There are two competing, economic narratives on India at the moment. They sit uneasily with each other. But both are correct.

The first narrative

The first centres around the dramatic improvement in macroeconomic stability. Just four years ago, India was the poster-child of emerging market vulnerability. Double-digit inflation, and elevated fiscal and current account deficits (CAD) drove India into a mini balance of payments crisis in 2013. Four years later, India is widely considered the “safe haven" among emerging markets. The CAD collapsed from nearly 5% of gross domestic product (GDP) in 2012-13 to less than 1% in 2016-17, and is currently financed twice-over by foreign direct investment. To be sure, much of the CAD narrowing is because of good luck (lower oil prices) but that is likely to sustain given the progressively lower break-even for shale. More generally, however, much of the improved balance of payments reflects distinctly improved macro fundamentals.

Foremost among them is the dramatic reduction in inflation. After averaging 10% between 2008 and 2013, consumer price index (CPI) inflation has averaged less than 5% over the last three years, despite successive droughts. To be sure, some of the disinflation is likely cyclical, reflecting generalized slack, manifested in the slowing of core inflation and slowing demand in the rural economy. But to attribute this purely to weak demand is to do injustice to policymakers. The sheer breadth of the food disinflation and the reduction in its volatility is likely underpinned by improved supply chains, muted minimum support price (MSP) increases, and proactive import management. Furthermore, with inflation expectations so adaptive, the sustained disinflation has likely also begun to soften expectations that have, in turn, contributed to the disinflation.

The progress on inflation can be seen best in two ways. With June inflation at 1.5%, who would have thought the first meaningful miss to the Reserve Bank of India’s (RBI’s) inflation band of 2-6% would be to the downside? Second, against the backdrop of the 2013 interest rate defence of the rupee, who would have thought that by 2017 the RBI would potentially be able to ease rates even when all the major central banks are headed the other way? Therefore, high marks for macroeconomic stability.

Equally, high marks for structural reform. The year 2016 witnessed four transformational pushes: Aadhaar, the bankruptcy law, goods and services tax (GST), and codification of the new monetary policy framework. To be sure, many had hoped for a simpler GST, but at least we finally have a common market and a value-added tax that spans the entire base. The productivity enhancing benefits of the former, and the compliance-inducing benefits of the latter, cannot be overstated. Over time, revenue buoyancy should hopefully induce the GST council to move to a simpler rate structure.

Similarly, Aadhaar is transforming the way the state interacts with the citizenry, the bankruptcy law should eventually help facilitate the much-needed “creative destruction" of capital, and the new monetary framework will ensure that inflation never again gets entrenched at 10%. These are not small gains. This, then, is the first narrative governing the Indian economy: heightened macroeconomic stability combined with stronger medium-term growth prospects.

The second narrative

There is, however, a second—more sobering—narrative: of a near-term slowdown that may be hard to reverse using traditional fiscal and monetary policy.

After the latest gross domestic product (GDP) revisions, the statistics have finally caught up with the economy. It’s clear now that growth had begun to slow well before demonetisation. Core GVA (gross value added adjusted for agriculture and government spending)—capturing the private sector business cycle—slowed from nearly 11% in March 2016 to less than 4% in March 2017. While deflator-related issues may exaggerate the levels, the slowing trajectory conforms with a wide variety of high-frequency indicators that reveal slowing growth for over a year now.

Furthermore, the recovery post-demonetisation has been incomplete. The seasonally adjusted levels of industrial production and auto sales, for example, are still below what they would have been had the pre-demonetisation momentum continued. No wonder then that pricing power remains weak, and core inflation continues to drift down.

But slowing growth should not surprise us. India has lost two important growth engines. Exports grew at nearly 18% a year for five years between 2003-08, propelling GDP growth to 9%. In the last few years, they have grown at a meagre 3%. A 15 percentage point slowing for a sector that constitutes 20% of GDP itself slows headline GDP by 2 percentage points (after accounting for the import content of exports). In addition, the collapse in oil prices boosted growth by more than a 100 basis points (bps) in 2015-16, but that support has disappeared with oil stabilizing. India, therefore, needed new growth drivers. But the “twin balance sheet" problem—unsustainable debt on corporate balance sheets and impaired assets of public sector banks—has become a significant headwind.

