Mumbai: The second Narendra Modi government has begun its innings in the midst of a sharp economic slowdown. Economic expansion in the fourth quarter of the previous financial year was at the lowest level in five years—and 2.2 percentage points lower than growth in the first quarter of that year. The recent loss in economic momentum will obviously be the dominant concern for new finance minister Nirmala Sitharaman as she puts the finishing touches to the Union Budget that is due to be announced on 5 July.

However, there are also deeper structural challenges that cannot be met with either fiscal or monetary stimulus to target aggregate demand.

The Indian economy is doing well if one makes a comparison with other major economies at this point of time, unless the recent slowdown deepens. That has led to a sense of premature hubris. The current economic momentum is less impressive when compared to the growth rates maintained by countries such as China or South Korea when they were at a similar stage of development. Average incomes in South Korea went from $2,180 in 1983 to $4,686 in 1988, i.e. in five years. Chinese average incomes rose from $1,966 in 2004 to $4,604 in 2008, i.e. in six years. On the other hand, Indonesia took 12 years to double its per capita income once it crossed the $2,000 threshold in 2007.

Will the doubling of average incomes in India from $2,000 to $4,000 move at Chinese or Indonesian speed?

The Indian economy will have to accelerate in the coming years if it has to move at East Asian rather than Indonesian speed. The experience of the past 10 years suggests that the growth rate that India can sustain within the constraints set by the other macroeconomic targets is 7% rather than 8%—or perhaps even lower. In other words, India finds it tough to grow at 8% while maintaining economic stability in terms of inflation, fiscal prudence and the current account deficit.

The tricky political economy decision for the government is whether to ease some of the economic stability constraints such as the fiscal deficit, the current account deficit and retail inflation in a bid to maintain economic growth at 8%; or continue to prioritize hard-won economic stability while facing the risk of social unrest as lower economic growth fails to provide the adequate number of jobs in formal enterprises; or put in place policy reforms that can help raise potential growth without creating periodic bouts of macroeconomic instability.

The most durable option is the third one. The failure to secure inclusive growth—either because of higher inequality or poor job growth—can lead to redistributive politics that eventually harms growth. The most likely political response in India is likely to be fiscal expansion through spending or monetary expansion to support a credit boom rather than redistribution via higher taxes on capital incomes. However, India needs structural reforms that can allow it to grow at a faster pace without high inflation, fiscal stress or balance of payments pressures. Here are five issues that need attention in the quest to increase India’s potential growth rate.

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The investment cycle

India has seen weak investment sentiment through most of this decade as private sector deleveraging, weakened bank balance sheets and persistent excess capacity has hindered the ability of companies to invest in new capacity. The investment rate as a percentage of GDP is around ten percentage points below its 2007 peak. The fall in the investment rate directly affects potential growth.

There are now some initial signs of a revival in investment activity. A stronger revival will run into the problem of availability of financial resources. The gross domestic savings rate has also been falling since the North Atlantic financial crisis. More rapid growth could address a part of this problem. National savings tend to be pro-cyclical, in the sense that higher tax collections during periods of rapid economic expansion as well as higher retained corporate earnings during profit booms help improve government and corporate savings respectively.

However, the bulk of Indian domestic savings come from households (including unincorporated enterprises). Household savings are usually steady through economic cycles. But, these have also been falling as a proportion of GDP in recent years. Financial savings have come down in tandem. A private sector investment revival will thus be constrained at a time when the total public sector borrowing requirement is already in excess of 8.5% of GDP. The broader challenge is to reduce the cost of capital in India through a combination of lower interest rates, lower rates of corporate taxation and reducing the relative price of intermediate capital goods.

The home market question

An investment revival addresses the growth challenge from the supply side. A more recent theme in India is whether there are demand constraints that could send India into the middle income trap. Economic growth catering to the top 15% of the population has its limits, as Rathin Roy of the National Institute of Public Finance and Policy has been arguing recently.

This home market issue goes back to an older discussion whether anaemic Indian industrial growth in the 1970s could have been explained by inadequate domestic demand rather than controls. Both sides of the argument have profound links to the inequality question as well as the internal terms of trade between industry and agriculture.

The problem of a narrow home market is less acute in countries that succeed in exporting to the global markets, so that foreign demand picks up the slack generated by weak domestic demand. India has not had enough success on that score, unlike many Asian countries that have generated jobs by selling to the international market.

Global trade is dominated by trade in intermediate goods thanks to transnational supply chains. These supply chains could be reformatted because of two changes in China—the trade war with the US as well as rising Chinese wages. India has an opportunity here to enter the new transnational supply chains.

Fiscal modernization

The Indian state is fiscally constrained, given its constitutional commitments to provide public goods as well as welfare schemes. One reason has been the inability to collect enough tax—especially income tax from citizens. European nations moved from an elite income tax collecting 1% of GDP to a mass tax collecting 5% of GDP, as Tomas Piketty and Nancy Qian showed in a 2009 paper. This transition happened between 1914 and 1945, when most advanced European nations were at average income levels comparable to India today. Some of the fiscal modernization is also explained by the need to collect tax to fund the two world wars. Most citizens in European countries pay income tax.

China has begun making the transition to fiscal modernization because of rapid personal income growth as well as under-indexation to inflation, as compared to the frequent increases in tax exemptions limits in India. India has failed to increase its income tax base . Higher income tax collections will have another advantage. It can create fiscal space for reducing consumption taxes such as the goods and services tax (GST).

Internal trade

The introduction of GST is indeed a transformative moment—India’s free trade agreement with itself. It creates an economic union more than six decades after political union. The creation of a unified Indian market is expected to lead to efficiency gains as companies rewire their domestic supply chains.

However, the first version of the GST is messy—a reflection of the messy federal bargaining that preceded its introduction. There is now a strong case for GST 2.0 with fewer categories, a lower standard rate and wider coverage. There have already been moves to ease the onerous compliance requirements that were required when the new tax was introduced. The ideas embedded in the first recommendations about the GST structure are still relevant.

The internal market also needs to be strengthened by reducing domestic transaction costs. GST takes care of part of the problem. However, there is a whole range of policy action that needs to bolster the impact of the new tax on economic efficiency.

A new financial structure

A dynamic economy requires a robust financial system that allocates the capital efficiently. The Indian financial system has faced immense stress in recent years, mainly due to the ballooning of non-performing assets, and a lot of the policy action has been focused on the trifecta of recognition, resolution and recapitalization.

The new regulatory architecture built around the Insolvency and Bankruptcy Code shifts the balance of power from borrowers to creditors—and will hopefully change the credit culture in the country.

However, a broader conversation on the financial structure is needed. India chose the universal banking model after the 1991 reforms, moving away from the specialist financial institutions of the earlier era that had access to subsidized liabilities. Commercial banks were tasked with supporting all types of economic activity—from personal consumption to infrastructure development.

The Reserve Bank of India has already begun a modest move away from this model through differentiated licences for payments banks, small finance banks and wholesale banks. The problem becomes especially acute in the case of large industrial projects as well as infrastructure projects. The task of funding them cannot be left to commercial banks alone.

India needs specialist financial agencies to do some of the heavy lifting as well as an active corporate bond market. One possible option is to let commercial banks focus on loans to small and medium enterprises, while larger projects are funded by specialist banks and the corporate bond market.

Niranjan Rajadhyaksha is a member of the academic advisory board of the Meghnad Desai Academy of Economics. This essay is based on a paper published by IDFC Institute.

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