India has a way of confounding expectations. Analysts agreed that, months after Prime Minister Narendra Modi’s ill-fated decision to withdraw 86% of currency from circulation overnight, growth would bounce back. Economists polled by Bloomberg expected growth in the April to June quarter to be 6.5%; other estimates were even higher. So when the government’s official statisticians released the real number last week—5.7% over the equivalent quarter of the previous year—there was general surprise, even shock.
From the outside, it may seem puzzling that Indian growth is stuttering, given the benign macroeconomic environment: easy money flowing in, global growth reviving, solid government revenues and deep foreign exchange reserves, oil that’s still not too pricey, and decent monsoons that have kept food prices and thus overall inflation low. This is a very different scenario than India faced the last time growth began to stutter, when the government had to deal with high oil prices sending inflation, fuel subsidies and the import bill through the roof, not to mention 2013’s so-called taper tantrum. So what could India be doing wrong, given that everything seems to be going right?
In fact, no one should be shocked. India’s economy has been growing less and less healthy for awhile. GDP growth has now declined steadily for six straight quarters. This is a slowdown caused by factors deeper than the cash ban or any other temporary phenomenon. Something is broken in the Indian government’s policy mix.
Growth is unlikely to revive till it’s fixed. It’s true there might be a bit of a dead cat bounce in the medium term: For example, manufacturers who were running down inventories in anticipation of India’s new indirect tax regime, the goods and services tax or GST, might expand output a bit more. Imports might fall a bit as a consequence of subdued domestic demand.
But none of that will change the fact that government spending and low oil prices have deceptively boosted the growth numbers, masking the true state of the economy. In fact, if public spending is excluded, growth in the past quarter barely topped 4%. Export growth is terrible and industrial growth is the lowest in five years. And the government will struggle to keep investing at these levels; it started spending big unusually early in India’s financial year, which starts in April, and has already run through 93% of its budgeted fiscal deficit.
This has been Modi’s preferred policy mix: government spending, including on infrastructure, combined with seeking heavy foreign exchange inflows to stimulate the stock market and fund the private sector. The model worked—just about—as long as oil and commodity prices were falling. That global phenomenon led to low inflation in India—a big importer of oil—and kept government revenues buoyant and costs low. Now it’s clear that this model is broken and has been for some time—since at least the beginning of 2016.
Last year, just as the effects of the oil bonanza were wearing off, Modi introduced “demonetisation," insisting that “the best time for surgery is when the patient is healthy." It turns out that the Indian economy wasn’t that healthy at all. Worse, the cash ban—poorly conceived and executed—has greatly damaged Modi’s reputation as an economic manager.
Nor can anyone explain why, if Modi wanted to expend his considerable political capital on a big and disruptive move, he would pick an untested policy with few benefits and big risks, one that his best economists warned him against—instead of, say, spending that political capital on cleaning up the bad debts that are choking India’s financial system, or on reform to India’s archaic, socialist-era factor markets. Now that the failure of the policy is generally accepted, it’s hard to see how his government can be trusted to introduce effective policy changes.
Yet, effective reform—and political will—is precisely what’s needed now. The government’s first task should be to clean up bad debts far quicker than it has so far—even if powerful people, including company owners, lose money in the process. Second: The government needs to stop chasing after foreign capital to replace shy domestic capital, if it means that the rupee stays high and exports struggle. And third: Officials must quickly fix those parts of the GST that are putting small companies and exporters out of business. It may take Modi some time to recover his reputation as an economic manager. That’s all the more reason to start the process now. Bloomberg View