Some stability, but risks remain

With destocking over, growth is stabilising but its revival faces several pro-cyclical headwinds

The (only) good feature of destocking-led economic slowdowns is that they end. After all, you cannot keep cutting inventories indefinitely. A significant part of the worryingly precipitous decline in gross domestic product (GDP) growth over the past six quarters was a drop in inventory: As GDP measures activity, inventory build-up adds to growth, and lower inventories take away from it. This is evidenced by the sharp divergence between growth rates in services and industry over the past six quarters, and the drop in the goods and services tax (GST) collections. There may be measurement-related issues in quarterly services growth (only a few comprehensive proxies exist) but for what it’s worth, it has not fallen as much as industry has, most likely because there cannot be much inventory in services.

We last saw this in the quarter before GST was rolled out, when growth of industry and services had similarly diverged: Goods supply chains shed inventory to make a clean start with GST. In the last five quarters, however, this has been caused by tightening financial conditions, which restricted credit availability for distributors, wholesalers and retailers across supply chains. The apparent demand visible to manufacturers was thus much weaker than real underlying demand.

There are clear signs that the phase of steep de-stocking is now over. Power demand growth, which had fallen by double-digits in October and November (likely as industries cut production to adjust for weak festive season sales), was only down 2 per cent in December, and was marginally up in the first week of January. GST collections and rail freight tonnage are also back in the positive growth territory. These are still weak numbers, but better than the sharp declines seen earlier.
 

If all else were normal, the end of destocking would be followed by restocking, and just as inventory depletion hurts GDP growth, replenishment would help growth. 

But financial conditions remain tight; and even financial firms that have the capital, products and processes and access to funds, are slowing down credit in response to the sharp drop in growth. With nominal GDP growth having halved, it would not be surprising if they undertook a broad-based reassessment of credit quality for existing borrowers.

Another headwind to growth would be expenditure cuts by state and central governments, as they try to meet their fiscal deficit targets in a year where tax collections so far have been well below expectations. Central government spending has grown 13 per cent over the prior year in the first eight months, but given the shortfall in receipts, if it sticks to its fiscal deficit target, expenditure in the last four months would be 1 per cent lower than last year. If disinvestment proceeds are lower than budgeted, the fall would be greater. State governments, for whom borrowing targets are frozen by the middle of the financial year, cannot expand their deficits now, and must curtail spending. They already appear to be delaying payments, for example, for crop-insurance, and towards the end of the financial year, even salaries to state government employees could start getting delayed. Such steps may compound the weak consumer sentiment, and further push out investment plans of companies.

Several of the natural stabilisers are not working currently. Generally weak economic growth drives down interest rates, but as documented frequently in this column and elsewhere, interest rates that borrowers see have been unchanged despite weak growth and low core inflation. 

Illustration by Binay Sinha

On another front, India’s foreign currency reserves have increased by more than 2 per cent of GDP over the past year. This is because capital inflows and exports have continued even as imports have fallen with weakening domestic demand. If foreign savers are willing to give more money than the country needs, either the currency would appreciate, or the cost of funds would come down. Neither has happened. The central bank’s purchases of dollars to keep the rupee from appreciation have been prudent, but these surplus funds have not led to any drop in the cost of capital in local markets too. Apparently targeting a steady growth in money supply, the central bank eschewed open market purchases of government bonds as its currency market interventions were sufficient for meeting its target money supply growth. One of the risks of a central bank buying government bonds is a weak currency, but such a large balance of payments surplus, that too triggered by weak domestic demand, shows that such risks are muted currently.

In popular commentary, over the past few months the number of problem balance sheets in India has risen from two to three and even four. While that may be true, we must remember that balance sheets can get stressed due to weak growth, and are not always due to theft or corruption. For example, a central government debt-to-GDP ratio at 45 per cent looked sustainable and was steadily falling due to high nominal GDP growth. But as growth slowed (initially only due to lower inflation), and the cost of debt stayed at 7 per cent, interest costs at more than 3 per cent of GDP suddenly looked daunting; last year they were nearly a third of incremental spending. If taxes grow at 8 per cent, in line with nominal GDP, and non-discretionary expenditure such as interest and salaries grow at the same pace, how can there be any fiscal consolidation, let alone space for additional spending? If slowing nominal GDP growth drives a new wave of stressed loans, the right solution would be growth revival, not another attempt to repair balance sheets.

Economic forces, though, tend to play out over time, even if more slowly than desirable. Let us consider the lower interest rates, which are necessary (though perhaps not sufficient now) for growth revival. Bank deposit rates have begun to fall, and should flow through to lending rates over time. Mortgage rates are down nearly 50 basis points in the last five months. Presentation of the Budget should reduce some uncertainty on fiscal deficits and spending, and April onwards state and central governments should be able to resume healthy spending. By then, absent more weather disruptions, headline inflation should also have corrected meaningfully. If there are no further accidents in the financial system, credit spreads should also start to fall, however slowly. The economy may then settle into a new slower rhythm, with growth a bit better than seen currently, though far from what the country has set its sights on. 

The writer  is co-head of Asia Pacific Strategy and India Strategist for Credit Suisse