9 min read.Updated: 18 Jan 2021, 09:05 AM ISTArvind Subramanian,Josh Felman
Beyond the Budget, the key to reviving growth lies in improving economic stewardship. Here’s how
In the upcoming Union Budget, measures must be urgently taken in order to address the protracted and worsening Twin Balance Sheet problem, including revitalizing the IBC.
NEW DELHI :
The upcoming Union Budget is a critical one, for it offers an opportunity to reset the economy so that it can boom again in the coming years. But this opportunity can only be seized if the Budget is based on a sound diagnosis of the problem: Where are we now and why? This piece aims to serve up a diagnosis and suggest a way forward.
In brief, we think that while new reform measures are always useful, the key to reviving growth lies in improving the “software" of economic stewardship, which is an ongoing effort, going beyond and after the Budget.
The government has been energetic in trying to improve the economy, taking many important actions. These include the goods and services tax (GST), aimed at turning the country into a true common market; the Insolvency and Bankruptcy Code (IBC), aimed at addressing India’s intractable problem of “capitalism without exit"; and inflation targeting combined with a broader promise of macro-economic prudence.
Other actions include liberalization of foreign direct investment, labour reform, and a large reduction in the corporate tax rate; a “New Welfarism", involving the public provision of critical private goods and services (such as toilets and cooking gas) to improve the lives of poor Indians; and notable strides in improving physical and digital connectivity.
Some actions have been widely questioned for their design and impact, notably the power sector reform UDAY, for which states bear much of the responsibility, and demonetization. Some measures have not yet achieved their objectives. The GST remains overly complex, limiting the benefits to economic efficiency. Also, the IBC has proved exceptionally slow. And now, its status is in limbo.
None of this is surprising. Not all reforms work, and even successful transformational reforms take time to bear fruit. What has been the impact of these actions? One must be careful here because not all outcomes can be traced directly to government actions: the starting point and external environment also matter, as do state governments and the Reserve Bank of India. With those caveats, is the economy more stable? Has it developed? Is it growing rapidly?
It is worth recalling that when the current government arrived in office macro stability had been lost. Those days are now distant memories. Inflation has been brought down to an average of 5%, the current account deficit has been narrowed to a very manageable level of 1% of GDP, and foreign exchange reserves have swelled to more than $600 billion. The fiscal situation has been kept under control.
Performance on development has also been remarkable, as measured by the government’s New Welfarism schemes. The latest National Family Health Survey (NFHS) surveys show that the pace of improvement in ordinary people’s lives, measured as the percent of households that have gained access to critical goods and services each year, has accelerated markedly since 2015 (see Chart 1).
At the same time, child health outcomes have been disappointing (see Chart 2). The NFHS surveys show that the pace of improvement in mortality has slowed, while most health indicators have deteriorated after many years of improvement.
One reason is that state-directed efforts are necessary but not sufficient to ensure proper nutrition. Families also need a macro-economic environment that provides a healthy growth in income. Has this environment been achieved? The traditional way to answer this is to look at GDP data. But the aggregate numbers are contested, so we have considered individual components of GDP expenditure, cross-checking them when necessary against alternative “solid" indicators.
The pattern in Chart 3 is clear. There was an enormous boom in the first decade of the 21st century, followed by a sharp decline under UPA-2 after the Global Financial Crisis (GFC). Since then, there has been no sign of a recovery, with growth indicators actually deteriorating.
What happened? Chart 4 shows the health of the corporate sector based on the CMIE database. They reveal a serious problem: the level of profits has collapsed, falling to the lowest relative to GDP since the early 2000s.
Why have profits collapsed? The infrastructure investment boom of the early 2000s ran into major difficulties, especially after the GFC. But bankrupt firms were not allowed to exit, resulting in overcapacity that dragged down profits for the entire sector and led to burgeoning non-performing assets (NPAs) at the banks.
This Twin Balance Sheet (TBS) crisis undermined growth because it meant that many firms weren’t sufficiently strong enough to expand—even if they were, banks were reluctant to lend. Real credit growth—the lubricant of any economy—consequently slid to historically low levels, and turned negative in recent years.
Summing up, the government has still not been able to overcome the problems it inherited. Now covid-19 has dealt another blow. Currently, 2020 growth estimates are being upgraded as economies are normalizing, but even revised IMF forecasts are likely to show India’s growth to be amongst the worst in the world. At the same time, macro-economic stability has been set back, as the fiscal position and inflation have deteriorated significantly. So, the RBI forecast that under the baseline scenario, the NPA ratio will almost double to 13.5% by September 2021.
