5 big economic challenges for Modi 2.0

Here are five big economic woes in front of the new government and some solutions to boost the economy

One theory emerging from the resounding win of Narendra Modi in the elections to the 17th Lok Sabha is that the state of the economy does not matter when it comes to Indian politics. While that may or may not be true, what is definitely true is that what politicians decide to do or not do matters for the economy. Keeping that in mind, let’s take a look at the biggest economic challenges in front of the new government, and what the economic czars of the new regime can do about it.

1) Consumption slowdown

As Mint has already reported more than a few times, everything from car sales, two-wheeler sales, and tractor sales have been falling. In fact, even moped sales have fallen over the last two months by 9.8% in March and 5.9% in April. Non-oil, non-gold, non-silver imports—another good indicator of consumer demand—have fallen over the last four months.

People are clearly not spending money at the same pace as they were earlier. It has been suggested by more than a few economists and analysts that the government needs to increase its expenditure in this financial year and the Reserve Bank of India (RBI) needs to cut the repo rate (the rate at which central bank lends money to other banks) further. With private consumption slowing down, the government spending more will lead to increased income in the hands of people, and then they will spend more and economic growth will revive. That’s the theory.

In fact, this was tried in 2008-2009 and 2009-2010. During and in the aftermath of the global financial crisis that started in September 2008, the Indian government increased its spending massively. The fiscal deficit of the government in 2007-2008 had stood at 2.59% of the gross domestic product (GDP). This was pushed up to 6.11% of the GDP and 6.57% of the GDP in 2008-2009 and 2009-2010, respectively. There was also a push in public sector bank (PSB) lending to the industrial sector. Of course, this revived economic growth for a couple of years. But along came double-digit inflation and PSBs were saddled with a huge pile of bad loans, which they are still struggling with.

At the same time, the government spending more means the government is borrowing more to finance the higher fiscal deficit. The trouble is there is only a limited amount of savings going around. And when the government borrows more, it pushes up interest rates. Take the current scenario. As of 10 May, the credit-deposit ratio of banks stood at 76.9%. This means that the banks had lent 76.9 out of every 100 they had raised as deposits.

When one takes into account a cash reserve ratio of 4%, which the banks need to maintain with the RBI, and a statutory liquidity ratio of 19% (banks compulsorily need to buy a certain amount of government securities), this means that banks are practically lending out almost all the deposits they have.

In this scenario, if the government decides to spend more, it will mean the government will have to borrow more. This will leave lesser for everyone else to borrow and push up interest rates. A credit-deposit ratio of 76.9% also explains why interest rates have barely gone down despite the RBI cutting the repo rate twice since the beginning of this year.

The learning here is that an expansionary fiscal policy (with the government spending more) and a loose monetary policy (with the RBI cutting the repo rate) cannot always be carried out at the same time. Sometimes, no government interference can be the best possible solution.

2) PSBs and NBFCs

The PSBs have been in a mess for some time now. As of 31 December 2018, the total bad loans of these banks amounted to 8.64 trillion (bad loans are largely loans which haven’t been repaid for a period of 90 days or more). In the last two fiscal years, the government has invested 2.06 trillion into these banks to recapitalize them and to keep them going. The interesting thing is that in the interim budget for 2019-2020, presented earlier this year in February, the government has allocated almost nothing towards the continued recapitalization of PSBs. The assumption is that these banks will not require any further capital, at least not this year.

This is wrong simply because the PSBs are barely able to recover a portion of the loans they write off. Between April 2014 and March 2018, the total loans written off by PSBs stood at around 3.16 trillion. Of this, around 44,900 crore of loans previously written off (around 14%) was recovered. If this continues, and there is no reason for it not to, then PSBs will have to write off a major portion of the current bad loans as well. This will ultimately be written off against future profits as well as the current capital of the banks. In this scenario, the government will have to continue investing money in these banks in order to recapitalize them.

One suggestion that has been made is that instead of recapitalizing these banks every year, the government should invest a substantial portion at one go. There are two problems with this argument. One is that this will push up government expenditure and that will have its own set of repercussions. Second and more importantly, the incentive for banks to recover loans, which have been written off, will go down even further. And that can’t possibly be a good thing.

The government also needs to prevent further accumulation of bad loans in the future. Given that, it is important that some of the smaller banks stick to lending just to the retail sector and the agricultural sector, where carrying out due diligence on a loan is easier. In case of lending to corporates, these banks should stick to giving working capital loans at best. Only the bigger lot (let’s say the biggest five or six banks) should be allowed to carry out lending for big investment projects.

If PSBs weren’t enough of a worry, the crisis in the non-banking financial companies (NBFCs) has only added to the overall weakness of the financial system. Among other things, the NBFCs are facing an asset-liability mismatch. They have borrowed money for the short-term and are lending it for the long-term (especially in the retail sector).

