The slowdown is cyclic, aggravated by a focus on structural reform, that neglected responding to a slowdown in industry and investment evident since 2011. There were structural features, such as constraints in agriculture, that kept food inflation high. But industry paid a disproportionate and unnecessary cost, since real interest rates were raised to the highest-ever historical levels to fight food inflation, for which their effectiveness was limited. The financial sector and foreign investors favoured the conservative monetarist stance, because they value macroeconomic stability, but perhaps they did not realise that excessive tightening also creates risk in Indian conditions. Growth that was lower than potential for almost a decade hurt investors also. Despite the noise about deficits and inflation, research shows that the country ratings are most strongly associated with per capita output, which depends on growth.

As real appreciation and high interest rates damaged domestic industry, the economy’s import dependence increased. As oil import dependence sets a floor to rupee depreciation, stimulating domestic demand and reducing supply costs to maintain the Indian industry’s export competitiveness is particularly important.

Tight liquidity

High real interests aggravated and sustained NPAs. Highly leveraged firms find it difficult to repay, more so if earnings fall since demand is kept low. An asset quality review cannot help when assets keep deteriorating. The decision to keep durable liquidity in deficit since 2011 aggravated matters. The deficit often became too large, since the Indian economy is subject to large liquidity shocks, for example from movements in foreign capital. Cash leakages are higher in tight liquidity conditions. Short-term liquidity available in the LAF was not an adequate substitute.

No offset for external shocks or short-run structural reform costs meant any fledgling recovery was short-lived. Those who question the Indian GDP estimates find it puzzling how growth reached 8.2 in the year after demonetisation. But this was precisely the period when banks and mutual funds were flush with funds, which they lent to NBFCs who on-lent to firms and consumers. The availability of liquidity was an important growth enabler. By 2018, durable liquidity had become tight again, partly due to foreign outflows. It was unfortunate that this tightening coincided with the problems in IL&FS, that severely constrained funding to NBFCs. The current slowdown started in the second half of 2018, with the tightening of aggregate and sectoral liquidity. It follows that a reversal can ameliorate it.

Moreover, government spending in the second half of 2018-19 was lowered by about 2 per cent of the GDP in order to meet fiscal deficit targets. This government tends to front-load spending and to spend more in the first half of a fiscal year. Private investment also slowed, partly due to pre-election uncertainty, while the global slowdown affected exports. Falling incomes, as well as credit, slowed consumption.

The liquidity deficit turned surplus only in June, after one year. The long squeeze had left pockets empty. There were hardly any real estate transactions. The consumption and growth slowdown is not surprising.

Change in monetary policy

The good news is that these conditions are changing. Monetary policy has finally become accommodative, liquidity is in surplus, many schemes are making it easier for NBFCs to get liquidity, and there are signs the government is front-loading spending again since July. The transfer from the RBI is only 0.75 of the GDP, but can help jump-start planned spending through a rise in money supply, without forcing the government to borrow ahead of revenues and thus raise G-Sec interest rates. The Finance Commission may relax the FRBM to enable counter-cyclical spending. Privatisation can transform government assets into infrastructure, which has more spillovers. For the first time after the global financial crisis, monetary policy is loosening to counter an external shock and the exchange rate has depreciated to competitive levels. The festive season should see some cheer. If real interest rates come down, the drag on demand, in place since 2011, would dissipate.

The reversal in macroeconomic tightening is sustainable because of the softening of three key structural constraints: A surplus in agriculture, together with soft global prices, will keep food inflation low. Also, the changing dynamics of global oil markets is likely to keep oil prices, and India’s import bill, manageable. Third, a functioning bankruptcy code, so that promoters cannot pass on all their losses to the taxpayers, makes fuller recapitalisation of banks possible. The robustness of regulation and corporate governance has steadily improved. Bankers also have greater safeguards against arbitrary prosecution. Banks have recovered some money, NPAs have bottomed out and credit growth shows signs of picking up.

Calculated reform

The traditional-reform lobby sees land-labour reforms as necessary for growth to revive. Those are the structural constraints they highlight. But structural reform cannot reverse the growth slowdown, since it has long delivery lags and large short-run costs. Reforms are required to bring down costs of doing business and improve productivity, but they need to be done continuously and unobtrusively, not as a big bang that creates resistance and spends political capital. The focus has to be on feasible, least-cost reforms that deliver fast.

Apart from preponing spending, some relief and confidence-building is possible for stressed sectors. Relief for sectors that have large spillovers on the rest of the economy can have the same effect as a macro stimulus. But such relief should be consistent with long-run reform. Ministries are working on packages with these features, after brainstorming and stakeholder consultation. These are being announced in quick succession, showing a willingness to listen and respond. However, more has to be done for bridge financing to the real estate sector, since banks will be busy with mergers. Otherwise, unfinished projects will then add to NPAs, while preventing possible homebuyers benefit from lower home loan rates and tax breaks. Co-lending with NBFCs and banks has potential, since the first can better assess credit risk and mange operational aspects, while the second have the funds. Foreign equity can also be leveraged.

The Economic Survey asks for a big bang rise in investment, using foreign triggers. But these are scarce in a global slowdown. They may not be irreplaceable, however. Small changes in the right direction can cumulate to tip the economy to a higher growth path. An investment GDP ratio of 32 is not low. If the propensity to spend rises marginally above that to save, it can raise growth, jobs, incomes, taxes and savings, as in past Indian high-growth cycles. For that, credit has to rise and the financial system has to deliver safely. As the government improves the supply side, monetary policy has to stimulate demand.

The writer is Professor, IGIDR, and Member EAC-PM