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Inflation | Reforms in 2020: Enough of Snakes & Ladders for economy

Inflation | Reforms in 2020: Enough of Snakes & Ladders for economy

By Ajay Chhibber

As India enters 2020, still unclear on how to stem the economic downward spiral, a somewhat longer perspective may help us understand our predicament and what lies ahead.

The slowdown that India has seen, especially over the last seven quarters, qualifies for some as a crisis. However, the political establishment appears ‘shaken, but not yet stirred’ into bolder second-generation reforms. It has recapitalised, merged, but not reformed, its state banks. Corporate tax cuts, even ‘ease of doing business’ are good piecemeal reforms. Necessary, but not sufficient to turn things around quickly. The last time India saw bold comprehensive reforms was in 1991, triggered by a balance of payments (BoP) crisis.

Those first-generation reforms eventually paid off across the board. India’s dollar GDP almost quadrupled from about $450 billion in 2000 to $1.67 trillion 2010, but since then has not even doubled to $2.9 trillion in 2019. GDP per capita almost tripled from $439 in 2000 to $1,346 in 2010, but has since only increased to around $2,000 in 2019. Trade and finance played a key part in this phenomenal rise in income in the previous decade. India’s trade to GDP ratio almost doubled from 26.9% in 2000 to 49.2% in 2010, but has since declined to 43% in 2019. And exports as a share of GDP rose from 13% in 2000 to 22.5% in 2010, and has since declined to 13% of GDP. India’s trade and export slowdown is much sharper than global averages, which have recovered in the last two years.

But some claim that this was also the period when credit-fuelled growth laid the basis for the banking sector problems India faces today. The private credit to GDP ratio shot up from 28.3% in 2000 to 50.5% in 2010, then continued until 2013, peaking at 53% before declining to 50% in 2019. That rapid credit expansion then became the non-performing assets (NPA) crisis for this decade, exposed due to slower growth and stronger regulatory pressure and norms by RBI.

At this stage, a 1991-style BoP crisis seems unlikely, given India’s huge reserves. What is more likely, unless the economy turns around quickly, is a downward spiral feeding on itself — an internal fiscal, financial sector crisis. The non-banking financial company (NBFC) crisis — whose costs for the banking sector are not fully known as yet — is the first manifestation of those problems.

Non-Performing Assets
The Narendra Modi administration cannot lay all these recent NPAs on to the credit binge of the previous government. Neither can it blame anyone else for the growing MUDRA (Micro Units Development and Refinance Agency) loan problems. RBI’s recently released financial stability report shows the risks of that downward spiral. Stress tests on the banking system show slower growth would add to NPAs paid for by huge injections of over Rs 3.5 lakh crore of taxpayer money into its state banks to cover their losses.

But by delaying quicker resolution of NPAs through a bad bank — and allowing it to dribble out through a slow National Company Law Appellate Tribunal/Insolvency and Bankruptcy Codebased process that’s not designed for a system-wide NPA problem — there are risks that a vicious downward spiral is developing into a bigger crisis. Slower growth would also deepen an already worsening fiscal crisis. India has ‘cosmetically’ met its central fiscal deficit target, but has seen its public sector borrowing requirement reach almost 9% of GDP. And with slower growth-cutting revenues and ambitious disinvestment targets, PSBR could go much higher and further damage chances of a recovery in private investment.

The Way Out
What will be the way out? Strong factor market reforms are unlikely. A government now preoccupied dealing with the Citizenship (Amendment) Act / National Register of Citizens issues, and having lost several state elections, will be unwilling to want to take on sensitive labour and land reforms. A combination of inflation and exchange rate depreciation is the most likely outcome. Historically, the rupee has followed a step-wise adjustment — it stays flat for a while, and then suddenly adjusts sharply. A big exchange rate adjustment in 1989-92 from Rs 16 a dollar to Rs 33 a dollar helped competitiveness and cushioned domestic industry from sharp import tariff cuts. The rupee drifted to Rs 45 a dollar by 2000, but then stayed flat for much of the golden decade, even appreciating briefly. It has depreciated in steps to Rs 70 a dollar over the last decade, ready for a sharp adjustment to over Rs 75 a dollar to correct the over-valuation as market sentiment towards India weakens. If it occurs, RBI should allow this exchange rate adjustment and not waste reserves fighting it. A sharp exchange rate adjustment may reduce the pressure to turn more protectionist, and boost exports.

Higher inflation will hurt the poor and middle-class no doubt, but will rebalance terms of trade to the farm sector, help get closer to nominal fiscal targets, and lower real interest rates that remain very high at 6-7% despite lowered repo rates — helping inefficient bankers with the highest spreads in the world while killing the economy.

With stagflation looming, 2020 will be another difficult year for sure. And if the economy sputters along at 4-5% growth, that $5 trillion GDP target seems unlikely even by 2030, unless the political economy changes and brings on the next set of reforms to accompany goods and services tax and corporate tax reforms, and more funds for PMKISAN and MGNREGA by cuts in wasteful electricity and fertiliser subsidies. Piecemeal reform is like a game of snakes and ladders — you go up one small ladder, and get bitten by a snake tumbling back to where you were. You need comprehensive bold reforms to catch the big ladder and on to the golden turnpike.

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