Two distinct features mark the three years of NDA government: sustained market buoyancy boosted by 7%-plus growth; and analysts chasing a mirage that this growth will raise corporate earnings. It remains a mystery as to why such high growth did not buoy corporate earnings, which only underscores the many difficulties in interpreting India’s macro numbers in recent years. Nonetheless, many analysts continue to exhibit optimism even amidst a sharp growth deceleration to below 6% in the past two quarters. They strongly believe that growth will rebound no sooner the economy is through with short-term pain inflicted by demonetisation and the transition to GST implementation.
How realistic is such optimism? Recall that not so long ago, a V-shaped rebound was predicted in the first quarter of 2016-17 as the shock impact of demonetisation wore off. With April-June 2017 growth sliding to 5.7%, expectations of an upturn have now merely been rolled over into the next quarter or at best, second half of the year. Why is that? Because most assume India’s potential growth rate to be closer to 8%; the GST and other reforms could raise it further. With inflation staying low, a quick cyclical recovery should therefore be the natural way forward, which is fairly consistent with any macroeconomic diagnostics.
But such optimism evades the hard question: What led to the deceleration that predates demonetisation? Why would growth fall off in a period when exports were rising and agriculture rebounded with a normal monsoon after two years of drought? Many analysts had already flagged that the extraordinary benefit from favourable terms-of-trade would come to an end—the IMF estimated such gains to be 2.5% of GDP—and also that the boost to manufacturing GVA from lower input prices would gradually subside. Therefore, the slowdown was not entirely unanticipated. But from a macroeconomic perspective, it is critical to assess if the short-term gains contributed to raising the economy’s potential growth.
Recall that in the period before the terms of trade bounty, India’s potential growth rate was estimated at about 6.75% by the IMF (Country Report No. 15/61: pg 29, March 2015) and 6% by RBI (Macroeconomic & Monetary Developments 2014-15, Update: pg 3, para II.2, April 2014). It had considerably fallen from its pre-crisis peak of 8% due to a trend decline in total factor productivity growth. But as growth accelerated beyond 7% from 2014-15, most analysts revised their potential growth estimates closer to, or even higher than 8%, based on econometric estimates that carry an end-point bias. These higher potential output growth estimates also appeared consistent with the persistent negative output gap and falling inflation.
But such a narrative cannot evade the more fundamental concern: If the investment rate was steadily falling throughout and there was no visible sign of productivity gains—microeconomics tells us that persistently lower capacity utilisation results in higher unit costs—then how rational was it to assume an increase in potential growth?
The alternative and more consistent macro framework may be that the potential growth slowdown persisted while growth driven largely by consumption demand rose above potential (positive output gap) thus slowing down the decline in inflation. This may also explain why core inflation remained sticky in this period in spite of both fiscal and monetary stance remaining contractionary. Once the terms-of-trade effects began to peter out, both output and inflation fell sharply. While potential output may possibly have further weakened due to the prolonged investment decline, it is certainly unlikely to have risen beyond 2014 levels, 6-6.5%. The remarkable feature of the period is that despite a series of small, medium and big reforms, investments failed to spark back to life. There are strong indications the slowdown in potential growth persisted.
How does that impact the future growth path? Reforms could help, but fruits from the just-instituted GST system are still in the distance. At this point, lead indicators are much worse than last year: Industrial production shows a discrete drop to 0.2% this April-June from 7% last year. A six-month contraction in durable goods’ production persists; it plunged to -0.9% in the recent quarter from 8% in April-June 2016, betraying the slump in consumer demand. Capital goods grew -4% in the period against a comparative 13% last year. The slack in industrial capacity is unchanged from 2014-15, an average 2 percentage points lower compared to average use in 2012-13. The weakness and shrinkage in non-food credit growth, broad based across segments, is well documented. Personal loans including housing, have slowed.
In fact, at this point most growth drivers are either weak or absent. Investment demand shows no signs of return and NPA resolution is at a very early stage. Exports are faltering while imports are rising. More importantly, private consumption on which rest all hopes of an upturn, is beginning to slow as personal incomes decelerate. In an environment of low inflation and high indirect taxation, the revival of private consumer spending will depend upon the trade-off, i.e., how much the increase in real incomes or more buying power from lower inflation outweighs the dampening effects of regressive taxation. Finally, government capex could also slow down with emergence of fiscal stress at central and state levels from increased revenue expenditures, especially from state salary revisions, subsidies, farm loan waivers, and so on. Weaker growth also lowers tax revenues, causing further strain.
Thus, an optimistic scenario may be that the growth path ahead is L-shaped instead of a V or a U: Growth may hover in the 6-6.5% region (see accompanying graphic). Lower potential output growth will also impose policy constraints, i.e. restrain the government from relaxing the fiscal stance or RBI from further monetary easing, unless growth persists below potential for a few more quarters.