This has been accompanied by concentrated stress in agriculture. With food inflation slowing much faster than non-food inflation, the terms of trade have moved sharply against agriculture for the last five years (see chart 1), squeezing real purchasing power for farmers. This sustained relative price shock has been exacerbated by successive droughts. The latest collapse in prices is likely the straw that broke the camel’s back. But reacting by sharply increasing MSPs—which the government has wisely restrained from—would simply re-stoke a vicious cycle of higher food and headline inflation, wages and MSPs. The real policy challenge is how to keep food inflation contained while providing a remunerative margin for farmers? The answer is well-known: increased agricultural productivity.

The policy challenge

The broader policy challenge is how to respond to the economic slowdown? Is a large, counter-cyclical fiscal or monetary response warranted? I will argue any such response will be highly inefficacious.

Take fiscal policy. Several states have promised farm-loan waivers to alleviate the rural distress. First, it addresses the symptom, and not the cause. Second, state finances are on a perilous path.The consolidated state fiscal deficit has widened by 1% of GDP over the last five years and largely undone the Centre’s consolidation. State market borrowing has doubled in just three years. Consequently, spreads of state bonds yields over government bonds have tripled in just the last two years. Higher spreads spill directly into the corporate bond market. We find that every 100 bps increase in state bond spreads pushes up corporate bonds spreads by 60 bps. This increase in spreads has meaningfully impeded transmission from the rate-easing cycle into corporate bond yields. The RBI has cut policy rates by 175 bps in the current cycle, and between March 2015 and March 2017, government bond yields declined 90 bps, but corporate bond yields fell only 30 bps. Keeping corporate bond yields higher than they need to be, at a time when the banking system is in such a logjam, risks crowding out private investment.

The increase in state bond spreads suggests markets are struggling to absorb more issuances. Furthermore, faced with a large balance of payment surplus, the RBI is likely to intervene aggressively to prevent more rupee appreciation (particularly since surging imports are creating concerns of import substitution with the rupee having strengthened 12% against the Chinese yuan since 2016) and then sell government bonds to sterilize the impact. Against this backdrop, any further fiscal relaxation by the Centre/states is likely to put significant pressure on bond yields, and private sector borrowing costs.

Finally, given the recent evolution of state finances, an increase of just 0.5% of GDP of the consolidated deficit will cause debt-to-GDP to start rising again. So fiscal space has been exhausted.

What about monetary policy? The inflation decline is certainly opening up space for some easing, but markets are expecting 25-50 bps of cuts at most, given the tougher task of keeping inflation at 4% across the entire business cycle, not just at the bottom ebb. But is monetary easing efficacious in the current environment? Monetary conditions have generally eased over the last two years, notwithstanding some increase in recent months (see chart 2). The RBI has cut rates by 175 bps, liquidity has gone from a deficit to a massive surplus, banks have slashed marginal cost-based lending rates by 90 bps post-demonetization, the benchmark yield curve has flattened materially over the last year, and yet credit growth continues its inexorable slowing. This clearly suggests other factors (balance sheets, implementation bottlenecks) are at play. Furthermore, transmission in the corporate bond market has been impeded by state fiscal dynamics, which are poised to get worse. Therefore, the RBI may well cut policy rates, but will it really move the needle?

That, then, is the second narrative. A sustained slowdown combined with limited efficacy of a standard, counter-cyclical response.

How should policy respond? The key is not to panic, but keep fixing the economy’s plumbing. Double down on asset resolution in the banking sector, plow stronger tax-revenue from demonetisation/GST into higher public investment, rein in state deficits to push down the private sector cost of capital, and keep plugging away on reducing infrastructure bottlenecks. Put differently, hang in till the growth dividend from deleveraging and productivity-enhancing reforms (GST, Aadhaar) kicks in. Unfortunately, there are no quick fixes at the moment. Furthermore, overreacting to the second narrative (slowing growth) simply risks jeopardizing the first one (macro economic stability).

Sajjid Z. Chinoy is chief India economist at JP Morgan. These are his personal views.

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