However, growth is unlikely to lift further from this peak, i.e., persisting output decline will restrict medium-term growth into the sub-5% region from the further loss of potential output and hurt to long-term productivity.

A year ago, when the NDA government was re-elected in May 2019, the key concern was whether it would be able to reverse the sliding growth trend. Barely two months later, in July, many regretted the budget as a missed opportunity, doubting the gravity of economic situation had been misread. Thereafter, several momentous reform announcements were made every two months. But the economy barely responded. The true private sector, excluding agriculture and government consumption, remained inert. Banks scarcely loaned, NBFCs seemed orphaned, private corporates remained in their shell, and household consumption began to retreat. These are all signs of dramatic fall in growth potential. But the misplaced debate was if the slowdown was structural or cyclical. Monetary-fiscal policies carried on cyclically when it was clear that reforms were not delivering.

The alarming deterioration in key macro-financial indicators tells the story (see graphic). Savings-investment rates have fallen above-7 percentage points, net household financial surplus shares in GDP halved, and private non-financial sector deficit shrunk to -2.2% of GDP. The failure of capital stock is associated with elevated NPAs upon financial balance sheets and the enlarged public dissavings (nearly 6% of GDP) and debt stock pressurising long yields. Export and foreign investment financing shares are weakened in relation to aggregate output. Financial intermediaries, banks and non-banks, are less capitalised relative to NPA levels, shrinking space to lend; they are lot less profitable or loss-making.

The pre-Covid pressure points were well-known: fiscal risk build-up, stressed and vulnerable financial sector with real economy entwined in the loop. The result was a policy trap—monetary policy had lost its edge, fiscal policy was dangerously bound, and with a fragile financial sector, instability risks girdled the noose.

The many structural reforms—GST, IBC, RERA, Indradhanush, etc—failed to deliver because the elements on which they aspired to revive the economy did not come alive, viz. financial weaknesses. No one could respond to fresh opportunities when credit was unavailable or too costly, or when potential borrowers were debt-troubled.

Potential output was continuously falling in the while. There’s trend lowering of GDP growth after 2011-12 as India never fully recouped losses inflicted by the 2008 financial crisis. Financial flaws persisted, later amplified by unchecked loan growth of NBFCs. The 6.4% GDP growth averaged in FY13-FY15 dropped below-6% average in FY18-FY20; the 8% growth in FY16-FY17 is one-off, sourced from positive terms-of-trade or good luck.

Macroeconomic policies did not recognise this. It is unusual the causes of a maintained growth decline remain undiagnosed; there is scant analysis of depressing structural reform outcomes. Public spending stepped-up pace, doubling to 11.5% average last three years over that in 2016-17 (6%), adding 1.3 percentage point on average each year to 5.8% GDP growth averaged in FY18-FY20.

The monetary policy committee (MPC) failed to distinguish that potential output has fallen. It lowered the policy rate 135 basis points in FY20, responding to a negative output gap but not quantified. RBI also endeavoured with every tool and trick to revive the economy. Much before March 2020, it opened various and targeted lending lines, scaled up open market operations and even resorted to yield curve control. But the central bank has been blocked at the entrance by risk-averse banks; crowding-out pressures kept yields high on the other side.

Interference with banks’ loan rate setting began years ago, i.e., shift to marginal cost lending rate (MCLR), continued to the repo-rate benchmarking last October. RBI obtained some transmission, but insignificant for existing loans. Net result of these efforts—bank credit growth halved the previous year’s in FY20! From a macroeconomic viewpoint, the central bank altogether failed to impact or stimulate aggregate demand.

Then came Covid-19. The MPC now says “…potential output has also fallen” (Member, C Ghate); “…the damage is so deep and extensive that India’s potential output has been pushed down, and it will take years to repair” (deputy Governor Michael Patra).

But this is not true. The crisis had already happened. The MPC never admitted this. Even as it urged government for structural reform efforts at regular intervals, the MPC responded to a bigger, negative output gap.

Covid-19 economic crisis is only layered over the existing one. There’s no doubt this will inflict deep and long-lasting damages, leading to further drop in permanent output. This decline owes much to weak pre-Covid macro-financial conditions that undermine resilience and bounce back strength, constrain fiscal sustenance and effective monetary policy support, blunt the Covid-19 support program and prolong the recovery process. A slowed recovery creates conditions for permanent demand and supply-side damages from bankruptcies, defaults, unemployment hysteresis, etc, which have potential to form a downward spiral.

Covid-19 also brings in a fresh source of shrinkage in demand and supply base: large-scale migration of the labour-force, whose magnitudes are not accurately known. The likelihood and strength of their return in future is uncertain. But even if they come back for economic reasons, reversion to full or pre-Covid strength is unlikely because of lower absorption capacity in a recession, low-growth period. Part of this labour-force could permanently fall off, impacting income and consumption.

The above traits and reasons indicate some of the Covid-19 losses could become permanent. India’s growth is unlikely to recover to pre-Covid trend in the medium-term. To be sure, after a severe contraction in aggregate output in FY21, a recovery is due for statistical reasons, return of a portion of demand and from restoration of supplies, although the peak can be debated.

However, growth is unlikely to lift further from this peak, i.e., persisting output decline will restrict medium-term growth into the sub-5% region from the further loss of potential output and hurt to long-term productivity.

The implication of further decline in trend growth is adverse for employment creation. A lower potential output would also mean tighter constraints upon monetary and fiscal policies in future because the output gap is smaller than policymakers currently assume.

New Delhi-based economist