Opinion | Managing India’s economic downturn: the demand side

There is a downturn in India’s economy that can no longer be ignored or wished away. Gross domestic product (GDP) growth in the first quarter of 2019-20 at 5% was the lowest in six years, even less than the last quarter of 2018-19 at 5.8%, which was the lowest in five years. The Reserve Bank of India (RBI) has reduced its 2019-20 growth forecast from 6.9% to 6.1%.

This slowdown has, inevitably, affected the disposable income of households, so that the increase in private consumer expenditure has witnessed a slump, dampening growth further from the demand side. The consequences for the automobile sector, which is the driver of manufacturing, and for construction, which is an important source of employment creation, are now being felt.

The fundamentals of the economy, except for the moderate consumer price inflation, are worrisome. Investment rates as a percentage of GDP are progressively lower. So are savings rates. The stagnation in the dollar value of exports continues. The problem is apparent even to those with a rudimentary understanding of the economy.

Yet, until recently, the government has been in denial mode about the slowdown. The Union budget presented in early July, following the massive electoral mandate, was a missed opportunity. It did little, if anything, to address the problem, obsessed as it was with the objective of keeping the fiscal deficit at 3.3% of GDP. Since then, as a consequence of significant changes introduced in the budget, stock markets have plummeted and business sentiment has floundered.

This led to some cognition of the problem in the government and a series of announcements by the finance minister. It began in late August with measures to boost the economy, correcting for mistakes on taxation, decriminalizing defaults on corporate social responsibility obligations, simplifying laws related to labour, companies and the environment, streamlining government procedures, facilitating capital flows in financial markets, and so on. Doing so many things, in the hope that something will happen, was akin to Freudian hyperactivity. It lacked cohesion and focus. Moreover, it did not recognize that there is bound to be a considerable time lag in any response of the economy to such measures on the supply side. If there is a proverbial slip between intention and implementation, a response might not even be forthcoming.

In late September, the government slashed corporate income tax rates. The effective rate, including the surcharge, was reduced from 35% to 25%. For new manufacturing companies, incorporated after September 2019, which start production by March 2023, it was brought down from 25% to 15%. It is hoped that this reduction, by as much as ten percentage points, will stimulate private investment. But theory and experience both suggest that tax cuts work with a time lag and do not ever lead to an equivalent increase in investment.

Higher profits emanating from lower taxes could be used by firms to restructure debt and clean up their balance sheets, increase dividends paid to shareholders, or reward senior management with stock options and directors on their boards with commissions. In the present situation, where firms are saddled with high debt-equity ratios, stock markets are nervous, and corporate behaviour on payouts is what it is, all three could happen. Hence, higher profits will not lead to a pari passu increase in investment. In fact, this increase might be a tiny proportion of the enlarged profits, particularly if business confidence remains low.

The irony is that the government, which was unwilling to relax the self-imposed limit on the fiscal deficit just three months ago, has now decided to forgo tax revenues by as much as ₹1.45 trillion. This alone will increase the fiscal deficit by 0.7% of GDP, compared with budget estimates for 2019-20. Given the time lags and the uncertainties associated with supply side measures, or tax cuts, everything that the government has done so far will do little, if anything, to revive growth in the short run, while the economy could enter a phase of secular stagnation.

In the short run, it is possible to kick-start economic growth essentially by acting on the demand side. This could and should have been done in the Union budget by stepping up public investment and government expenditure. Through multiplier effects, it could also have provided a stimulus to private investment and private consumption. It was suggested by many of us at the time. But the government, persuaded by fiscal conservatives, stubbornly resisted.

The silver lining to the cloud is that the government has recognized the problem with deficit fetishism. The magic number of 3% is not sacrosanct. Government borrowing is always sustainable if it is used to finance investment and if the rate of return on such investment is greater than the interest rate payable. Conforming to stipulated limits only leads the central government to fudge figures, or push out borrowing needs to state governments and public sector enterprises, or both. The time has come to abandon this obsession.

It is now absolutely essential to step up public investment and government expenditure to revive growth from the demand side before it is too late. For this purpose, letting the fiscal deficit rise by 0.5% of GDP will provide ₹1.06 trillion. Over time, as growth revives, the fiscal deficit will rise less because tax revenues will increase. In fact, the resource-transfer of ₹1.76 trillion from RBI has provided the government with a windfall bonanza, meant to finance the fiscal deficit, which can be used partly for this purpose.

The slowdown in the economy is visible. Even so, it is a quiet if not silent crisis. But economic downturns do have political consequences when they begin to hurt people—ordinary people.

Such crises then become audible in the streets. Past experience in India’s vibrant democracy suggests that, once that happens, political goodwill erodes rapidly and parliamentary majorities do not suffice.

Deepak Nayyar is emeritus professor of economics, Jawaharlal Nehru University