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India’s Growth Slowdown: The Reasons And The Fixes, According To Neelkanth Mishra And Sajjid Chinoy

Reasons for the growth slowdown and least disruptive policy actions, according to Neelkanth Mishra and Sajjid Chinoy.



A man sits on a tire as a passenger holds a ladder while riding a motorcycle. (Photographer: Brent Lewin/Bloomberg)
A man sits on a tire as a passenger holds a ladder while riding a motorcycle. (Photographer: Brent Lewin/Bloomberg)

The slowdown in the Indian economy, now apparent from data such as weaker GDP growth, plummeting auto sales and falling core inflation, has prompted calls for corrective action. Options range from monetary support in the form of lower interest rates, to fiscal support via tax cuts to boost spending, to fixing longer-term structural issues facing the Indian economy.

Determining the best course of action, though, needs two fundamental questions to be answered:

What led to the growth slowdown in the first place? And what are the least disruptive policy options to correct the slowdown without throwing caution to the wind? BloombergQuint spoke to Neelkanth Mishra, chief India strategist at Credit Suisse and Sajjid Chinoy, chief India economist at JPMorgan for their views.

Opinion
Debating India’s Growth Slowdown With Neelkanth Mishra And Sajjid Chinoy

Watch the entire conversation here:

Edited transcripts of the interview:

What are the core issues behind the slowdown we are facing now?

Neelkanth Mishra: We had monetary tightness which has persisted too long. I measure it in the form of M3. There is a quite a bit of unnecessary confusion around liquidity. Let me just give you numbers. Currency in circulation is about Rs 21 trillion, M0 is about Rs 28 trillion, M3 is Rs 154 trillion. So, all of these reasons that government is not spending enough or that too much currency has gone into economy because of elections, all of those are useless.

The problem has been that M3 growth has been much below GDP growth for almost three years. M3 as a percentage of GDP, the cumulative number, is down by almost 6 percent points. This I think is reflective of super tight monetary policy, some of it inadvertently, meaning that they didn’t expect that inflation will stay so low. This has already done its damage. It’s like high blood sugar or high blood pressure, if it is diagnosed too late, it has already done its damage.

The second problem I think is the tightness in the financial system which reflects the problems of the half-hearted approach to privatisation of the financial system that the government has taken. They wished that PSU banks will keep losing market share fast enough and the system would get privatised without them having to use any political capital. So, we have seen the problems of that approach. Unlike in telecom and in airlines, the private sector banks do not want to grow at 60 percent. They will only grow at two times the nominal GDP. So, the market share loss will only be gradual.

For a couple of years the financial system tried to create capacity, licenses were available on tap, lots of new licenses given. NBFCs were allowed to grow, which was regulatory easing in a way. But now that the NBFCs have stopped growing as well, they have a clear problem of financial system capacity. Now the government desires that the PSU banks grow again, but in the current framework that growth is also slow. So, this combination is the root cause of the slow down.

That is availability of money, essentially, in a very basic way.

Neelkanth Mishra: Yes. And there is also badly co-ordinated policy. So, we have seen all the negative side effects of low food inflation, which is that the farmers are under stress, the income transfer from rich to the poor, which we often discuss, is not happening.

We have also seen the winding down of the pay commission cycle. Once every 10 years we see massive volatility in state and central governments salary and pension bills. They go up by 2-2.5 percentage points of GDP and then fall by up to 3 percentage points. You cannot really talk about fiscal health without stating where you are in the pay commission cycle.

Where we are is that the next pay commission is due 2026. We have gone through the 7th Pay Commission and our fiscal deficits are intact. The last two times this happened our fiscal deficit just shot through the roof. Adjusted for that, our bond yields and our interest rate should have been much lower, but we have done bad job while explaining it to the bond market. The consumption stimulus that the pay commission gave has been therefore much weaker than in the earlier cycle.

So, badly coordinated policy as well has led to what we have seen as a very sharp slowdown.

Do you want to weigh in on money supply issue? Is this not just the consequences of the banking cleanup and was it not going to take this amount of time unless you did some stressed asset fund?

Sajjid Chinoy: I will step back and make it even more fundamental. Basically, the fact is over last five years there has been one engine of growth, which is consumption. We have seen that net exports have deducted from growth every year. Investment is endogenous. It reacts to consumption and exports. So, exports have not given you much. This is important to remember. In the 2003-08 period, all of India’s 9 percent growth was largely on the back of exports. Exports grew at 17 percent a year for five years. Private consumption grew at 7 percent and investment grew 16 percent a year. So, I think that is one under-appreciated headwind.