What then needs to be done? Consider why the government’s measures have so far failed to achieve the desired results. Transformational measures always require tweaking to ensure that they work properly. So, just as important as new measures—perhaps even more important—are continued adjustments to the earlier reforms, such as the IBC and the GST, to ensure that they achieve their objectives.
But surely this cannot be the only reason for the discrepancy between “inputs" and “outputs". One cannot but help suspect that something must be missing, somewhere.
One possibility is that the “hardware" of reform measures has not been accompanied by sufficient “software". What is the software of economic reforms? Traversing the sequence from planning to implementation sound policies require accurate data, fair decisions, statecraft to win support, policy consistency over time, and rule of law in implementation. This software affects the impact of reforms because it engenders (or damages) credibility, that is, the trust of investors, citizens and the states. And trust is critical for convincing firms to invest and states to implement centrally-sponsored schemes.
Consider each of the elements of policy software to see how well they are working:
Data integrity: Accurate data is a prerequisite for good policy decisions, while publishing reliable data enables governments to earn the public’s trust. But reliability seems to have eroded in recent years. In some cases, methodological problems have been noted. In other cases, reports have not been published or released and then withdrawn. In the fiscal accounts, despite improvements, increasing off-budget expenditures have rendered the deficit figure less meaningful.
Fair decisions: Policy decisions need to be even-handed, both in fact and perception. If they are not even-handed in fact, they will damage the economy by giving some firms (especially the large) advantage over others. And if the public perceives they are unfair, that they are based on connections rather than merit, the stigma against private enterprise will grow, eroding support for market-oriented reforms. The current government has made extensive efforts to create a level playing field, including a reliance on auctions and use of technology to automate public procurement and tax filing. But certain decisions—in retail, telecom, airports—have been perceived as demonstrating favouritism, reinforced by the reduction in Parliamentary discussion of policy initiatives. Stigmatized capitalism remains a serious problem.
Statecraft: Once a policy is formulated, statecraft is needed to gain support of the stakeholders, especially the states, because nearly every major issue requires joint action. A splendid example of this process at work was the passage of the GST, which was possible only because the government was able to win over opposition parties and reluctant states. Since then, however, statecraft seems to have gone missing—on the covid-19 response, GST compensation and agriculture. This risks trapping policy-making in a vicious cycle, in which a lack of trust hampers implementation, further eroding trust.
Policy consistency: Once consensus is achieved and a major policy initiative launched, governments need to ensure that subsequent measures remain in line with the strategic objective. Often this does not occur. For example, doubling farm incomes has been undermined by the repeated imposition of export bans and stocking limits on agricultural products, which depress prices received by farmers. Convincing foreign firms to Make in India has been undermined by the rejection of verdicts of international arbitration tribunals in the Vodafone and Cairn Energy cases (both unfortunate UPA legacies).Widening the tax base was set back when in 2019 the income tax threshold was raised dramatically, removing about three-quarters of taxpayers from the tax net.
Rule of law: Finally, policy implementation needs to be evenhanded and perceived as so by the public. In other words, the contracts—the explicit and implicit promises the state makes to its citizens— need to be implemented punctiliously. To rectify this problem, the government has been making considerable efforts to improve the climate for doing business.
Even so, this government, like all its predecessors, is embroiled in contract disputes with its contractors, especially on infrastructure projects. Its arrears to suppliers run high and there is anxiety about arbitrary tax enforcement. These problems need to be addressed before one will be able to convince firms to undertake high-investment, long-gestation, risky projects and Make in India.
What, then, is the way forward? The direction is clear enough: the government needs to find a way to restore dynamism to an economy that has long been weak, and has now been ravaged by the pandemic. The real question is how this can be accomplished.
Are there measures that could be included in the Budget, which would provide the long-missing tonic for the economy? No doubt there are useful steps that can be taken. There always are.
In particular, in view of the latest grim assessment of the banking system by the Reserve Bank of India, measures must be urgently taken to address the protracted and worsening Twin Balance Sheet problem, including revitalizing the IBC.
But more than any one measure announced on one day, restoring dynamism requires improving the “software" of policy-making itself: the way that policies are formulated, publicly articulated, and implemented. This requires ensuring data integrity, embracing transparency and a level-playing field in policy decisions; governing through consensus-building, compromise and patience; maintaining policy consistency; respecting and building institutions; and promoting rule of law.
For, only once this software is firmly in place, and backed up by soft power, will the private sector respond by investing in projects of the kind that will truly build the nation. And only then will the promise created by repeated electoral success be realized and the Indian economy boom again. The 24x7 effort to continually improve this software will therefore perhaps be more important than the Budget itself.
Arvind Subramanian is professor, Ashoka University and former chief economic adviser. Josh Felman is principal, JH Consulting. A detailed version of this piece.
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