The advance GDP estimates, which do not incorporate demonetisation effects, project a deceleration to 7.1% in 2016-17 from 7.6% last year. (Reuters)

The first quarter of 2016-17 was marked by stories of green shoots firming up and further uplifting growth. We had discounted such views in these pages in May 2016, convincingly making the case that most lead indicators were not sustaining beyond a few months; pro-growth acceleration arguments were therefore, on a weak footing. Optimism nevertheless held high upon expectations of good monsoons and implementation of the 7th Pay Commission award to boost consumption. Both materialised. Plus bountiful revenues from fuel taxes ensured there wasn’t any fiscal stress in financing higher salaries.

And yet, the economy slowed even before demonetisation. The advance GDP estimates, which do not incorporate demonetisation effects, project a deceleration to 7.1% in 2016-17 from 7.6% last year. But the more striking feature is a sharper slowdown of both industry and services (excluding public administration); the former is anticipated growing only 6.1% from 8.8% a year ago, while the latter is seen chugging along at 6.8% instead of 8.6% in 2015-16. From the demand side, gross fixed capital formation (GFCF) is projected to contract; private consumption will slow down to 6.5% against 7.4% last year.

This slowdown is a bit of an anti-climax for the government and RBI and raises policy concerns: How come private consumption slowed in a year when inflation fell, agriculture growth rebounded and the government disbursed a hefty pay hike? Why does private investment remain withdrawn and is retreating at a confluence of falling loan rates and FDI at historic peak in a backdrop of rock-solid macroeconomic stability?

These questions can neither be brushed aside as temporary aberrations, nor buried under near-term concerns about post-demonetisation developments. Because this trend reversal could be worryingly related to the government’s strategy of incremental reforms!

Optimism misplaced

The timing for demonetisation couldn’t have been worse. It was an unanticipated blow to a faltering economy. Most forecasts however expect a V-shaped rebound in about two quarters in 2017-18. These completely downplay the slowdown that evidently set in much before demonetisation happened; if anything, it could have knocked it down further. The self-explanatory charts accompanying this piece cast a shadow over this optimism.

A health-check shows most lead indicators still weak, some more fragile than before. Exports and IIP gained some traction over a negative base, but it is uncertain if these will hold up beyond a few months. Capacity utilisation remains where it was in last several quarters. Real bank credit growth has fallen further to zero; credit to industry saw deep contraction. Non-performing assets rose sharply; with demonetisation, these could deteriorate further.

Corporate top line, volumes’ growth is mostly subdued; margin pressures re-appeared with trend reversal in input prices. The infallible proxy for business health could be real corporate tax revenues-trend growth fell sharply to 1.5% in April-December 2016 from 8.1% in 2015-16 when deflated with WPI and turned negative when adjusted with CPI. Likewise, real excise duty collections (corrected for additional revenue measures, ARMs) that track manufacturing activity dropped to 2.3% in April-October, 2016 from 7.5% in 2015-16 when deflated with WPI for manufacturing.

Post-demonetisation, these trends have worsened further. Puzzling where the optimism comes from!

Work not done

Reforms are aimed at pushing growth, a strikingly similar concept to that of ‘force’ in physics. Force is applied to move an object, which is defined as ‘work done’. If applied force fails to displace the object, ‘work is not done’. Interpreted differently, applied force either did not have sufficient mass or acceleration to outweigh the opposing forces. If growth begins to falter mid-way through a recovery, how should reform efforts be judged?

The optimism of most analysts is underpinned by several baby-step reforms undertaken by the government, the assumption being “the whole would be bigger than its parts”—not big bang, but “persistent, creative and encompassing incrementalism” under the overarching ‘sweet spot’ of ‘a strong political mandate and favourable external environment’ (Economic Survey, FY15). It was argued these wouldn’t just guide prospective action but also be the benchmark for retrospective assessment.

Juxtapose this assertion with the moribund private investment, the contracting stock of capital, and you wonder where have things gone wrong? Let us return to the simile of ‘mass” and ‘acceleration’—it becomes apparent that all parts haven’t formed the critical mass or gained acceleration to push growth higher. Reasons could be several: i) reforms like inflation targeting combined with fiscal consolidation could have severely constrained demand in the short-to medium term; ii) retrospective taxation-related uncertainties could have persisted far too long; iii) the pace of clearing stalled projects might have lost momentum; iv) savings from subsidy reforms could’ve been sub-optimal, slowing public capex; v) initiatives like Indradhanush might still be at an early implementation stage; vi) factor market reforms relegated to states might have fizzled out as attraction for investors; and/or vii) GST, bankruptcy laws’ implementation may have been delayed.

What stands out is the failure to meaningfully address the balance-sheet distress of big corporations and banks, a key element in reviving investment and growth. Initiatives from RBI like CDR, SDR, S4A, etc, hardly managed to reduce the stock of stressed assets. Rising NPA levels suggest the fortuitous window of three years of above-7% growth, driven by terms-of-trade gains might fast be closing; if demonetisation worsens this any further remains to be seen.

You May Also Want To Watch:

Economy at the cusp of recession?

The exhaustion of all growth drivers, in conjunction with reversal of an extraordinary positive terms-of-trade settings, surely suggest deceleration instead of a V-shaped recovery? Regard each demand driver by turn.

Private consumption is wilting with the rising burden of indirect taxes—now plainly regressive—and waning real incomes.

Government capex spending has hit a ceiling as the windfall fuel-duty revenues disappear, corporate tax revenues decline and adverse base effects set in, apart from increased expenditure liabilities from wage revisions.

External conditions are no longer as favourable for prices and interest rates, which narrows policy choices through effects upon exchange rate and capital flows. India also faces unique, adverse and possibly lasting headwinds to its services’ exports even as those of goods recover; this increases external sector pressures.

Private investment has failed to revive despite the modest fiscal pump-priming and innumerable reform efforts. Foreign direct investments have failed to stem the downward slide, while themselves tapering off.

The government is pinning its hopes on lower interest rates for revival of investment and consumption demand but it is uncertain how much this can help if structural issues remain unaddressed. Uncertainties after demonetisation could be dampening; delayed rollout of GST does not help either. One must also flag that excessive pressures upon the exchange rate beyond a critical threshold could trigger fresh stress in corporate balance sheets from unhedged exposures, in a throwback to events of 2013.

With private consumption tapering, terms-of-trade impetus fizzling out, no investment revival and insufficient fiscal room for capital spending, the economy could be on the cusp of a recession?

Hopefully, the forthcoming budget may address many of these concerns.

The author is a New Delhi based economist