Now, when consumption growth is outstripping income growth and you are dipping into savings to finance consumption, there is natural limit to how many years you can run that. So for me, it is a much simpler story, where on the secular basis household savings have been coming down almost every year for last 5-6 years and that story can’t continue.

What has compounded the slowdown in the last 24 months is two things. One, I agree that the NBFC sector stress has had an impact on urban consumption. A lot of leveraged consumption has been financed by NBFCs and there is a dramatic slowdown there. Even though banks are picking up some of the slack, it seems like there is a supply shock of funding to certain parts of the economy like SMEs, mid-sized corporates and housing. I think that has hurt urban consumption in last 6 months.

In rural areas, again, the story is quite straight forward with the terms of trade having moved against agriculture for the last 10 years, and particularly in last 3-4 years. So, when terms of trade move that sharply, then purchasing power gets impacted as wages fall. It was a matter of time before rural consumption began to soften.

So, in a way you have got the perfect storm. The secular rundown of savings which has hurt consumption, compounded by worsening terms of trade for farmers, and the NBFC shock.

So, for me the worry is that the fix is not going to be quite so easy. I think that on the NBFC sector, we don’t want policy makers to rush in to create moral hazards. I think any kind of liquidity window is premature. Let the market mechanism play itself out that is healthy for the long run. For me, the market failure is asymmetric information. Investors can’t separate the good apples from the bad apples. That is going to take some time to work out unless there is some asset quality review (AQR). The AQR is going to be much more complicated in a shadow banking systems. So, there is no switch you can turn on there.

For private sector banks, incremental credit-deposit ratios are high, so transmission is impeded. Public sector banks have the liquidity but not the capital. You don’t want them to lend very aggressively without governance reforms otherwise you will have an NPA problem five years later.

And the last thing is that I don’t think there is much fiscal space. The headline deficit looks great at 3.4 percent, but that is in part because a lot of borrowing has been pushed off the balance sheet. So, I think the holistic assessment is if you add up the centre, the states and look at the PSUs. Taken together, public sector borrowing requirements are close to 9 percent of GDP.

The governments has an unenviable task. GST collections have been lower than expected, there was the pay commission, the 14th finance commission. Fact is that the sum total of our borrowings are pretty much eating up all of the household financial savings, which is why the yield curve is so steep. At this point, any kind of fiscal stimulus that people are clamoring for will be counter-productive because it will further hurt monetary transmission. That yield curve, which is 120 basis points steep, could get steeper if there is stimulus.

We need to take a deep breath. There are no easy fixes. This has to be 12, 24 or 36 month project.

Where is the money supply problem emerging from? Is it just because of the banking system?

Neelkanth Mishra: Currency in circulation is Rs 21 trillion, M0 is Rs 28 trillion and M3 is Rs 154 trillion. The engine that converts this 28 trillion to 154 trillion is not working.

The whole argument that transmission is not happening because there are not enough deposits is a futile argument. Deposits are low as credit creation is low. Why is credit creation a problem? Partly, because of rates being too high and most of it is because of monetary signaling.

For the longest time, we have worried about our interest rates being too high. If you are trying to compete against China, where people borrow at 6 percent and you are borrowing at 12-14 percent, then you are starting with a big disadvantage. We had high rates because we had high inflation and high fiscal deficit. Finally, we managed to solve the inflation problem. Absolute fiscal deficits are still high but on a relative and time series basis, they are low.

We should have lower rates.

The real repo rate can come down by 75-100 bps from here. It could go below 5 percent. The term premium should correct too. The problem has been less fiscal and more about poor signaling. If you forecast that inflation is 3 percent but one year later it will be 5 percent then why will anyone buy duration (long duration debt).

Another problem is that we lack clarity on what is the real neutral rate. If the real neutral rate, as RBI said, was 1.5 percent and if MPC’s inflation projection is 3.5 then you can do the math and say repo rate should be 5 percent and bond market can respond to it. That’s a neutral rate. If they are accommodative, repo rate could be 4-4.5 percent. Maybe in the current regime, they want it to be 2-2.5 percent but that should be stated and then the bond market can react to it.

