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Friday, January 28, 2022

Sustaining growth after pent-up demand fades

🔴 Policymakers must chart out a course of action that delivers on promises, quickly

Written by Pranjul Bhandari |
Updated: December 24, 2021 8:29:41 am
At a time of heightened exogenous shocks, government policy needs to be a source of stability and predictability. (File)

After a volatile year, the outlook for 2022 comes with several uncertainties. Yet, one thing is becoming increasingly clear. Strong growth in the latter part of the year and beyond will depend on the steps taken now. And there is no time to waste.

First, some context. The economy has rebounded after a hugely disruptive second pandemic wave. But the recovery has been more gradual than rapid. GDP has just about reached pre-pandemic levels, implying there’s been no growth since early 2020 for a country which was used to experiencing 6 per cent growth per year on average before Covid-19.

One problem is that there is ample evidence that income inequality has risen. While the rich have been spending over the last few quarters, they have splurged on imported consumer durables (running at 37 per cent above pre-pandemic levels) rather than on domestically produced ones (running 6 per cent below pre-pandemic levels). And this has weakened the trickle-down effect.

But this is likely to change. And recovery is likely to gain pace over the next couple of quarters. With vaccination rates rising, demand is fast pivoting from goods to services (like travel, eating out, etc). Surveys of purchasing managers show that demand for services has begun to outpace manufacturing. Most services are domestically produced, and the benefits are expected to filter down from the top of the pyramid to the bottom.

Alongside this, there are also signs that residential real estate construction is picking up as people splash out on better homes after being locked up for several months. This, another form of pent-up demand, could increase spending on labour and materials, and also aid the trickle-down effect. The risk to this narrative is the spread of the Omicron virus in a way that pushes out pent-up services demand to a quarter later.

But, by definition, pent-up demand runs its course, and after a couple of exuberant quarters, growth may begin to slow around mid-2022, or a quarter later if Omicron delays things. This is also the time when the scars from the pandemic could begin to show more clearly. Big companies have grown through the pandemic, while small and informal firms and their employees have struggled. Rising inequality was further exacerbated when global commodity prices rose sharply a few months ago. Amid rising input costs, smaller firms faced more significant margin pressure than larger firms, who were able to pass on input cost pressures to consumers more easily.

About 80 per cent of India’s labour force is employed in the informal sector. And we believe about half of them have lost income in the pandemic period. This was not visible when pent-up demand was dominant. But as that spending fades, the income losses at the bottom of the pyramid and the demand disruption that has caused will likely become more pronounced.

To be fair, all is not bleak. Two new growth drivers have emerged in the pandemic period. High-skill exports such as IT services, autos, pharmaceuticals, mobile phones and specific machinery, have gained global market share over the last few years. Unfortunately, low-skill exports haven’t risen as impressively, and in fact, have been losing market share in areas like textiles. Combining high and low-skill goods, India’s overall global export share has been stagnant at 1.8 per cent. Two, the tech start-up scene is growing rapidly, attracting large financial inflows. In fact, 50 per cent of India’s FDI is now digital, up from 20 per cent a few years ago. This sector has many positives such as nurturing an entrepreneurial culture, creating jobs and spurring capex. But while fast growing, it remains a small share of GDP. For instance, the rapidly growing IT sector still employs only about 1 per cent of the labour force.

All said, these new and rapidly growing sectors may not be able to immediately fill the gap which fading pent-up demand leaves behind in the second half of the year.

And this is where public policy will have to step in. Careful policy steps now will help set the stage for sustaining growth down the line. But what needs to be done? Luckily, nothing new. Rather, simply delivering on old promises, but quickly.

At a time of heightened exogenous shocks, government policy needs to be a source of stability and predictability. Last year’s budget promised gradual fiscal consolidation with fiscal transparency, and high quality spending. It will be critical to deliver on each of these. Given the vulnerabilities in the bottom of the pyramid, elevated social welfare spending for longer will be important. Given limited resources, it may be a good idea to fund pre-existing job creation schemes like NREGA, rather than being pressured to start new ones.

The same goes for policy reforms. The government is already pursuing some important reforms related to fiscal policy (for instance, asset monetisation), the financial sector (for instance, the creation of a bad bank) and manufacturing (the production-linked incentive scheme). Implementing them properly is a better strategy than announcing new reforms.

Sectors like power and telecom have faced policy shocks over the last few years. Efforts to improve policy certainty can have a positive spillover effect. In fact, it’s the only way to get the rather elusive private capex cycle going. Our analysis shows that four things matter for raising investment — the health of corporate balance sheets, world growth, policy certainty and the domestic growth expectation.

The outlook on the first two is positive, but that’s not good enough. The last two are closely interlinked and need to be nurtured.

And the central bank faces an urgent task — immediate inflation control, which is also its primary legislated mandate. Core inflation in India was elevated even before global inflation started to tick up. Inflation expectations have risen over the pandemic. Monetary policy needs to be normalised quickly as any delay risks even bigger rate hikes down the road, which could be painful.

Growth will be strong in the next few quarters. It will be fuelled by pent-up demand for goods, services and housing. The challenge will be to use this period efficiently and take some important policy steps, which would set the stage for continued strong growth once pent-up demand fades. The good news is that the steps needed have already been laid out by policymakers. The challenge now is to walk the talk.

This column first appeared in the print edition on December 24, 2021 under the title ‘2022: Reap what you sow’. The writer is chief India economist, HSBC Securities and Capital Markets (India) Pvt Ltd

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