Home / Opinion / Columns /  An uneven economic recovery requires us to focus on demand

The second wave of the pandemic now seems to be receding, thankfully. The economic costs are likely to be lower than what we saw in the first wave. There are four major reasons to say so. The lockdowns imposed by various state governments are less stringent than the national lockdown last year. Companies as well as governments have now learnt how to manage operations during lockdowns. The revival in economic activity in many other parts of the world can support exports even when domestic demand is weak. The availability of vaccines offers hope—though mutations of the virus could prevent a complete return to normalcy for another year.

The Reserve Bank of India has said in its new annual report that the experience with the Indian business cycle over the past 25 years shows that sustainable economic recoveries are usually led by private-sector demand rather than government spending. And recoveries after crises have been led by private-sector consumer demand rather than private- sector investment demand. The two are not independent of each other. An increase in private-sector investment can result in higher consumer demand if accompanied by new job creation.

The impressive economic recovery from September 2020 was likely powered by a rebound in consumer spending. The harsh lockdown during the first wave had led to a sharp increase in the financial savings of households. One part of this was forced savings as people could not leave their homes. The other part was precautionary savings in the face of huge economic uncertainty. Extra savings were spent down after September. It is very likely that a milder version of this will be on display when the economy opens up at the end of the second wave.

However, there are another set of economic trends that deserve more attention, especially given what the Indian central bank has said about the importance of private-sector demand in earlier recoveries. This column has noted on two occasions that the recent economic recovery has been powered by profits rather than wages (‘Will our economic recovery be led by profits or wages?’ on 18 August 2020 and ‘The Indian economic recovery seems to be led by profits, not wages’ on 1 December 2020).

One simple way to understand this is as follows. National income is the sum of the earnings of the main factors of production—labour, capital and land. The wages, profits and rent they earn give us an estimate of net national income. The gross figure can be calculated if one adds other variables such as depreciation and payment to international factors of production. A very simple way of looking at the economic recovery before the second wave picked up momentum is to look at what has happened to wages and profits.

Economists at Azim Premji University have estimated that as a result of job losses as well as a decline in incomes for many of those who held on to their jobs, the share of wages in gross domestic product (GDP) fell by more than five percentage points, from 32.5% in the second quarter of 2019-20 to 27% in that quarter of 2020-21. Most of this was due to a decline in earnings, especially among the bottom half of the population.

On the other hand, corporate profits have grown strongly in 2020-21 because of a variety of factors, including lower wage, interest and input costs. Business Standard newspaper reported this week that the ratio of corporate profits to GDP was at a 10-year high, based on a constant sample of 1,054 companies that have declared annual results so far. These are some of the biggest companies in India. A more comprehensive picture of the share of capital income in value addition will be available once larger studies such as the All India Survey of Industries are available.

The initial indications are that the Indian economic recovery in the second half of 2020-21 was led by profits rather than wages. This by itself is not a problem, but it is one given the current economic situation. Much of the traditional industrial sector has excess capacity right now, so companies are likely to use their higher profits to repay debt rather than invest in new capacities. Data on corporate deleveraging bears this out. It would have been different if capacity utilization were high. What this means is that a higher share of profits in national income at this juncture is unlikely to boost aggregate demand.

How should policymakers respond? The initial response to the pandemic was dominated by monetary easing, regulatory forbearance and credit guarantees. These helped prevent a destructive wave of enterprise failures. The productive capabilities of the economy—the supply side—were protected. The fiscal expansion that accompanied this was mainly because of automatic stabilizers such as lower tax collections, and higher spending on the rural jobs plan. The discretionary fiscal impulse was relatively modest.

The monetary policy bullets have now been used up. A quick recovery in domestic demand should hopefully result in higher tax collections, which makes a temporary fiscal expansion less risky than otherwise. Given the lower share of labour income in GDP, and the fact that higher profits will be used to reduce debt rather than invest in new capacity, the government needs to focus its energies on public investment as well as some form of one-time income support so that aggregate demand does not falter when the second wave ends.

Niranjan Rajadhyaksha is a member of the academic board of the Meghnad Desai Academy of Economics

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