This story starts with the global financial crash. Desperate to stave off the impact of the crisis, the Indian government went in for a huge monetary and fiscal stimulus. The fiscal deficit went up from 2.5% of gross domestic product (GDP) in 2007-08 to 6.5% in 2009-10. Interest rates were lowered. Banks continued to lend hand over fist, especially to the infrastructure sector—bank credit to infrastructure was up an eye-popping 40.7% in 2009-10. The corporate sector responded enthusiastically—growth in gross fixed assets was 19.95% in 2008-09 and 19.3% in 2009-10, according to the CMIE database.

But the stimulus only succeeded in delaying the inevitable. International crude prices rocketed, domestic inflation soared and the central bank started raising interest rates in 2010. The current account deficit widened. The result was a balance of payments crisis in 2013 and plunging growth.

By the end of 2013, though, the worst seemed over. GDP growth in 2013-14 was 6.4%, above the previous year’s 5.5%. The balance of payments crisis had passed. The fiscal deficit/GDP ratio was well below the high of 2011-12. From December 2013, inflation too started falling.

China emerged as an unlikely saviour for the Indian economy. Chinese GDP growth plunged from 10.6% in 2010 to 6.9% in 2015. And since China was the biggest mover of commodity prices, they fell dramatically. The IMF industrial inputs price index, which averaged 197 in 2011, fell to 123 by 2015. US shale oil production also pushed down oil prices. Brent crude oil prices, which averaged $112 in 2012, had fallen to $52 by 2015. The International Monetary Fund, or IMF, calculated that the windfall gain for India on account of the fall in commodity prices was over 3% of GDP in 2015 and another 0.5% in 2016. This column had pointed to the windfall gains last October.

To gauge the extent to which lower oil and commodity prices supported growth, consider that India’s GDP growth at constant prices improved from 7.5% to 8% in 2015-16. It was the fall in commodity prices that enabled the economy to show higher growth.

That, in turn, enabled the government to reduce subsidies, prune the fiscal deficit as well as step up capital expenditure. Food inflation was controlled by keeping minimum support prices under check.

As oil and commodity prices stabilized, however, this boost to growth started to disappear. For a time, the implementation of the seventh pay commission recommendations supported domestic demand. But growth started falling off from the June 2016 quarter. This was exacerbated by the shock of demonetisation and later by the disruption caused by the introduction of goods and services tax (GST). What’s more, bad loans from the earlier lending spree came home to roost in bank balance sheets.

This, in a nutshell, has been the story of the Indian economy in the last decade or so.

What of the future?

The Bull case

The cheery, glass-always-half-full view of the economic slowdown is well known and clear enough. We’ve had some setbacks due to demonetisation and the introduction of the GST, but that’s water under the bridge. Growth will soon be back on track and the economy will be off to the races. This is the scenario with which the stock market is operating, with their optimistic projections of corporate earnings growth.

Baby Bear

But the bears are lurking in the woods. As we’ve seen, the slowdown in the economy started before demonetisation. What is the guarantee then that growth will return to normal as the effects of demonetization and GST wear off? An HSBC report by Pranjul Bhandari and Aayushi Chaudhary says, “Growth had begun to slow from the middle of 2016, well before the demonetisation episode. In our view, it was led by the rolling off of the oil bounty. This driver of growth does not exist anymore."

There are few signs of a revival in investment demand. Commodity prices have been moving up again, which could offset any improvement in the global economy. The banking system is still in deep trouble. The waiver of farm loans will stretch the resources of the states and the axe may fall on capital expenditure. Nobody knows how badly the informal sector will be affected as a result of the note ban and GST, and the impact on jobs and consumption demand. In short, the recovery is likely to be much less certain and will take time.

Big Bear

Under this scenario, the recovery is going to take even longer, ironically because the government is doing all the right things. In addition to the headwinds mentioned in the Baby Bear scenario, the inability of businesses to make a fast buck by getting cheap coal or cheap spectrum or other publicly-owned resources, the clampdown on crony capitalism—if it is indeed serious, will all act as a brake on accumulation. Some of these issues were raised in this column three years ago.

Says Axis Bank chief economist Saugata Bhattacharya, “The attempt to bring about a structural change in the economy by way of the crackdown on black money, benami properties and increasing formalization may slow growth for some time." Also disruptive, if implemented properly, will be the Real Estate (Regulation and Development) Act, 2016. In short, cleaning up Indian capitalism and a frogmarch to a formal economy will entail costs. The folks at Ambit Capital had warned of this as far back as March 2015, in their report, Modi hits the ‘reset’ button. The government’s objectives are admirable, but they have the potential to slow down the economy for a few years until businesses are forced to learn the new rules of the game.

Extreme Bear

Proponents of this view are far less sanguine about the long-term prospects of the Indian economy. They believe, as Abheek Barua, chief economist at HDFC Bank, says, India is in danger of being caught in a middle-income trap. As the ADB’s Asian Development Report, 2017 points out, Asian economies have successfully transitioned from low- to middle-income status, but the road ahead will be very different. What is needed now, says the ADB, is “encouraging innovation and technological progress, upgrading human capital quality, and investing in information and communication technology (ICT) and other advanced infrastructure".

But isn’t India still in the stage of Lewisian transformation, in which the economy develops as people move out of underemployment in agriculture to more productive jobs in industry? India may have already missed that bus and Barua says it is not possible to go down the road that China travelled. We will have to chart our own path, which is not going to be easy. The increasing capital intensity of manufacturing, automation and the backlash against globalization will all work against us, and finding good jobs for a burgeoning workforce will be a huge challenge. Absent the productivity, institutional and human capital improvements, low growth rates could be the new normal.

Manas Chakravarty looks at trends and issues in the financial markets. Respond to this column at manas.c@livemint.com.

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