India in need of a two-speed economy

The boost in consumption will provide the fast-pace growth that will help make up for the slow speed of structural reforms like GST and demonetisation


Budget 2017 focuses on creating a stronger middle class and boosting domestic consumption by cutting taxes for small businesses as well as low- and middle-income earners. Photo: Indranil Bhoumik/Mint
Budget 2017 focuses on creating a stronger middle class and boosting domestic consumption by cutting taxes for small businesses as well as low- and middle-income earners. Photo: Indranil Bhoumik/Mint

The term “two-speed economy” has become infamous of late. It has often been used to describe economic models where one section of a country’s economy is booming, while others are lagging behind.

In recent years, this was the case in Australia, where the mining and commodities boom shielded the pain of sectors such as manufacturing and retail, and in China, where the export and manufacturing sectors overshadowed other issues. The key concern is that such an economic model is unbalanced and risks hurting growth in the long run. Most economists and observers agree on this.

However, when it comes to India, there is a strong case for a two-speed economy.

The slow runner

The Indian government has unveiled a range of initiatives over the past year that will have a big impact on economic growth. The two biggest ones have been the passing of the goods and services tax (GST) Bill, the biggest reform in India’s indirect tax structure, and the more recent demonetization move.

The latter, which saw the government scrap the Rs1,000 and Rs500 notes overnight, is one of the most radical economic moves by any country.

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One of the key objectives of both these moves is to bring the informal economy and the money it generates—commonly referred to as “black money”—into the formal fold. The moves aim to get unaccounted cash back into the banks, as well as have more Indians pay the tax they owe.

Unaccounted wealth has been an issue that has hurt the Indian economy for decades. Various estimates put the size of India’s shadow economy at more than 20% of its gross domestic product (GDP). At current levels, that equates to $415 billion in unaccounted wealth.

The move has had an impact on the economy, as many had expected it to. Sectors such as real estate, jewellery and big-ticket luxury items have borne the brunt, as undeclared wealth is often used to fund these purchases. Many expect these sectors to see subdued growth in the short-to-medium term due to the demonetization move, which in turn will have an impact on the economy.

However, as the informal economy becomes formalized, growth in these sectors is expected to stabilize in the long run. At the same time, as more Indians start to pay their share of taxes, government revenue will rise. This will help finance the much needed improvements in infrastructure across the country which have been a key concern for companies investing in India. The knock-on effect from that will likely be more foreign investment flowing into the country, which will generate more jobs, boost the middle class and trigger a cycle of sustained economic growth. However, this will take some time.

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This is evident from the World Bank’s latest move, where it cut India’s GDP growth forecast for 2016-17 to 7%, from its previous estimate of 7.6%, citing the impact of demonetization. Although it has forecast that the country will regain momentum in the following years with a growth of 7.6% and 7.8% due to reform initiatives.

The sprinter

India, though, does not have the luxury of playing just the long game. India needs to maximize its growth potential over the next 16 years. That is because come 2038, India’s demographic dividend will tilt in favour of dependants, both old and very young. Therefore, India requires a growth boost in the short term. This is where the government needs to focus on creating a stronger middle class and boosting domestic consumption.

The latest budget has taken this into account by cutting taxes for small businesses as well as low- and middle-income earners. This will put more cash in the hands of these businesses and households. Small and medium enterprises (SMEs) contribute 38% to India’s overall GDP. Giving them more cash to spend—be that for investing back in their business to boost growth, or to reward their employees—will have a direct tangible impact on the economy.

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It is the same for households. Across the world, it is a country’s middle class that has a multiplier effect on the economy. When they earn more, they tend to spend more, which boosts businesses, who in turn employ more people, who then start making money and spending it. It’s a virtuous cycle, and one that India needs.

As such, the finance minister’s focus on rural India, farmers and SMEs is a step in the right direction. The finance minister has announced a 25% funding increase for the Mahatma Gandhi National Rural Employment Guarantee Act (MGNREGA), India’s rural-work programme, which is expected to generate more employment in rural areas. He has also announced a slew of measures to boost the agriculture sector. These include higher agricultural credit, higher allocation for irrigation projects and a crop-insurance scheme. The higher allocations for MGNREGA will also be used to dig farm ponds.

These measures will not only help improve farmers’ incomes, but also help boost productivity in the sector and make food more affordable. This is extremely important, not least because food is a major contributor to India’s overall consumption. According to the World Bank, food and beverages account for nearly 45% of total household consumption in India.

India needs this two-speed economy for both economic and political reasons. Economically, the boost in domestic consumption will lead to faster growth, which will help make up for the slow speed of the positive impact of structural reforms like GST and demonetization. Politically, it will help cushion the short-term pain and make it easier for the government to continue its reform agenda.

Debashish Mukherjee is a partner at A.T. Kearney India.

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