The slowing of GDP growth to below 6 per cent has created consternation and concern in many quarters. Unsurprisingly, in this age of instant gratification, some have immediately called for a fiscal stimulus to re-stoke growth. To assess the efficacy of any intervention, however, it’s crucial to first correctly diagnose the problem. Wrong medicine can often be worse than the underlying ailment.
Let’s first stipulate some facts. Growth has now been slowing for five quarters. The slowdown has been accentuated in 2017, but in the face of two large shocks — demonetisation and GST — should this really be a surprise? Instead, the real puzzle is despite this slowdown, manufacturing imports have accelerated sharply in recent months, thereby widening the current account deficit (CAD). Even as growth has slowed from 6.1 per cent to 5.7 per cent, the CAD has quadrupled from 0.6 per cent to 2.4 per cent of GDP. Seventy per cent of this is on account of increased manufacturing imports. If domestic demand is slowing, why are imports accelerating? Something doesn’t add-up.
We, therefore, need to answer three questions. Why has growth slowed since 2016? Why are imports accelerating despite weaker growth in recent quarters? And, what then, is the optimal policy response?
So what’s behind the slowdown? GDP growth was running at 7.3 per cent in 2014-15. Then oil prices collapsed and provided India with a large positive terms-of-trade shock. We estimated this would boost growth by about 100-150 bps. Unsurprisingly, growth accelerated to 8 per cent in 2015-16 despite a drought. The key, however — and as we pointed out at the time — is the growth impact from oil would be transitory, and disappear once oil prices stabilised. The slowdown from March 2016 was therefore an inevitable consequence of the oil windfall rolling off.
Further, the economy was embarking on de-leveraging with policymakers correctly doubling-down on impaired asset recognition and resolution. De-leveraging inevitably impinges on growth, but is a necessary pre-requisite to future investment. De-leveraging and the dissipation of the oil-windfall, therefore, inevitably combined to slow growth from 9.1 per cent in March 2016 to 7.5 per cent in September 2016 — the levels that existed before oil collapsed.
Over the last three quarters, however, growth has slowed another 200 bps to 5.7 per cent, against the backdrop of demonetisation and GST. Some of this is transitory related to GST-destocking and most expect growth to recover to above 6 per cent later this year. But something bigger is also at play. Consumption has recovered to the same growth rate as before demonetisation, even as softer private consumption has been offset by stronger public consumption. Investment continues its inexorable slowing, but only accounts for a third of the recent slowdown, and exports are stronger in 2017, as global growth has accelerated. So what’s accentuated the slowdown in the last three quarters?
Much stronger import growth! Imports contracted almost five per cent in the year before demonetisation, in real terms. Since demonetisation, they have been growing at 13 per cent. The increase is across the board — jewellery, electronics, paper, plastics and chemicals. Stronger imports alone subtract 300 bps from headline growth — even after adjusting for imports that are re-exported. Therefore, stronger imports can explain the entire slowdown since demonetisation, and then some. Furthermore, even as imports have surged domestic production has softened, and is lower than what the pre-demonetisation momentum would have implied.
What all this suggests is that domestic supply chains may have been disrupted in the manufacturing sector post-demonetisation — likely involving SMEs — and that activity has (temporarily) been replaced by imports. This explains why imports began to pick-up almost exactly around demonetisation despite slowing domestic demand. This should not be surprising. The point of demonetisation/GST is to formalise the economy. This necessarily involves disrupting supply chains that run through the informal sector. The hope is that eventually these supply chains will be routed through the formal sector domestically. In the transition period, however, some disruption is inevitable, and is being filled by imports. For the economy as a whole, this is tantamount to an adverse supply shock. Viewed this way, it’s easy to understand why growth is slowing but the CAD is simultaneously widening.
Some may argue that stronger imports simply reflect a stronger currency. But the rupee has been appreciating for more than three years. How come imports began to accelerate only after demonetisation? Till recently, the rupee strengthened sharply against the Chinese yuan, but the share of Chinese imports has not picked up. Others may argue imports are being over-invoiced to mask capital flight. But why then are monthly imports reflecting the domestic cycle, with July imports very weak on GST destocking and August imports correspondingly stronger on re-stocking.
So, here is where we are: The growth slowdown before demonetisation was a natural consequence of the oil windfall rolling off and the economy embarking on de-leveraging. This has been compounded by a negative supply shock after demonetisation, as supply chains have potentially been disrupted inducing more imports.
What then is the appropriate policy response? If it’s a transient supply shock, it will self-correct. But even if it lingers, we should not respond to a negative supply shock with a positive demand impulse. Expansionary fiscal is unlikely to rehabilitate disrupted supply chains. Instead, a fiscal stimulus — in the wake of an adverse supply shock — will simply stoke more imports and result in a larger current account deficit. With global financial conditions tightening in recent weeks, the last thing India needs is fiscal adventurism (particularly against the backdrop of worsening state finances) that ends up further pressuring external imbalances, with the CAD already widening to 2.4 per cent of GDP.
Instead, supply-side shocks need supply-side solutions. We need to continue improving the regulatory and business environment for SMEs, improve their access to credit, resolve teething GST problems and simplify the burdens of firms competing in the formal sector. More generally, we need to keep pushing hard on the stressed-asset resolution, so that the twin-balance sheet problem does not remain a binding constraint for larger firms.
India’s economic history is replete with the same lesson. Every time policymakers trade-off some macroeconomic stability for growth, the economy ends up with neither. The current government has heeded these lessons remarkably well, and shown admirable fiscal restraint. We shouldn’t blemish that record. Markets will continue clamouring for a “stimulus”. That is their nature. But policymakers must exercise strategic restraint. As they say in French: Reculer pour mieux sauter. Let’s step back now to jump further later.