The slowdown of GDP growth to below 6 percent in recently announced April-June quarter of 2017 grabbed headlines. It was the sixth consecutive quarter of slowdown, a fall of 3.5 percentage points since January-March quarter in 2016. Immediately, Yashwant Sinha, the former finance minister, proclaimed that the economy is on a downward spiral, and is poised for a hard landing. He was supported as well as countered by many. Even, PM Modi stepped forward with talks about economic revival through a strong power point presentation. So, is the economy hard landing or robustly reviving? Actually, the truth is somewhere in between.
It will be wrong to say that present slowdown is entirely due to demonetization and GST. The slowdown had started much before that. Just before the new government came to power, the macroeconomic vulnerability had increased with India gaining entry into the infamous ‘Fragile Five’ club. The economy was limping back to normal in 2014. But the new government accepted the interim budget projection of the previous government and subjected the recovering economy to large fiscal consolidation. However, the government was lucky as it gained massive bonanza with sharp fall in oil prices. That cushioned the economy. The additional excise revenues and lower subsidy outgo helped it to plug in deficit and implement reforms like market-linked oil prices. However, a gradual fiscal consolidation would have helped the government to recapitalize the banks. It was a mistake to hope that the legacy problem of non-performing assets (NPAs) of banks would disappear as growth improves. Twin balance sheet problems of banks and corporate continued to be a drag on the economy. The share of investment in GDP came down by 5.8 percentage points in March 2017 from 34.3 percent in March 2013.
It needs to be acknowledged that the demonetization exercise could have been executed better in order to reduce pain in the informal cash-based sector. It also brought forth the serious governance issues in the banking sector. The structural reform of GST, so soon after demonetization, created confusion. Structural changes are always disruptive with immediate teething problems and gains are realized in the long-term. Obviously, GST network with its forward and backward linkages will take some time to smoothen out.
This brings us to the immediate issue of what caused the first quarter GDP growth to move to three-year low of 5.7 percent. The noise about slowing consumption, poor investment and higher government spending in the GDP numbers overshadowed a few interesting points. First, if one looks at Growth by economic activities, then GDP growth without ‘Agriculture’ and ‘Community, Social Services’ (that represents government spending) actually increased by 5.5 percent from 3.8 percent in the previous quarter. This indicates that government spending, though high, has slowed and the economic activities are gradually recovering led by remonetisation. The slowdown in manufacturing sector is primarily because of de-stocking due to the GST.
Second, large subsidy outgo during the quarter also caused the total output to move lower as GDP is calculated by adding the net indirect taxes (NIT= indirect taxes minus subsidies) to Gross Value Added. This will reverse in coming quarter. Third, Private Investments in this quarter emerged out of contraction and moved to positive territory, even though it remained weak.
Most importantly, details indicate that massive growth in imports brought GDP down. Net exports (exports minus imports) shaved off as high as 2.6 percentage points from headline GDP number. Imports have grown at about 30 percent on average in the first six months of this year compared to 8 percent in last three months of 2016. This increase in imports was across the board. It is indeed puzzling that while growth has slowed to three-year low, the imports (including manufacturing products) have increased to push current account deficit to four-year high of 2.4 percent of GDP. Of course, appreciating rupee and problems with GST might have contributed to slowing exports. But can import surge so dramatically in an economy with low domestic demand? According to JP Morgan report, this is due to disruption in the manufacturing supply chain, particularly in the SME sector, due to demonetization. This caused lower domestic production which was plugged by higher imports. This was equivalent to negative supply shock.
Some of the reasons of slower growth like GST related destocking, supply disruptions, higher subsidies are expected to reverse in coming quarters, but drivers of growth remain weak. Though it is difficult to comment on trend based on just one month’s data, the recent high-frequency numbers are encouraging. After couple of months of disappointing numbers due to GST led disruption, Industrial Production recovered to 4.3 percent in August. Sale of Cars, two-wheelers and Commercial vehicles jumped in September indicting improvement in both consumption and economic activities. Even exports growth increased while imports slowed in September. The GDP growth can be expected to pick up going forward.
Any knee-jerk reaction to give fiscal stimulus to increase consumption can be unfortunate at this point. There is little space for expenditure in the budget in the second half of this year. However, the economy cannot afford a big fiscal squeeze. Moreover, we cannot have diverging fiscal and monetary policy at the same time. The government should increase investment spending in infrastructure including low-cost housing projects. Construction sector has the potential to have multiplier effect in various segments. There is a need to handhold the SME sector which is hard hit by demonetization, to move to formal economy. These will help generate jobs that are of significant importance. Recapitalising the banks and resolving the stressed assets problem is essential for growth.
The economy has been slowing since the oil bounty had rolled off, even before demonetization. The structural reforms further increased disruptions. Discussion about the economy now feels like the ‘Blind men and the elephant’. But the elephant neither has stopped moving nor is dancing, it is just moving slowly.