As of now, I don’t think the bond market understands what the change to accommodative mean. As a few rate cut happens, as the bond market starts to front-run these rate cuts, the term premiums will come down automatically. It is just poor signaling which is causing the term premium to stay so high.

Sajjid Chinoy: If this was signaling, you would see it in all rates market. Think of the OIS (Overnight Indexed Swap) market, which is the cleanest indication you will have of monetary policy. The OIS market has priced in another 25-50 bps points of rate cuts. The bond-swap difference which in a way represents the fiscal premium is at very high levels. The OIS market believes that more rate cuts are coming and they are pricing in 25-50 basis points of cuts. Despite that the bond markets is where it is.

But it is true that the MPC reacted late and lost the window to cut rates sharply...

Sajjid Chinoy: Many of us, including me, got the food inflation forecast wrong for a couple of years because we didn’t know how much of the food price decline was structural and how much will mean- revert. But let’s go six months back. Core inflation, which I think is the most reliable indicator of slack in the economy, was running at six percent through most of 2018.

In September and October, nobody was saying that a big slowdown is coming. The Fed raised rates till December. In the last six months, both the global and domestic economy lost lot of momentum. You can see that in the data for core inflation in 2019, which is running at an annualised momentum of 2.5 percent. Did anybody say in January that the Fed will be cutting rates in the second half of this year? U.S. growth in the first quarter was 3 percent and for second quarter it was 1 percent. For China, it was 6.7 percent and for second quarter it was 6.1 percent. Euro area growth is much slower too.

So, the economy has been hit by shocks. NBFC problem is much more acute than people thought about 6-8 months ago. Food inflation is much lower, so the terms of trade got much worse. And exports have not grown. So, the macro economic environment has changed meaningfully, as have the growth-inflation dynamics.

Neelkanth Mishra: We are not trying to justify what MPC did or did not do. Sometimes you can diagnose a medical ailment too late. The fact is that the 15-year average real repo rate is zero. The five-year average is 2.5 percent. There is the problem.

In May 2016, we wrote about agricultural surpluses. Food consumption cannot grow beyond a point. Agricultural productivity will keep rising. It was all there and visible. The reality is, if you catch elevated blood pressure too late, you go to test for organ damage. Similarly, if you let real rates stay so high, you have to go and see what lasting damage has been done to the economy.

As a matter of principle, I disagree with linking domestic rates to global rates because one of the reasons as why we have controls on the capital account is that we should have more control on our interest rates. Whether the global economy is slowing or accelerating, lot of problems which we have are of our own creation.

Especially, if you have gone through a period of significant reforms like IBC, GST, you should have buffered the economy with easier fiscal and monetary condition. On the fiscal side, there is clearly no scope and I won’t even recommend it. It should have been easier monetary conditions. But sadly we missed that boat. Now that we missed that boat, we should rectify it by accelerating that process.

So you would have wanted 50 bps rate cuts front loaded?

Neelkanth Mishra: That’s unlikely to happen but I would have recommended it.

The other issue people bring up is - will interest rates help growth? About 15-30 bps lower rates will not have an impact. If you bring mortgage rates down, even PSU banks which are currently very reluctant to lend will be very happy to issue mortgages. If mortgage rates fall from 9 percent to 7 percent, don’t you think there will be real improvement in demand of real estate by the salaried class? Of course, there will be. At the margin, people will be willing to invest.

Finally, the supply chain bullwhip is something that we under-appreciate. Slight volatility in demand can cause significant volatility away from the end demand. The reverse can happen too.

Because of persistent weak liquidity, a decline in money multiplier, we are seeing destocking in the supply chain. Car sales are not falling by 20 percent. It is just that the perceived demand for automakers is down by 20 percent. They are cutting production by 20 percent and therefore their suppliers are having to close production for few months which is causing another negative cycle.

Whenever M3 growth picks up to 12-13 percent, you will see a whiplash on the other side. You will see everyone trying to build inventory. I think the economic revival will be as sudden as the decline has been but we need to get the monetary conditions right.

Sajjid Chinoy: For 10 years, if the real repo rate was zero and for the last five years if it was 2.5 percent, then what was inflation for those 10 years? It was in double digits.

So, we have been there where we had double digit CPI inflation in this economy, when real rates where zero. So, maybe we could have cut rates by another 25-50 bps. But we went through a 10-year cycle with double digit inflation, got stuck in a wage spike spiral, which culminated in 2013 taper tantrum crisis.

