The New Normal — Masks, Social Distancing And Lower GDP Growth

Policymakers and economists worry that India’s potential growth could drop further in the aftermath of the Covid crisis.

Migrant workers sit at a bus terminal as they wait to catch state provided transportation to their home villages, in Greater Noida, Uttar Pradesh. Photographer: Anindito Mukherjee/Bloomberg
Migrant workers sit at a bus terminal as they wait to catch state provided transportation to their home villages, in Greater Noida, Uttar Pradesh. Photographer: Anindito Mukherjee/Bloomberg

The Covid-19 pandemic is likely to push India into the deepest recession the country has seen since independence. But it may have an even more ominous impact — on India’s potential growth.

Potential output refers to the level of output that is consistent with full capacity utilisation along with low and stable inflation. The maximum sustainable level, or the potential output, is then used to judge the output gap, which is the difference between actual output and potential output. This, in turn, is a key determinant for interest rate policy.

India’s potential growth rose steadily from 5% in the 1980’s to a peak of about 8% during the 2003-2008 period, according to a 2016 RBI working paper, ‘India’s potential output revisited.’ After that it decelerated and the paper pegged it at close to 7% in the 2009-15 period.

Policymakers and economists now worry that India’s potential growth could drop further in the aftermath of the Covid crisis, pushed lower by a fractured financial sector and weaker capacity utilisation. “The damage is so deep and extensive that India’s potential output has been pushed down, and it will take years to repair,” cautioned RBI deputy governor Michael Patra in the minutes of the last Monetary Policy Committee meet.

BloombergQuint spoke to economists to understand what could impact India’s potential growth.

Pranjul Bhandari, HSBC

Potential growth has been sliding since FY18, after a pick-up between FY15 and FY17, Bhandari, chief India economist at HSBC wrote in a note dated June 18. Potential GDP growth was at 6% in the FY18 to FY20 period, ahead of the Covid-19 pandemic, she estimated.

Now, after the pandemic, potential growth could fall by 1 percentage point to 5%, taking it to the lowest its been since the turn of the millennium.
Pranjul Bhandari, Chief India Economist, HSBC

What will drive the fall? To judge that Bhandari assessed the three factors of production —capital stock, labour and total factor productivity.

Labour market conditions, with migrant workers returning home, is likely to hurt growth in FY21 but may not prove to be a long-term deterrent. Capital stock, which in this context means assets such as plants and equipment, is likely to be a longer term drag.

The biggest drag on potential growth, however, is likely to come from a weak financial sector. This could lead to low credit growth and impinge on consumption and investment.

“Only undertaking important reforms can push potential growth back up,” Bhandari said. These reforms include those that tackle the reasons behind banking sector stress such as land and power sector reforms. Equally, a more efficient insolvency mechanism, should be a priority, she said.

Pronab Sen, IGC

Potential output is largely driven by investment intentions, according to Pronab Sen, country director for the India programme of the International Growth Centre. Sen is also India’s former chief statistician,

Before demonetisation, India’s potential GDP growth was estimated at about 7.5%.

Now, potential growth has steadily come down as growth in capital formation by the private sector has been shaved by as much as a percent every year over the past four years, said Sen. This alone translates roughly into a decline of 0.2 percentage points in potential growth every year.
Pronab Sen, Former Chief Statistician of India

Stressed balance sheets in the financial sector and lower investments will create demand and supply side challenges for capital formation, further pushing down potential growth, he said.

Though the availability of skilled labour poses a challenge to productivity, it’s not as relevant amid the current labour surplus, Sen said.

NR Bhanumurthy, BASE

To understand what may push down potential GDP growth, it is useful to understand the drivers of potential growth before the global financial crisis, when India was touted to touch double-digit growth rates, said NR Bhanumurthy, vice chancellor at Bengaluru Dr. BR Ambedkar School of Economics.

Financial intermediation and strict adherence to the FRBM Act were major factors driving potential GDP growth then. The India growth story was largely believed to be a savings-led investment growth story. Along with high household and corporate savings, the government too, for the first time, ran a positive savings rate because of the FRBM Act. In terms of inflation, India was amid “the great moderation period”.

Now, weak financial intermediation and the lack of adherence to the targets set by the FRBM Act, will push down potential GDP growth.
NR Bhanumurthy, Bengaluru Dr. BR Ambedkar School of Economics

India’s fiscal deficit before the pandemic was estimated at 4.6% of GDP. The FRBM Act targeted a fiscal deficit of 3% of GDP by March 31, 2021. Instead, the actual fiscal deficit this year is likely to be substantially higher.

Thomas Rookmaaker, Fitch Ratings

Rating agencies, too, have raised a red flag over the possible impact of the Covid crisis on potential growth.

Rookmaaker, director of sovereign ratings at Fitch Ratings, said it remains to be seen whether India can move back to growth rates seen before the pandemic. Ahead of the crisis, Fitch estimated India’s potential growth at between 6.5-7%.

The big question is to what extent the financial sector is able to perform its traditional role as a provider of credit and facilitator of GDP growth.
Thomas Rookmaaker, Director - Sovereign Ratings, Fitch Ratings.

Fitch said the country’s medium-term growth prospects could be impacted by renewed asset quality challenges faced by banks and liquidity issues faced by non-bank lenders. SMEs, too, have been hit by several shocks in the past couple of years, he said.

Reforms are important to push up potential growth. While some of the measures announced by the government, could be transformative, the outcome depends on the details of the reforms which aren’t out yet, he said.

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