition entails a sacrificing of significant amount of aggregate demand which was being financed from unaccounted incomes, then this is a structural negative shock to the economy.

No amount of interest rate reductions or even conventional fiscal measures such as building more roads or buying more food grains from farmers is going to compensate for this demand.

Ethically, there is nothing one can say against the turning of tables against people who were not paying their due to the sovereign in terms of taxes. But, in material terms, this cleanliness drive in the Indian economy might have come at a huge price.