The COVID-19 pandemic has brought global economic activity to a virtual halt. While the world was long expecting a recession, the pandemic has pulled the trigger. The IMF estimates the global economy to contract by -4.9 per cent this year and the cloud to deepen should the virus not recede in the latter half of 2020. As for the Indian economy, growth has been decelerating for the past eight quarters, and indications by the RBI suggest that growth is contracting for the first time in four decades. While the recently announced economic package provides much-needed near-term liquidity support and long-pending structural reforms aiming towards medium-to-long-term stability, we must address the elephant in the room — the need to further aid a demand recovery. As the economy begins to reopen, we explore the components of aggregate demand and explain why government expenditure is perhaps the only component that can aid growth going forward.
Keynesian theory suggests that for aggregate demand to increase, at least one of the components of GDP needs to expand. Growth in the Indian economy has been dominated by consumption (PFCE), followed by investments (GFCF), government expenditure (GFCE) and net exports (NEX). However, consumption and investment demand have been subdued for the past few quarters, dragging down overall growth.
These two components were perhaps casualties of a sharp deceleration in credit supply even after an impressive bank cleanup exercise by the government and RBI. The IL&FS debacle in September 2018 only made matters worse. The NBFC sector, which played an important role in fuelling India’s consumption growth, suffered from funding crunches leading to a further squeeze in credit supply, thereby impacting consumption demand. This deceleration is likely to exacerbate going forward, with estimates suggesting that PFCE will grow at its slowest pace in 15 years.
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While the government and RBI have taken impressive strides to ensure adequate liquidity, uncertain economic prospects provide little comfort for bankers to lend further. Even though we may see the release of some pent-up consumption, industry-wide job/pay-cuts with a growing sense of uncertainty over the future may limit spending to non-discretionary items and force people towards precautionary savings.
A similar cause for worry is the declining rate of investments. Broad-based utilisation levels, as represented by the RBI, dropped to 68.6 per cent in Q3FY20, well below the 75 per cent benchmark for new capacity addition, implying suboptimal levels of fresh investments. A higher rate of investments is essential for sustainable economic growth. The deteriorating economic scenario and increasing levels of debt with rating downgrades for industries are likely to aggravate existing problems. With utilisation levels at historic lows and significant hurdles in raising new capital, any new capacity addition in the near-future looks highly unlikely.
Global trade has been undergoing several disruptions since 2009. Heightened trade tensions between the US and China, with the onset of the pandemic, only make matters worse. Global trade, as monitored by CPB, witnessed its steepest decline since 2009, falling by -4.3 per cent in March over the previous year, with only downside risks from hereon. As for India, our limited share in global trade along with a battered domestic and global outlook provides little room for exports to contribute towards growth.
Lastly, government expenditure is the only exogenously determined element in a Keynesian framework. The positive push required to aid a demand recovery has to come through the government, seeing as there is limited room for consumption, trade or investments to expand significantly. However, with sparse resources that India has, we must deploy funds that yield a higher return. One key area that can provide the necessary support is infrastructure investment. A study by S&P Global estimates 1 per cent of GDP spend on infrastructure can boost real growth by 2 per cent while creating 1.3 million direct jobs. Historically, countries have used infrastructure to provide counter-cyclical support to the economy. Some of the most remarkable references are the New Deal in the US, Germany’s expansion post-WWII debt reduction (1953) and more recently with China in the wake of the Global Financial Crisis. Reports suggest that China is sticking to the same strategy this time around with nearly $600 billion worth of special bonds, it is again looking towards infrastructure to revive growth.
Notably, infrastructure has strong links to growth and with both supply and demand-side features that help generate employment and long-term assets. India already has an upper hand here. Front-loading key projects with greater visibility from the recently announced National Infrastructure Pipeline (NIP) could aid in a quicker recovery.
How do we do this? India already has several institutions for infrastructure development purposes from the likes of IIFCL, IRFC to more recently NIIF. However, over these years, their scale and functioning have remained inadequate. Perhaps, a relook, to restructure these into one large development institution could help reduce inefficiencies and allow for greater leverage.
Taking a cue from China, floating special infrastructure bonds through this organisation to accelerate the funding of the NIP could aid a speedier recovery. Further, taking a page from the New Deal and its Reconstruction Finance Corporation, this institution’s ability for greater leverage can be used to make amends to our credit channels as well as the development of state government and urban local body bond markets. This could help businesses and bankers overcome risk aversion and bring back trust in the system while financing new paths for growth.
At a time when liquidity is ample and the cost is low, borrowing shouldn’t be so scary. The exogenous component could step-in in a greater way, perhaps because, it is the only one that can.
This article first appeared in the print edition on June 30, 2020 under the title “Spending our way out”. The writers are part of the Economics & Finance team at NITI Aayog. Views are personal
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