The decade gone by began with—and ended in—a bust. Yet there is something to cheer: The Indian economy demonstrated an unprecedented flexibility. The suppleness—manifest in the swift fiscal-monetary stimuli of 2008-09 and the quick realignment of the corporate sector to the downturn—contributed to the lithe return of growth to regular trends within a year. The recovery contrasted sharply with the three-year stretch following the 2000-01 slowdown. The policy takeaways are clear: Build upon this flexibility for increased elasticity of macroeconomic responses and remove the rigidities in price-wage adjustments.
The policy response to the 2008 crisis deserves a closer look. Fiscal activism was deployed—the first time since liberalization—to deliver a significant stimulus of 1.8% of gross domestic product (GDP). Thus, private demand was effectively substituted by public spending, which contributed an average 2 percentage points to growth for four consecutive quarters. Monetary policy supported this stance through traditional and unconventional measures.
Illustration: Jayachandran / Mint
The corporate sector responded quickly to changing market conditions: Firms slashed inventories, cut costs and increased employee productivity. Businesses realigned production levels to a revised demand curve; many reshaped their strategies towards rural demand, relatively shielded from the crisis, while some converted the recession into a growth opportunity. The information technology sector, one of the hardest hit, reoriented itself towards the domestic market.
The recovery was aided by the flexibility in the product and factor markets. The corporate sector had healthy balance sheets and sturdy cash flows on the eve of the downturn. This gave firms the cushion to adapt to the volatility in exchange rates, interest rates and input prices. Profits retained as a percentage of profits after tax were nearly 80% in 2006-07 and 2007-08: This imparted flexibility to investment plans when credit became scarce and costly.
The factor market—particularly finance—is more adaptive today than in 2000-01. The financing environment is flexible and there is a larger pool of capital, enabling firms to withstand distress by reducing debt through non-bank funds such as share sales to institutional investors, corporate retail deposits and commercial paper issues. Many big companies—Tata Motors, Hindalco, Suzlon—expanded rapidly during the boom; they soon found themselves overstretched as demand collapsed and credit costs soared. Yet, they could nimbly cut leverage and consolidate operations.
In the labour market, too, real wage rigidities have been decreasing over time due to rising contractual employment, weakening unions and increasing competition; this permitted firms to increase labour productivity to some extent. For instance, revenue per employee accelerated marginally to 14.5% during 2008-09 against 14% the previous year, for a sample of 700 firms across the services and manufacturing sectors.
It was against the backdrop of this increased elasticity in the economy that the monetary fiscal policy thrust could deliver swiftly. This experience also throws up policy issues that deserve to be flagged.
First, the ability to respond counter-cyclically to shocks needs to be strengthened by creating fiscal room. This can be done through fiscal consolidation and, over time, the creation of budgetary reserves. It must be emphasized that the size of the fiscal response in India was severely constrained by its shaky public balances.
In contrast, China could adopt the same route on a larger scale with confidence. The effectiveness of fiscal stimuli—which crucially depends upon the reactions and expectations of economic agents—was also considerably diminished in India as the financing gap widened beyond 10% of GDP. The erosion of sovereign credibility increased uncertainty and solvency risks, creating upward pressure on bond yields as investors demanded a higher risk premium. This, in turn, led to rating downgrades. These reactions also negated the supportive monetary stance by pushing up long-term interest rates.
Second, there is a need to create institutional counter-cyclical responses. Currently, the automatic stabilizers in the economy are not versatile and potent enough—as they would be, for example, in the European Union, where social benefit outlays shrink during an upswing and expand during a downturn. Using surpluses generated during an upswing as a shield when the cycle turns will lessen the need for discretionary fiscal stimulus, which can be disruptive and less effective than automatic stabilizers.
In monetary policy, the rigidity of interest rates needs to be addressed. In response to a 400 basis points policy rate cut, the average lending rates declined only by 275 basis points and, that too, with considerable lag. Minus this stickiness, a fuller pass-through would lead to a better adjustment of demand, especially for investment.
The labour market adjustment is yet to catch up, despite the structure of labour compensation becoming more adaptive. A credible social safety net could pave the way for flexibility here. It is only then that real wage flexibility could attune the response of prices to monetary policy.
Creating macroeconomic space in these spheres will cover broad risks and increase the stretch ability of policy responses in the future; it will also create room for further lowering of interest rates and an improved adjustment of demand. For the new decade, increasing the flexibility of the economy further is the way to go.
Renu Kohli was, until recently, with the International Monetary Fund. Comments are welcome at firstname.lastname@example.org