I disagree that India is a closed economy. Exports-to-GDP, between 2002 -2012, doubled from 11 percent to 25 percent. We are now at 21-22 percent. It is no coincidence to me that inflation and growth has soften in last six months precisely when every other country is going through growth and disinflationary shocks. We are not as unique and as closed as we think we are.

Third is, we are seeing liquidity going to surplus. Has it meaningfully changed transmission? It hasn’t, because these frictions are real and different.

As we go from shadow banking back to commercial banking, the re-intermediation of credit will result in tighter financial conditions because commercial banks are subject to greater regulatory preemption. As the asset and liability side moves, the liability side is subject to greater preemption. Not a good or bad thing but it happens.

Small savings rate is much higher than deposit rates. Therefore banks are hesitant to cut. Credit premia have gone up not just in the NBFC sector but even for mid-corporate borrowers. So, we have a natural experiment ongoing where liquidity from RBI has gone from a meaningful deficit 7-8 months ago to a surplus now. May be it has made a small difference.

It will be a mistake to put all of the ills in the economy at the doorstep of policy rates or liquidity. We have to accept that the investment-to-GDP ratio has been falling for 7-8 years. It has pre-dated the pick up in real rates. This is a wonderful opportunity for a strong majority government to do some of the heavy lifting. The AQR would not be easier if real rates are 50 bps lower. Terms of trades for farmers will not improve if rates are 50 bps lower. I don’t think the power sector problem will disappear or land acquisition will be easier if rates are 50 bps lower.

So, this has to be more holistic approach. All of the heavy lifting cannot be done by monetary policy, particularly at a time when fiscal policy is an overhang and undermining transmission of monetary policy. Part of the reason why small savings rates are high is because you now need that money to finance the government balance sheet.

The budget presents not only a dilemma but a wonderful opportunity too. The dilemma is, when growth is slowing and monetary policy is not effective, then shouldn’t fiscal policy be easing. That’s the theoretical argument. Fiscal policy should be counter-cyclical. But the reality is, if at this point you get 0.5 percentage point of GDP as stimulus, it will be counterproductive because all rates will go up in the system.

But there is a way out and the way out is through asset sales. Last year they sold 0.5 percentage points of GDP. Let’s hypothetically say they double that to 1 percentage point of GDP. Then you can do the two things at the same time. You can keep the fiscal deficit of 3.4 percent like last year and the bond market will be comforted. At the same time because you are generating more revenue through asset sales and not through taxes and duties, the fiscal impulse is positive. So, you get the best of all worlds. You are imparting a positive 0.5 percentage point of GDP fiscal impulse to the economy. Fiscal policy is actually being counter cyclical without the deficit widening. This is the year where those kind of solutions need to be entertained.

Neelkanth Mishra: The disinvestment side is a given. Not just privatisation but also asset sales.

But you are not as negative on fiscal policy? You don’t think that they are slipping as much as people fear they are because of public sector borrowings. Can you explain why?

Neelkanth Mishra:  The understanding of the PSBR (public sector borrowing requirement) itself needs to be a lot more nuanced. If Food Corporation of India has higher borrowings because suddenly instead of holding 8 million tonnes of buffer stocks they are holding 38 million of buffer stocks, so, 30 million is extra which has to be paid for. But against that liability, there is some asset as well.

For example, if you are building a high speed rail, JAICA is not going to give you a loan just like that. You have to create an off-balance sheet provision and then seek the funding. In the case of Mumbai metro, 12-14 percent of funding might be coming from state budget, the rest will come from other agencies. Would that funding have come if it was on budget? No.

Our analysis of PSBR is that it needs to be looked at on a time-series basis. It  also needs to be a bit more nuanced about what type of borrowing actually reflects deficits being pushed out.

The framework that we have created is that we break down interest rates into four parts - inflation, real repo rate, term premium and credit spread. The last bit, which is credit spread, is where the financial system capacity comes in. We have a problem that financial system capacity is depleted. The ones who are standing can demand whatever net interest margins they want. Even below that there is a term premium and real repo rate. There is significant reduction in rates which is possible.

But doesn’t the fiscal part play into term premium or credit spread. Even the public sector companies are now borrowing at spreads which are far higher than earlier.

Sajjid Chinoy: In part, because quasi-sovereign debt issuance is so large.

Neelkanth: When we are talking about small savings and inflows there, they are linked to G-sec yields.

