Modinomics 2.0

When economic agendas stand out, for whatever reasons, they become eponymous. Take, for instance, Abenomics. It’s a label for Japanese Prime Minister Shinzo Abe’s policies to raise his country’s inflation rate, considered too low to sustain growth. Trumponomics refers to Donald Trump’s economic nationalism, marked by threats to cancel the United States’s free-trade pacts. Modinomics—Naren-dra Modi’s economic agenda—on the other hand, is increasingly getting equated with shock therapies, thanks to a bungled demonetisation and a complicated goods and services tax (GST).

After the bitter pills, the Modi government will now look to go easy and consolidate the expected gains, according to emerging signals. It’s not just the slowdown that could necessitate a softening. The political scene is heating up too. Between now and the next Lok Sabha elections in May 2019, assembly elections are due in 12 states.

The bigger battles will be in Gujarat (December 2017), Karnataka (April 2018), Madhya Pradesh, Chhattisgarh and Rajasthan (December 2018). The BJP will face the Congress as the key opponent. In at least three states—Gujarat, MP and Rajasthan—the BJP will watch out for any signs of anti-incumbency.

“The (Modi) government is unlikely to throw caution to the wind, but some shades of populism are likely to emerge,” says Sonal Varma, the chief India economist of Nomura Holdings. “We also exp-ect the government to pause on fiscal consolidation in FY18,” she adds. If Varma is right, that means some loosening of purse-strings.

The big question that’s now being deb-ated is whether a fiscal stimulus—for the first time since the 2008 recession—is now inevitable. In September, finance minister Arun Jaitley had said that “app-ropriate action” would follow soon to address slipping growth.

To be sure, Jaitley hasn’t hinted explicitly at a stimulus yet, but kept the options open-ended. “I have not used that phrase (fiscal stimulus). I said, we will respond to situations and your fraternity (journalists) translated the word respond as meaning stimulus. So you are the ones who should be answering and not me,” the minister told reporters on October 15 while on his Washington trip.

NITI Aayog vice-chairman Rajiv Kumar has already said he did see a case for a stimulus as long as it was used for capital expenditure and not frittered away in doles. Even non-government economists now feel some sort of a stimulus is necessary.

How to fix growth? Economist Deepak Nayyar, emeritus professor of economics at Delhi’s Jawaharlal Nehru Uni-ver-sity, who advised the government during India’s economic reforms of 1991, says, if there is a slowdown or downturn in an economy, governments should use counter-cyclical, expansionary, macroeconomic policies to revive growth. “Fis-cal policy should provide a stimulus, preferably by stepping up public investment,” he adds. “Monetary policy should provide a stimulus to private investment by lowering interest rates. The government is doing the opposite by adopting pro-cyclical policies.”

‘Counter-cyclical’ and ‘pro-cyclical’ measures are broad terms used to desc-ribe a government’s fiscal policy. A counter-cyclical fiscal policy, which Nayyar has advocated, means that during a slowdown, the government pumps up spending or lowers some taxes as well as lending rates to stimulate growth. A pro-cyclical policy denotes the opposite.

On October 24, the government finally announced its plan to address the underlying malaise of the economy: mountains of bad debt and non-performing assets (NPAs) of banks (see graphic). It plans to infuse Rs 2.11 lakh-crore into state-run banks, of which Rs 1.35 lakh-crore will come from so-called recapitalisation bonds. The rest will come from the budget and borrowings. A fiscal stimulus technically must add to the government’s deficit. The bank recap plan, acc-ording to the IMF’s accounting methods, will not be considered as debt, but acco-rding to India’s accounting methods, it will be considered as such.

The plan however has come late, given that private investment had wobbled. Gross fixed capital formation as a share of GDP—the standard measure of private investment—slowed to 27.5 per cent from 30-plus levels.

Why has private investment shrunk? Industry always raises capital for investment needs through bank borrowings. If they can’t, for some reason, then private investment shrinks. It’s like turning off the credit tap, a lifeline. This can hurt the economy bad.

So, why have firms been unable to borrow? Banks currently do have a lot of money to be sure, especially after dem-onetisation. However, that doesn’t mean they can continue to lend because their ‘capital adequacy’ has fallen dangerously due to NPAs. The capital adequacy ratio—which banks must maintain to avoid their own collapse—is the share of capital to risked assets. If that falls below a certain threshold, banks will shut down their lending window. That is at the root of the crisis.

The recap bonds, announced by the government, will now be subscribed to by banks. The proceeds will be used by the government—which owns these banks—to inject equity into them. This will raise the banks’ capital adequacy. Although there will be no actual cash infused, the balance-sheets of banks will be technically cleaned. The bad debts will still need to be recovered.

Modinomics, what?

To be sure, the sum of Modinomics is more than demonetisation and GST. For instance, the Modi government, by acc-epting the recommendation of the 14th Finance Commission, had given a big boost to states’ spending power. Article 280 of the Constitution requires a rev-iew of how revenues are shared bet-ween the Centre and the states every five years, through the setting up of a fin-a-nce commission.

