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December 27, 2019

Indian Economy: The slowdown domino

The year draws to a close on a sombre note with no reliable signs of a turnaround. Rather, recent data shows worrying growth-inflation dynamics. Inflation is ballooning and industrial production, slipping further. Recent surveys by the Reserve Bank of India (RBI) show a precipitous drop in business and consumer sentiment and a pick-up in inflation expectations, too. Amid all this, there is limited room for counter cyclical stimulus. If at all, it needs to be exercised with caution. Past experience informs us that fiscal and monetary policies cannot be stretched too thin, for then, the economy becomes highly vulnerable as inflation and other macro distortions creep in.


The current slack in the economy and lack of policy space mean that economic recovery will be a grind up. We recently cut our gross domestic product (GDP) growth outlook for this fiscal to 5.1%, taking into account weak growth in the first half of this fiscal (4.5%) and mild recovery in the second (5.5%). The RBI, on its part, chose to take a breather it its December policy, after five continuous rate cuts this year.


The government, however, cannot afford to sit still. Recent data on government spending shows a tilt towards fiscal stimulus - government consumption spend expanded at 15.6% in the second quarter of this fiscal. If this trend continues, and is not accompanied by fast-tracking of receipts through divestments and asset monetisation, fiscal slippage is inevitable. 


Not only this, a fall in GDP growth sets in a vicious cycle of low growth, low tax revenues, and hence, low ability of fiscal policy to support growth. The axe typically falls on potential enhancing capital expenditure, as revenue expenditures (interest payments, salaries, etc.) are typically sticky in nature. The gross tax revenue of the central government rose by merely 1.2% during April-October 2019, versus an average of 14.5% for the same months of the last five years. Reduced ability to spend has not led to crimping of expenditure so far – the central government revenue and capital expenditure grew by over 13% during April-October 2019. 


States however face a double whammy in this situation: one, their ability to raise revenues is impaired due to economic slowdown and two, the transfers from central government are much lower than budgeted. Unsurprisingly, therefore, states’ tax revenue growth during April-October was an anaemic 1.8% compared with an average growth of 12.2% during the same months of the last five years. In turn, capex has suffered: while total expenditure of states grew 8.3%, their capex growth was only 1.8% in April-October on-year. States now account for almost two-thirds of the budgetary capex of the Centre + states. The trend of slowing capex at the state level, therefore, does not augur well for the overall capex cycle, as the private investment scenario continues to remain subdued. Therefore, all eyes will be on how states grind up their capex during this fiscal, as that would have a much larger bearing on the investment cycle than what the Centre spends through its budget. 


Here are three developments to watch out for in the coming year. These will shape the speed of recovery, its sustainability, as well as India’s long term prospects: fiscal policy stance in the upcoming budget; progress in de-stressing of financial sector; and streamlining of already implemented reforms (Goods and Services Tax, Insolvency and Bankruptcy Code) and a fresh wave of pending structural reforms (land, labour, and ease of business).