But they have not adjusted the way they should. There was a 40 bps reduction in yields a quarter before but small savings rates fell by 10 basis points.

Neelkanth Mishra: I don’t know the formula. Is it average or quarter end? If it is quarter end, then you are right. In government, everything is done by formula. I don’t think there is that much of volition which comes in. May be in the October-December quarter we will see a cut.

Sajjid Chinoy: I don’t think it will be ideological. Government is faced with a tough hand. Growth is slowing, GST is in infant stages.

I am making a more practical argument. The PSBR was about a percentage point lower in last five years. It is moved up by a percent today. When any government uses up a vast majority of financial savings, at the first hint of private investment picking up, one of two things must necessarily happen. Either there is crowding out, yields go up, term premium gets steeper. Else, private sector is forced to finance domestic investment via foreign financial savings, which means, necessarily by construct, the current account deficit needs to widen which creates its own vulnerability.

A lot of off-balance sheet borrowing is for capex, which is a good thing. But last year, 44 percent was from FCI, at a time when you saw payment to FCI on the balance sheet coming down. That is the part that we need to pause and think about. It may be that some of the public capex is warranted but the judgement has to be if that will push up the cost of capital for private sectors then what is the fiscal multipliers vis-a-vis some of borrowings on balance sheet.

So, both of you are in agreement that you shouldn’t allow for a slightly higher deficit. Let’s say 3.6 percent?

Neelkanth Mishra: If they did not want that number to slip beyond 3.4 percent in January, then the likelihood of that happening in July after a landslide victory in election is very low.

Sajjid Chinoy: It is important that fiscal policy is not pro-cyclical, which accentuates the slowdown and then you get stuck in a hysteresis. I will worry less about whether the number is 3.4 percent or 3.6 percent. I would look at PSBR.

More importantly, I will look at two things. One is, credibility of assumptions that underlie any number and what’s the road map which the government gives to the bond market for the next 3-5 years.

Based on the interim budget, the revenue numbers tough to meet. GST collection have to go up by 30 percent, gross tax revenue has to go up by 23 percent in an economy which is slowing. What I would like to see is that the assumptions are realistically revised down. I really hope this is the year that we double-down on asset sales because then you can have the best of all worlds. You can show higher public investment and give the economy a boost and yet have the deficit number remain the same so bond markets are calm. There is a way to have your cake and eat it too. If there is ever a time and moment, then now is the time to do it.

One hopes that it is only asset sales and not arm twisting the RBI for more money.

Sajjid Chinoy: We need to step back and take much more holistic view that this is going to be some combination of strategic disinvestment and also asset recycling. There are so many infrastructure assets that we have, which are operating right now which pension funds abroad will be very glad to hold. So, we have to think outside the box. This is not like selling your family silver to pay a credit card bill. What we are advocating is 1 percentage point of GDP in asset sales and replace that with higher productivity public investment. It is called an ‘asset swap’ in the corporate sector. You sell low productive assets and re-invest in high productive assets. I would argue selling stakes in PSUs to invest in roads, bridges, energy is a productive asset swap.

Do you think asset sale is the good thing if we don’t want to expand fiscal deficit?

Neelkanth Mishra: There is so much of land. In my hometown, there is big stadium where you can do soccer tournaments but you only get Independence day parade on it.

Niti Aayog gave a list to the government in 2016 (of possible divestments). Another aspect, where the government will have to use its political strength, is that there is natural reluctance within the government by the permanent bureaucracy to let go off control of some of these assets. That resistance has perhaps been harder to overcome than it seems from outside.

Sajjid Chinoy: We had lot of great reforms over the last 15 years, including GST, but they are running their course. We need to get a burst of 7-8 percent growth for the next five to ten years, which is what the young economy needs especially without the tailwind of exports.

Very few countries have grown at 8 percent and anywhere close to double digits without having double digit export growth. I can’t think any of it. India aspires to grow at 7-8 percent for next 10 years or even more. We have to revisit the reform anvil. There is lot of difficult stuff there. Land is hard, labour is hard, power distribution is hard, privatisation of banks is hard. Within that menu of reforms, I would argue selling down assets is perhaps a low hanging fruit.

With such a strong majority, the first budget of second term, it will not only allay fears that fiscal policy is worsening, it will also mean that monetary and fiscal is working in tandem. It will send a very unambiguous signal about the agenda in next five years. I think it will have multiple benefits.