Ensuring And Sustaining A Strong Recovery: Need To Shun Incrementalism

As the nature of pandemic and its economic impact becomes clearer, it looks like we are going to be in an economic downturn for a considerable time. The COVID curve has not yet flattened in India. Unless the vaccine becomes a reality, we might continue to be bogged down for several more months. While we wait to see the impact of the ‘Atmanirbhar’ package that was announced a few weeks back, it is now more important than ever for the Government to put in place a bold forward-thinking strategy for robust medium-term economic growth.

There are three elements that the Government will need to achieve the aspiration of breakout growth. Firstly, issues assailing the financial sector like high-interest rate, low depth, and low policy transmission need to be addressed. Second, demand must be unlocked through a combination of targeted government spending and restoration of consumer confidence. Thirdly, once the animal spirits are unleashed, the Government will need to guide the industrial and service sectors – especially the MSMEs to fully achieve their potential.

A large part of the stimulus program is comprised of credit expansion programs. The largest component of the same was the INR 3 Lakh Crore emergency working capital facility for businesses, including MSMEs. As of July, banks have only extended loans to the tune of INR 1L Cr. Feedback from the ground indicates that the transmission has been poor: banks are just not extending loans as the Government has envisioned. Along with the issue with the loan availability, the interest rate also is a big hurdle for businesses in India fighting to compete at an international stage. For example, the lower interest rate of 3-4% in China allows pharmaceutical firms to raise capital cheaply to build scale. Indian firms raising capital from India will be set back by up to 5% of the total value due to a higher interest rate.

There is a need to bring in fresh, bold thinking into the handling of the financial sector in India. Incremental and conservative reforms will only result in a similar impact on the economy, not the step change that GoI is expecting. High levels of NPAs and stress of bank balance sheets are major reasons for both higher interest rates and lower availability of loans. In this scenario, it may be educational to look at China in the late 1990s/ early 2000s.

Figure 1: China GDP in current USD. Chinese GDP was USD 2.3 Tn in 2000

China was at a similar level as India of today if not behind in late 1990/2000s. The interest levels were ~8% in 1995-98. NPA levels of major banks were as high as 40-50% (Lardy 1998, BIS 1999). China embarked on a systematic program to recapitalize banks since 1998. In 1998 alone, Chinese Government injected RMB 270 Bn (3.18% of GDP, CEPII 2006-04). Multiple tranches of infusion followed in subsequent years. In comparison, Indian Government’s plan is just INR 2.1 L Cr. spread over several years. This is just 1.4% of India’s GDP.

China followed up the cash infusion with significant big bang reforms in the banking sector, i.e bringing in foreign expertise. They allowed FDI into the banking sector to raise capital to fund recapitalization. The net impact of this was that the interest rate in China reduced to 3-4% compared to 8-10% in India. This has contributed towards a nearly five-fold increase in Chinese GDP within a space of 10-12 years. The government of India needs to take up bold reforms to address these issues in India as well, or else the dream of India becoming an alternate export hub competing with China may remain distant.

Figure 2: Interest rates were brought down by nearly 50% between June 1996 and June 1999.

There is a need to shun incrementalism in fiscal spending. While the Government currently seems to be pursuing indicators like debt to GDP ratio and deficit to GDP ratio, this can limit spending in the current scenario. A one-time bold fiscal expansion may be undertaken in this scenario. Even if debt and deficit as a percent of GDP increases momentarily, the effect will get dwarfed if GDP growth reaches 8-10%. Under the current scenario, such growth rates can only be achieved through bold fiscal spending akin to the Marshall plan post World War 2. If strict guard rails are in place, state governments can lead much of this fiscal expansion.

Healthy competition on development between states facilitated by better fiscal space and policy headroom will put the country in a great position to achieve breakout growth. It may be noted that decentralization and fiscal relaxation were two important recipes China followed in the early 2000. 

The above two measures can significantly boost both supply and demand sides in the country. This needs to be coupled with reduced tax overreach can enhance consumer confidence and unleash animal spirits in the economy. Once we reach that stage, guiding and enabling businesses will help the country achieve breakout growth.