Will today's economic scratch leave a scar?

Attention is turning to India's post-pandemic potential growth, which could fall to a two-decade low

Economic growth estimates for the current year continue to be lowered, simply because so little about the trajectory of Covid-19 is known. In fact, some fatigue has set in over the excessive analysis around this year’s growth. And slowly, but surely, all eyes are looking further ahead. What does the future hold when the pandemic is behind us?

The concept that best encapsulates the debate in one number is potential growth. Technically speaking, this refers to the level of economic growth that can be sustained without stoking inflation or other macro imbalances. Functionally, it serves several purposes for investors and governments alike. 

Long-term equity investors pin their hopes on high potential growth when building up their positions. It is potential growth that will determine if elevated public borrowings can fall over time, thereby influencing the sovereign ratings that India receives. For the policymakers, too, assessing potential growth makes clear what is needed for fiscal support and reforms. So, where will this all-important number be once the pandemic is over? We take a stab at answering this question. 

In a growth accounting exercise, gross domestic product (GDP) is assumed to be produced by combining physical capital and human capital at the economy’s overall level of productivity (also known as total factor productivity, or TFP). 

By our assessment, potential growth fell from over 7 per cent before the global financial crisis to 6 per cent on the eve of the pandemic, led by weak nationwide balance sheets, particularly those of banks and corporations. A weak global growth environment did not help either. 

But where will it rest after the pandemic? To work out an estimate, we rely on previous multi-decade lows and how long a recovery took for each factor of production (capital, labour and TFP). India may not have cleaned up effectively after previous slowdowns, so this method, we believe, captures the unique traits of Indian policymaking. Our assumptions suggest that capital investment will take the most time to recover as it does during periods of uncertainty, but even TFP and labour will only gradually go back to the pre-Covid-19 levels. 

We find that potential growth could fall by 1 percentage point to 5 per cent in the post-pandemic world. To be fair, potential growth is likely to fall in other parts of the world, and India is unlikely to be a standalone. But it would be at odds with previous expectations of potential growth rising, and will also mark the lowest potential growth for India since the turn of the millennium. 

What will drive the fall? Both labour displacement and financial sector stress are likely to weigh on growth in FY21e. However, we believe migrant labourers who have fled to their rural homes could return to the cities soon. 

We find that 60 per cent of rural migration is aspiration-led. Government policies to boost rural wages may help retain some workers in the villages, but staying back may not be attractive enough for workers searching for the 2.5x higher income that urban India promises. Once the sowing season is over and Covid cases abate, these workers are likely to return to their urban work places. 

Instead, financial sector weakness could be the key driver of the 1 percentage point drop in potential growth. Growth was slowing even before the pandemic and India’s banks and shadow banks were at the heart of it. Non-performing loans at banks are likely to soar further during the pandemic, making banks even more risk-averse. Shadow banks also face liquidity issues. 

The result could be inadequate loan growth by banks and shadow banks, meaning not enough funds being available, which could weigh on medium-term growth. 

Some argue that capital markets can fill the gap. After all, the pandemic is more a demand shock than a supply shock, which means that while growth has fallen, inflation and trade deficit remain low. This means that the central bank can keep monetary policy loose without worrying too much about macro instability, which should be supportive of the debt and equity markets. 

The problem is that the benefits of buoyant capital markets go mostly to highly-rated corporations. In normal times, the benefits would trickle down to the rest, as smaller companies are vendors of the bigger ones. But this time, the lack of demand means that there aren’t too many orders out there that can trickle down.

Also, data is not supportive. The last few years have been characterised by softening bank credit and rising dependence on corporate bonds. And yet, growth has fallen in this period, suggesting that bond market buoyancy was not able to offset the banking system distress. 

Others argue that consumers or the government can come to the rescue as in the past. 

Unfortunately, both are grappling with their own problems this time around. Consumers are uncertain about jobs and are not able to spend their way out of the slowdown. The government has entered the pandemic with an elevated debt load, and is not able to expand much. 

Only undertaking important reforms can push potential growth back up, in our view. Reforms that tackle the reasons behind the previous build-up in bad loans are critical, like those related to land and the power sector. Reforms that help clean up corporate and bank balance sheets—for instance, a more efficient Insolvency and Bankruptcy Code procedure— should be top priority.

The writer is chief India economist, HSBC Securities and Capital Markets (India) P Ltd