Time to address structural issues to push growth

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Published: Thursday, 26th September 2019

The reduction in the corporate tax rate and other relief announced by the government as part of a stimulus package will mean revenue foregone to the tune of Rs.1,45,000 crore, or 0.68 per cent of GDP. This is a huge incentive by any account. It comes on top of a slew of other measures relating to sector-specific fiscal concessions and funding up of recapitalisation of public sector banks.

The anatomy of the plunge in the growth rate shows that on the demand side, investment (fixed capital formation) remained low at 4 per cent (following a 3.6 per cent print in Q4). But the most perceptible drop came in private consumption growth, falling from an average 8.1 per cent in FY19 to 3.1 per cent. This is indicative of a demand deficiency-led slowdown. Consumption expenditure, both private and government, took a hit in Q1 while investment growth remained roughly flat.

The fiscal arithmetic of the revenue foregone on the government budget needs to be contextually addressed. The headroom for absorbing such a huge hit in revenue emanates largely from the surplus transferred from the RBI to the tune of Rs.1,75,987crore, or 0.83 per cent of GDP, including advance surplus payment of Rs. 28,000 crore. Though this is not explicitly set out in the budget, reports have said that the Union Budget for 2019-20 estimated the RBI surplus payment to the tune of Rs. 90,000 crore, or 0.43 per cent of GDP. This amount, thus, has already been taken into account by the Government of India (GoI) relative to GDP while estimating the revenue deficit (2.3 per cent) and fiscal deficit (3.3 per cent) relative to GDP.  Thus, cteris paribus, the net impact on the budget will be 0.28 per cent, and as a result, revenue and fiscal deficit will turn out to be around 2.6 per cent and 3.6 per cent.

Two critical issues arise. Will the package, even if it entails a huge fiscal burden, help in the revival of growth and in sustaining growth after it is revived?  The Indian economy has recorded a massive slowdown in Q1 of the current fiscal (measured in terms of real GDP emanating from the demand side), falling to 5 percent as against around 8 per cent in the corresponding period of the previous years.  The slowdown in the growth rate was expected in official circles (the RBI Monetary Policy Committee put it at 5.8 per cent as the lower bound in H1) and as well as in market circles (5.7 per cent was mostly a consensus figure) but such a steep fall came as a rather nasty surprise.

The anatomy of the plunge in the growth rate shows that on the demand side, investment (fixed capital formation) remained low at 4 per cent (following a 3.6 per cent print in Q4). But the most perceptible drop came in private consumption growth, falling from an average 8.1 per cent in FY19 to 3.1 per cent. This is indicative of a demand deficiency-led slowdown. Consumption expenditure, both private and government, took a hit in Q1 while investment growth remained roughly flat. Contribution of private consumption to overall GDP fell substantially. Similarly, the growth rate from the supply side measured in terms of Gross Value Added (GVA) was 4.9 percent. A perusal of the relevant data reveals that very weak manufacturing segment growth (0.6 per cent), contraction in agricultural growth (2 per cent as against 5.1 per cent in Q1 of 2018-19) and a slowdown in financial services contributed to the fall in economic growth.

Revival of investment rate depends on savings rates but the latter has nosedived in its important constituents, particularly a negative savings rate of 0.9 per cent of the government sector in 2017-18 and stagnation of the household sector savings at around 17.0 per cent of GDP in recent years.

A glance through the past trend reveals that India’s real GDP growth print stood at an average of 7.7 per cent and as high as 8 per cent in Q1 of 2018-19. However, the economy began to lose momentum through the course of fiscal 2018-19 (Q2: 7.0 per cent, Q3: 6.6 per cent; Q4: 5.8 per cent). Reflecting this trend, the full fiscal growth rate was 6.8 per cent in 2018-19.

How can growth be revived? Fiscal, liquidity and administrative measures are designed to address the twin balance sheet problems viz; (a) balance sheet of the corporates and (b) balance sheet of the banks. As expected, the corporate sector and the market have responded in a very positive manner. Some optimism has been noticed. However, the perceived optimism needs to be translated to reality. In essence, economic growth is a function of savings and investment. According the available data, savings and investments relative to GDP have not moved higher. For example, “the domestic investment rate measured by the ratio of gross capital formation (GCF)  to GDP had risen to a peak of 39.8 per cent in 2010-11 before a prolonged slowdown set in, taking it down to 30.9 per cent in 2016-17,” as the RBI stated in its annual report released barely a month ago.

Revival of investment rate depends on savings rates but the latter has nosedived in its important constituents, particularly a negative savings rate of 0.9 per cent of the government sector in 2017-18 and stagnation of the household sector savings at around 17.0 per cent of GDP in recent years. In tentative estimates, as revenue deficit relative to GDP will increase by 0.3 percentage points, government dis-savings could go up by the same magnitude. There could be some savings by the corporate and we assume the loss of 0.68 per cent of GDP to the budget will be translated as a gain to the corporates. Thus, the net gain (savings of corporates minus the dis-savings of the government sector) could be around 0.3 per cent of GDP. This development thus will help the revival of growth but at a margin.

It is high time to make a paradigm shift from the overreliance on monetary and fiscal policy to structural reforms in agriculture, labour market reform and above all enhancing productivity with focus on human capital development. There is in the end no shortcut to faster GDP growth.

In the above context, it is important to address the question whether the plunge in growth is cyclical or structural. The RBI annual report for 2018-19 has called it cyclical. This is corroborated by the monetary policy interventions of four successive policy repo rate cuts by the Monetary Policy Committee (MPC) since February 2019.  Furthermore, the RBI Governor is reported to stated that there could be scope for further policy rate cut. However, this view is misplaced. The slowdown is more structural in nature, as argued above, and in this situation, a rate cut can achieve little, if anything at all.  

There has been a perception that a reduction in the corporate tax rate will increase FDI flows. FDI flows depend on push factors (for example, the world economic outlook) and pull factors (the Indian growth scenario, corporate balance sheets, governance and profitability, government fiscal position etc). Thus, there may not be a direct and one-to-one correspondence between tax reduction and FDI Flows. In 2018-19, foreign investment net was 1.1 per cent of GDP as compared with 2 per cent in 2017-18. The reversal of this trend also critically depends upon the pull and push factors stated above.   

In sum, an overreliance on a rate cut and tax reduction is short lived. There could be revival of growth but at a margin. According to a RBI study on factor productivity in India (Annual Report 2018-19), the total factor productivity (TFP) growth in India recorded a deceleration from 1.8 per cent during the period 2003-07 to 0.8 percent during 2008-16. More importantly, the contribution of agriculture to TFP has fallen. It is high time to make a paradigm shift from the overreliance on monetary and fiscal policy to structural reforms in agriculture, labour market reform and above all enhancing productivity with focus on human capital development. There is in the end no shortcut to faster GDP growth.

(Pattnaik is a former Central banker and a faculty member at SPJIMR. Views are personal)