India's policy fault lines

The continued rise in Covid-19 cases and localised lockdowns in several states have increased the risks to economic recovery. If the trend continues in the coming weeks and months, the scale of contraction in the Indian economy would only increase. Rating agency ICRA, for instance, now expects the economy to contract by 9.5 per cent in the current financial year, compared to its earlier forecast of 5 per cent contraction. Other forecasters are also revising their estimates as the recovery seems to be losing momentum. The halt in the economic slide will depend on how quickly India is able to contain the pandemic. However, this would not automatically result in a robust rebound. There are a number of structural issues, which can potentially impede a sustainable recovery. The pandemic has, in fact, deepened some of the fundamental flaws.

It is important to note that the economy was losing momentum even before the Covid crisis. A sustainable recovery, therefore, would depend on how some of the legacy issues are addressed. This column covers three broad areas. First is the state of government finances. The general government budget deficit would easily go into double digits this year. The debt stock is projected to go above 85 per cent of gross domestic product (GDP). An expansion in the budget deficit is inevitable in a crisis year, but the problem for India is that government finances are constantly stretched. As a recent note by State Bank of India showed, public debt increased from 67.4 per cent of GDP in 2011-12 to 72.2 per cent in 2019-20.

Worryingly, even this elevated level of debt doesn’t reflect the true picture. Both the central and state governments have been shifting liabilities to the books of state-owned enterprises. This cannot continue indefinitely. The fact that India almost never followed fiscal discipline in spirit can now hurt. For instance, in the current year, over 43 per cent of the Union government’s budgeted net tax collection was set aside for interest payments. This is bound to go up sharply and would further limit the government’s ability to spend. Therefore, the government will need to reassess its revenues and redirect expenditure in the medium term. Meanwhile, to sustain expenditure and contain debt, it should look for monetising assets in a big way. Continuing with past practice will increasingly constrain the government’s ability to augment productive capacity of the economy.

The second weakness is the fragile financial system. The latest Financial Stability Report of the Reserve Bank of India shows that non-performing assets (NPA) in the banking system are likely to increase significantly, particularly for the public sector banks (PSBs). The stress tests show that gross NPAs in PSBs can go over 15 per cent under the baseline scenario by March 2021. One of the biggest reasons for growth slowdown over the past several quarters was the weakness in the financial system, particularly the PSBs. To be sure, the accumulation of NPAs in PSBs after the last financial crisis were never fully addressed. The problem of PSBs is essentially an extension of faulty fiscal management. Since the government always has different priorities, it is not able to put adequate capital in banks that it owns. 

Further, PSBs and public financial institutions are often seen as an extension of the treasury. Banks are directed to lend to boost economic activity, which affects their asset quality. This needs to change. PSBs need comprehensive reforms and the objective should be to eliminate their dependence on the budget. The banking regulator is also partly responsible for the weakness of  the financial sector. The lack of appropriate supervision led to failures in the non-banking financial company space, resulting in serious risk aversion, and a private bank had to be rescued because of delayed intervention. Superior regulatory oversight is critical for a resilient financial system that can fund India's growth.

Finally, the general policy environment needs attention. While the government has done a fair bit, which has pushed up India’s ease of doing business rankings, more needs to be done. Also, several decisions taken by various levels of government in managing the pandemic have not helped. For instance, despite an improved understanding of what needs to be done to contain the virus, several states are imposing intermittent lockdowns, which are affecting economic activity. In the area of economic policy, the increasing focus on containing imports, for instance, would affect growth prospects. It will also hurt India’s chances of global value chain integration. It is important to recognise that India is not a default destination for firms moving out of China.

India will need to create an enabling environment and state governments have a big role to play. It does not help India’s case when state governments randomly cancel contracts or dictate who private firms can hire.  In this context, the Centre would do well to work with states to implement reforms and avoid random regressive decisions. A sustainable economic recovery, once the virus is contained, will depend on how quickly India tackles its structural flaws.