After over a year in office, the Modi government set up the 14th Finance Commission on December 15, 2015, which recommended—by majority decision—that the states’ share in the net tax proceeds of the Centre would be inc-reased to 43 per cent, a huge jump from the existing 32 per cent.

Then, count in a massive financial inc-l-usion drive. Nearly 60 per cent of Indians don’t have access to banking. A drive for financial inclusion has helped create basic bank accounts (the Jan Dhan scheme) for 300 million Indians as of October 18, 2017, with total deposits of Rs 67,000 crore.

The bankruptcy code, perhaps the most underrated reform of Modinomics, is also aimed at improving growth. In India, legal options for dealing with debt default is out of line with global standards. That’s why debt never gets recovered. The bankruptcy code, at its heart, now means that when a firm defaults on its debt, its management shifts from its shareholders and promoters to a committee of creditors who have lent money to the firm. The committee gets 180 days to come up with proposals about revitalising the company or liquidating it.

The Insolvency and Bankruptcy Code, as it is called, will “lay the foundations for the development of the corporate bond market, which would finance the infrastructure projects of the future”, a finance ministry document states.

So far, the Modi government has aimed squarely at enhancing taxes of all kinds through crackdowns on evasion and narrowing the fiscal gap, which is the difference between what the government earns and spends. It has spent more in infrastructure to boost growth rather than on random populist schemes.

The government had also resisted any big hikes in farm minimum support prices, the assured price that the government offers to farmers for some crops. Higher MSPs are like pay hikes for farmers, but they also artificially raise food prices. MSP hikes under the NDA government have averaged 5 per cent, in contrast to 15 per cent of the UPA years. This helped the Modi government to avoid the previous UPA regime’s costly effects of high MSPs.

During the UPA years, high food inflation from higher MSPs and MNREGA wages (which are, by law, indexed to inf-lation) led to what economists call a ‘wage-price spiral’: more inflation leading to more (MNREGA) wages leading to more inflation. It is only towards the end of October that wheat support price for the upcoming winter-sown season were raised 6.8 per cent, the highest increase since the Modi government took office. This could arrest falling farm incomes, hit by deflation (see graphic).

What went wrong?

Did Modinomics—with demonetisation as its hallmark—cause the slowdown? Data show it did not, because growth began slipping well before it was ann-ounced (see graphic). But it certainly added fuel to fire.

A look at some basic data now clearly reveals the economy’s current malaise. GDP growth hit a three-year low of 5.7 per cent in the three months to June that stripped India of the ‘world’s fastest growing economy’ tag. When the disastrous growth figure was announced, this correspondent had asked T.C.A. Anant, the chief statistician of India, at the official media briefing, whether this was all the result of demonetisation. Respon-ding, Anant had said: “There’s no straight forward link. There are other dynamics you can’t ignore.” He was right.

To understand what went wrong, one must see what was going right. The ‘other dynamics’ emphasised by Anant are the real reasons for the slowdown. A simple explanation is the crash in exp-orts. Sajjid Chinoy, chief India economist at JP Morgan, says the drop in exports is enough to explain a fall of “200 basis points” from GDP growth. One basis point is one-hundredth of a percentage point. So, that’s a straight fall of 2 per cent from GDP growth.

In the five years between 2003 and 2008, India’s exports grew at 18 per cent. That’s when overall GDP grew at 8 per cent plus. In contrast, over the last five years, exports have grown just 3 per cent. This is a 15 percentage-points slip—from 18 to 3. This was partly because of a strengthening rupee and low global dem-and, factors outside the government’s control. The export sector is critical because it accounts for 20 per cent of India’s GDP.

While exports were falling, something curious happened. Imports excluding gold and oil began to rise, immediately after demonetisation, despite slowing private consumption and demand. This is because firms began importing goods they were earlier making domestically because their supply lines were disrupted by demonetisation. “There were permanent output losses,” Chinoy says.

What next?

The big-ticket reforms are “behind us” and the next round of policies—Modi-nomics 2.0—will be aimed more at incremental reforms, says economist Varma. Political considerations, she says, could start to play a “more dominant role in driving economic decisions”. In October, for instance, the governm-ent finally cut the excise duty on petrol and diesel. The labour ministry is working on a new soc-ial security plan for the poor.

Quite simply, Modinomics 2.0 could well see higher spending directed at soc-i-al sectors and small enterprises. A Rs 6.9-lakh-crore investment package for constructing 83,677 km of roads, ass-ured payments to small and medium enterprises within 90 days, micro loans to small firms as well as more handholding of small businesses are in the offing. For instance, more businesses will now qua-lify for a scheme under GST that all-ows small firms to pay lower GST rates.

The government has said it wasn’t thinking of overshooting its fiscal deficit target of 3.2 per cent for the year. But that’s not written in stone. Indeed, at his speech at the IMF on October 14, fin-ance minister Jaitley said—referring to the fiscal target—that though “the government is fully committed to maintain prudent fiscal balance, there may be needed to allow somewhat higher fiscal deficit. Our government will endeavour to improve upon fiscal numbers next year by enhancing the quality of expenditure and tax mobilisation.” Read bet-ween the lines.