Basically, in the aftermath of huge bad loans accumulated from lending to industry, banks went slow on further lending to the sector. Nevertheless, they had to lend money to someone. They found a new saviour in NBFCs. As of 18 March 2016, the total bank lending to NBFCs had stood at around 3.52 trillion. By 29 March 2019, this had jumped to 6.41 trillion, a jump of close to 80% in a little over three years.

What is currently needed is an asset quality review of the books of systematically important large NBFCs by the RBI.

3) Lagging Exports

One of the clear learnings from the history of economic development is that almost every country that has gone from being a developing country to being a developed country has done so through the export route. First, the country starts with low-value labour-intensive exports and then gradually over the years moves on to high-value ones. The low-value exports create jobs at a massive pace.

In 2018-19, the exports of goods stood at $329.6 billion. This was the first time that exports in absolute terms were higher than the exports of $310.1 billion in 2014-2015. Nevertheless, that is not the right way of looking at the situation. Over the years, the Indian economy has also grown in size and that needs to be taken into consideration as well.

Exports to GDP ratio in 2018-2019 stood at 12.09% of the GDP. It was just about higher than the exports to GDP ratio of 11.78% in 2004-2005. This is a serious anomaly which needs to be set right. Also, India seems to be moving away from low-value exports. As the RBI Monetary Policy Report of April 2019 points out: “An important feature of India’s export basket in recent years has been a shift away from primary and traditional low value-added exports to higher value-added manufacturing and technology-driven items."

This is proven by one look at what constitutes India’s goods exports. The exports of leather and leather manufacturers peaked at $6.2 billion in 2014-2015. In 2018-2019, they were at $5.3 billion. The exports of ready-made garments reached a peak of $17.4 billion in 2016-2017. In 2018-2019, they were at $16.1 billion. When it comes to agriculture and allied products, the exports peaked at $43 billion in FY14. In FY19, they stood at $38.5 billion.

These are all low-value labour-intensive exports. India hasn’t done well on this front while high-value skill oriented exports have done well. In the recent past, we have lost out to other Asian countries. The new government needs to encourage labour-intensive exports at all costs. For starters, this means carrying out labour reforms, where the smaller firms employing up to 200-250 people aren’t expected to follow the same rules as the larger ones.

4) Loss-making PSUs

Not many people may know that in 1951, just after independence, India had only five central public sector enterprises (CPSEs). The total investments of these companies added up to a minuscule 29 crore. As of March 2018, there were 339 CPSEs with a total investment of 13.73 trillion. In 2017-2018, the top 10 profit making CPSEs made a total profit of 98,707 crore. This was around 61.8% of the profit made by profit-making CPSEs. The companies which make a profit operate in more or less government monopoly sectors like coal or in sectors like oil, where the government has a tremendous head-start. But that’s not the point here.

A bulk of the 184 CPSEs that made a profit in 2017-2018 were basically not worth the trouble. Of course, there were many loss-incurring CPSEs as well. Of these, the top ten loss making CPSEs lost 26,480 crore. BSNL and Air India incurred losses of 7,993 crore and 5,338 crore, respectively.

Any talk of selling or shutting down such companies creates a lot of hungama. Nevertheless, there are many other small CPSEs, which barely make any money or make losses, every year. They also don’t employ many people like the bigger CPSEs. There is a lot of capital blocked in these companies. Over and above that, these companies are sitting on a lot of land, which can be sold, and money can be raised to build the better physical infrastructure that the country badly needs.

5) Agriculture distress

The short-term reason for distress in agriculture has been falling food prices. Nevertheless, there is a long-term reason as well. In 2004-2005, agriculture, forestry and fishing, as a percentage of GDP, stood at around 21%. It has since dropped to around 13.1% .

This means that people need to be moved away from agriculture and that is something which hasn’t happened. Typically, as countries move from being developing countries to becoming developed countries, the farming labour first moves en masse towards low-end construction and real estate jobs, given that the skill set required for these jobs is very low. In India, that hasn’t happened to the extent necessary. The real estate prices in cities have been at astronomical levels, leading to less buying of homes and, in the process, there has been a slowdown in new real estate launches. There is not much that the government can do about this, unless it starts from scratch by trying to clean up political finance in the country. But they can do a thing or two about creating construction jobs. As mentioned earlier, many CPSEs can be done away with, the capital blocked in them unlocked, and their land sold to finance the creation of new physical infrastructure in the country and, in the process, create low-skill construction jobs.

To conclude, the problem often with governments in India has been that they try to do too many things. But there is an opportunity that the new government has to do a few things, do them at an adequate scale, and do them right. That’s what India needs over the next five years.

Vivek Kaul is an economist and the author of the Easy Money trilogy.

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