The recently released data for the first quarter of 2017-18, showing GVA (gross value added) growth at only 5.6%, should be seen as a warning signal. What is most disturbing is that industrial growth (which includes construction) was only 1.9% over the same quarter in the previous year, the lowest in 21 quarters. Since this is the sector that will generate much of the employment needed outside agriculture, policy makers would be well-advised to worry and take corrective steps.
Too much of the discussion on the slowdown in the last two quarters has focused on whether it was due to the impact of demonetisation or, more recently, the destocking effect of the goods and services tax (GST). Demonetisation was undoubtedly more disruptive than was earlier projected, and its impact also lasted longer, but the economy will recover from this one-time shock. The destocking effect of GST is almost certainly a one-quarter problem.
The real problem is that these short-term phenomena are masking a more worrying underlying downward trend in growth. GVA growth had increased from 7.2% in 2014-15 to 7.9% in 2015-16. It then slowed down to 6.6% in 2016-17, and the first-quarter results for the current year suggest that the deceleration is likely to continue. We need to pay more attention to underlying weaknesses that may undermine our growth performance unless consciously corrected.
Weak investment demand
Declining investment is a major problem that has been evident for some years. Gross fixed capital formation in current prices fell from 31.3% of gross domestic product (GDP) in 2013-14 to 27.1% in 2016-17. This needs to be reversed. Drilling deeper to look at investment by sub-sectors (public, private and households, which includes the informal sector) reveals an interesting picture. Data is available only for gross domestic capital formation and only up to 2015-16. While public investment increased from 7.1% of GDP in 2013-14 to 7.5% in 2015-16, this was more than offset by a decline in private capital formation. Private (corporate) capital formation declined marginally from 13.1% of GDP to 12.9%. The household sector saw a much sharper decline from 12.6% to 10.8%. This is especially worrisome because the household sector includes small non-corporate businesses and is a major creator of employment. In fact, when the data for 2016-17 become available, they may show a further decline in this sector because it was the sector most adversely affected by demonetization.
There is talk of expanding public investment to make up the slack. We could certainly do with more public investment in infrastructure, but this will run into fiscal deficit constraints, especially since the deficit on the states side is likely to be exceeded. There is little merit in pushing the industrial public sector units (PSUs) to take on large investment programmes as a pump priming activity. They are not particularly efficient users of resources, and pushing them to invest more at short notice will only lead to poorly planned projects.
Private corporate sector investment is constrained by balance sheet stress. Hopefully, this will be addressed by the ongoing process of debt resolution, but that will take time. Results will begin to show only a year later at best. Meanwhile, we need to do what we can to reverse the declining trend in non-corporate private investment.
There is no magic wand that will revive investment activity. Private investment is as much a matter of investor mood and expectations as of hard business calculations. When the mood is positive, investors invest happily in spite of many deficiencies in policy. When there is a change in mood, for whatever reason, they retreat into a shell. In such periods, it is a good idea to do as much as possible to fix the policy problems we know exist, so that when the mood turns again, it will produce an extended burst of fresh investment, and hopefully also better quality investments.
What can we do that will have the maximum impact? Improving infrastructure, especially roads, power and railways, is undoubtedly the best way of “crowding in” private investment. Setting clear targets and monitoring progress in public investment in infrastructure will help. Small businesses need an urban environment that gives them economies of agglomeration, ease of doing business and low transaction costs. Many of these areas are in the domain of the states, but some are in the domain of the Centre. A clear timeline by which the Centre plans to meet specific goals linked to creating an investor-friendly environment, and monitoring progress, would send a positive signal to business, and also encourage individual states to do their bit.
Fixing the slowdown in bank lending is low-hanging fruit. There are many structural items on the agenda, such as mergers of banks, recoveries of non-performing assets through the bankruptcy code route, and recapitalization of public sector banks. These are all important but will take time. Meanwhile, the immediate problem of the slowdown in public sector bank lending needs to be tackled. Banks may be hesitant to lend to big corporates that are over indebted, but they can surely do more, with all due diligence of course, for small businesses which must be feeling the pinch the most.
Weak export performance
The other major structural weakness we need to address is export performance. Exports are often mentioned as providing a demand-side stimulus for GDP, but this understates their importance in promoting growth. While exports add to demand, the imports which they finance constitute a corresponding leakage from demand. The real case for a greater export effort is that it will increase India’s linkage with global markets and global technology trends, with potential productivity gains. It will encourage the growth of strong Indian firms exporting to world markets, and planning their scale of production to achieve and maintain global competitiveness. This will also make them generators of high quality employment in the process.
In the years of rapid growth from 2003 to 2010, our exports grew much faster than world trade, and our share in world exports increased, albeit at a slow pace. Export performance has collapsed in recent years. In US dollar terms, exports in 2016-17 were slightly lower than in 2011-12. Export volume growth in the first quarter of 2017-18 was only 1.2%. And we cannot blame world trade for this because countries like Bangladesh and Vietnam have done much better.
Our share in world exports is 1.7% compared to 13.2% for China. China gave exports very high priority. We may not be able to do everything China did, but we can certainly do much better than we have. However, for this we will have to go beyond expanding and revamping existing export promotion schemes. These schemes simply do not address the real constraints that limit our export performance.
A credible export agenda requires policy interventions that lie outside the domain of the commerce ministry. These include improvements in infrastructure and logistics, building coastal employment zones, better bank finance for exporters, and most important, labour law reform. Progress in these areas requires a clearly defined agenda, with full inter-ministerial commitment on implementation.
On issues such as labour reform, a strong political effort is necessary to convince all stakeholders of the need for these reforms. We have a choice between introducing labour flexibility, which (along with other steps) will increase the number of quality jobs albeit at the expense of reducing the degree of job security—or sticking with job security as a non-negotiable issue and facing stagnation in quality job creation.
We also need a political decision on the endless Regional Comprehensive Economic Partnership (RCEP) negotiations. The buzz in the capitals of the Association of South East Asian Nation countries is that India does not want a successful conclusion. Unfortunately, Indian business has not embraced this agenda.They are concerned primarily about protecting their market and not enough about integrating with global value chains, which is the only way exports can increase. The RCEP negotiations will resume in December. We are unlikely to get all that we want in services. Are we willing to reach a reasonable compromise?
Exchange rate policy and interest rates
The real effective exchange rate has appreciated by about 9% over the past few years against our trading partners. This has an adverse impact on exports and also on domestic producers competing against imports. Politicians like to think that a strong exchange rate is a sign of strength, and this is true when the high exchange rate reflects high levels of productivity. However, a strengthening exchange rate in an environment where exports are weak, and domestic producers are asking for tariff protection, is a sure sign of exchange rate misalignment driven by strong capital flows. The Reserve Bank of India (RBI) should be persuaded to target the real effective exchange rate more effectively.
Interest rate policy is another instrument that can have a short-term impact. The RBI’s repo rate is not by any means the only factor that is relevant in reviving growth. However, when inflation is well within the tolerable range, and growth in the first quarter has dropped to 5.6%, compared with the RBI target of 7.3% growth for the year as a whole, there is surely a case for more aggressive lowering of the interest rate.
The usual fear that lowering interest rates may prompt a capital outflow is a relevant consideration. However, in the current situation, where capital flows are excessive and have pushed the real exchange rate to appreciate, some “market driven” depreciation may be a good idea. The Monetary Policy Committee should ponder these closely related issues seriously.