Photo: iStock
Photo: iStock

Opinion | What mild signs of an economic recovery imply for Indian policy

India may be headed for a weak recovery in the second half of the current fiscal year but stimulus measures must support it

Economists have been busy in recent weeks snipping their growth forecasts for the current fiscal year. They have good reasons to do so. The first quarter that ended in June saw the Indian economy expand at 5%, its slowest pace in six years. It was a shocker. The actual growth rate was around 0.7 percentage point lower than consensus expectations.

And there is wide agreement that the second quarter numbers are also going to be bleak—perhaps even worse than the first quarter. Industrial production fell in August. Core sector output—that has a 40% weight in the index of industrial production—was down a massive 5.2% in September. It is quite likely that at least some of the decline in output in September can be explained by disruptions in supply caused by heavy rain across the country in that month, and thus overstates the problems in the industrial economy.

Yet, whatever the reason, the decline in production is undeniable. It will inevitably show up in the second-quarter production data. A look in the rear-view mirror can be instructive. The Indian economy grew at 4.3% in the three months ended March 2013, the worst quarter this decade. In case the performance in the second quarter of the current fiscal year is lower than that, then these three months will see the Indian economy grow at its slowest since the immediate aftermath of the North Atlantic financial crisis. India experienced a V-shaped recovery after that shock.

What is particularly worrisome is the early data on economic activity in the third quarter that began in October. The Purchasing Managers’ Index (PMI) for October fell to a two-year low in October. Collections of the goods and services tax (GST) continue to be weak. However, there is still reason to believe that the Indian economy will see a mild recovery from the third quarter.

There are three reasons for believing so. First, the strong monsoon in most of the country should be good for the winter crop. Second, there is likely to be some sequential improvement in aggregate demand as lower interest rates begin to make an impact after the usual lags. Third, there will be a statistical boost from the base effect.

Yet, economic growth for the entire year is still likely to be weak even after the recovery in the second half of the fiscal year. The growth recovery will in all probability be accompanied by a pickup in headline inflation as well. Consumer prices in September grew at around twice the pace at which they grew in January. Inflation has gone up in eight out of the last nine months for which data is available. It is important that policymakers do not misread this combination of a mild growth recovery with inflation momentum to prematurely tighten macroeconomic policy. There continues to be a strong case to keep the demand stimulus in place.

However, there are certain pressure points here. The July budget was built on unrealistic tax collection estimates, and the recent cut in corporate tax rates will further hurt government revenue this year, unless there is a steep rise in company profits. The fiscal deficit in the six months to September this year is already nearly as large as the entire budgeted number. Fiscal slippage seems almost certain, leaving very little space for further fiscal expansion to stimulate private sector demand.

There is far more scope for monetary easing, but the transmission of lower policy rates into lower lending rates has been very slow, partly because of an overhang of extra government borrowing. As Neelkanth Mishra of Credit Suisse has pointed out in a recent report, the gap between the weighted average lending rate on outstanding loans and the repo rate is now the widest on record. Credit spreads in the bond market are also stubbornly high. And, as this column too had earlier pointed out, broad money has been growing at a slower pace than the expansion of base money through expansion of the Reserve Bank of India balance sheet.

A comparison with the Indian slowdown in the beginning of this decade—when the economy lost momentum for five quarters in a row—is instructive. A supply shock sent inflation soaring and also led to an unsustainable current account deficit. India is now facing an aggregate demand shock, which is why inflation is below target while the current account deficit is under control, despite a sharp decline in the national savings rate.

India thus seems to be headed for a weak recovery in the second half of this fiscal year. A stronger recovery seems unlikely right now, given the overall synchronized slowdown in the global economy as well as the fresh round of stress in the financial sector, especially in shadow banks. There continues to be a case for stimulus, given the fact that growth continues to be below potential, but this space is also narrowing.

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

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