Why growth is a worry

As cyclical growth turns down and domestic policies become more accommodative, growth will pick up cyclically, albeit with a lag, but a discussion on ways to lift the trend is necessary

The growth of an economy consists of a trend (potential), and cycles around this trend. In India’s case, there are reasons to worry about both. India’s potential growth rate has moderated over the last decade. Various techniques — from statistical filters to production function estimates — suggest India’s potential GDP growth rate has moderated from around 8 per cent in 2003-08 to around 7 per cent currently, and this decline can be traced to a slower pace of investment (capital accumulation) and lower (total factor) productivity growth. 

A significant build-up of core inflationary pressures has typically coincided with periods of GDP growth exceeding 7 per cent, another sign of where trend growth lies. This (slowing trend) is a longer-term worry, which we discuss later.

In the near term, concerns are centered on the cycle itself. India has experienced two full cycles since the 2008 global financial crisis: A V-shaped 2009 recovery followed by a prolonged slowdown over 2011-12, and a recovery starting in 2014 that petered off in 2016 due to weak global demand, fading effects from lower oil prices and the (transitory) hit from demonetisation. 

The economy embarked on a third up cycle in mid-2017, aided by a rebound in global growth and remonetisation, but recent data suggests this cycle has also peaked. We see two factors behind our view that a cyclical slowdown is underway. First, the fading impact of US fiscal stimulus, lagged effects from tighter US monetary policy and China’s deleveraging campaign, the US-China trade tensions and a weak tech cycle are driving a synchronised global growth slowdown. We expect weak global demand to mainly hurt India’s export-oriented and manufacturing sectors, reducing GDP growth by around 0.2-0.3 percentage points (pp) in FY20. Second, the full effects of tight domestic financial conditions (of 2018) have yet to play out. While the non-banking finance company (NBFC) crisis appears contained on its surface, subsurface cracks have formed.
 

Banks have stepped up credit expansion, but much of this was either re-directed towards retail lending or pumped back into better-rated NBFCs (and not as growth capital). Segments perceived as higher risk and inherently more dependent on NBFCs for funding remain credit constrained. We would classify commercial real estate and small and medium enterprises in this segment. Thus, there is a growing divergence between the haves and the have-nots.

For the haves (with lower perceived risk), costs have risen but funding is available. For the have-nots (with higher perceived risk), funding availability itself is a challenge. If working capital remains constrained, we would expect production declines and investment delays for under-construction real estate projects. We estimate tighter financial conditions will reduce GDP growth by another 0.2-0.3pp in FY20.

All is not doom and gloom. We need to consider the possible supports from easier fiscal policy, accommodative monetary policy and the global policy pivot (US/China). How much offset can these factors provide?

For both monetary and fiscal policies, there are transmission leakages and lags. The government announced an income support scheme for marginal farmers, but not all states have digital land records that are linked to bank accounts, which will lead to spending undershoot. Weak nominal GDP growth is also a negative for tax revenues and, if revenues disappoint, the higher spend on consumption will come at the cost of lower public capital expenditure. Thus the aggregate fiscal impulse will not be large.

Monetary policy is likely to remain growth supportive but with transmission lags. Elevated credit-deposit ratios and high government borrowing suggests the transmission to lower deposit and lending rates will be slow. For the ‘have-nots’, transmission is not just about cost or availability of capital; it is a confidence issue. For confidence to return, an asset quality review of NBFCs may be necessary, albeit at the right time. Together, we expect accommodative monetary and fiscal policies to add around 0.4pp to FY20 growth.

Globally, the policy pivot has perhaps removed the tail risk of a sharp global growth collapse, but China stimulus remains in its early stages and each incremental easing of credit is proving to be less growth effective. Thus, global growth may remain weak in the coming months, but a stabilisation is likely later in 2019. 

In sum, we see four clear implications. First, India’s economy is currently being hit by both global and domestic shocks, which will likely slow growth to 6.2-6.3 per cent y-o-y in H1 2019 (January-June) from 6.5-7.0 per cent in H2 2018. Second, given policy transmission lags — both global and domestic — any cyclical recovery will likely be backend weighted and visible only in H2 FY20 (October-March). Third, given monetary easing is being transmitted by banks to retail consumers and fiscal spending is geared towards revenue expenditure, the cyclical recovery should be driven by consumption again. And fourth, given the weak starting point, GDP growth in FY20 is unlikely to be higher than in FY19 (7.0 per cent). 

Coming back to the medium-term priority of resuscitating trend, larger questions remain: How do we increase domestic investment without support from global growth? If government spending is increasingly geared towards consumption, how do we create space for public capex? Finally, what other reforms should be implemented to increase productivity? 

Overall, as cyclical growth turns down and domestic policies become more accommodative, growth will pick up cyclically, albeit with a lag, but a more active dialogue on ways to lift the trend itself is necessary. Otherwise, the economy will continue cycling up and down around a downtrend.

Varma is chief India economist; Nandi is India economist, Nomura