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Budget 2019: The Old Economic Order Has Changed, But India Hasn’t

Policymakers continue to hope that globalisation’s gravy train will return. This could end up in tears, warns Jahangir Aziz.

A truck driver sleeps in a hammock under a truck as he waits outside the Inland Container Depot in Tughlaqabad. (Photographer: Pankaj Nangia/Bloomberg)
A truck driver sleeps in a hammock under a truck as he waits outside the Inland Container Depot in Tughlaqabad. (Photographer: Pankaj Nangia/Bloomberg)

Setting aside questions around the quality of data, concerns over slowing growth and rising unemployment have been intensifying in India. The ongoing soul-searching and hand-wringing among analysts and policymakers have so far brought up a laundry list of solutions. These solutions fall into three categories: loosening monetary, fiscal, and regulatory (particularly financial and environmental) policies to support the growth in this ‘cyclical’ slowdown; building more physical infrastructure (roads, railways, and metro-rails) on the principle that “if you build it, they will come”; and keep discussing reforms in land, labour, and public-sector undertakings to keep investor interest alive.

I will argue that these suggested policies are flawed—and dangerously so—because by loosening policies India could easily face serious macroeconomic instability, and significant resources could be spent on infrastructure projects that may not be of much use in the new global economy. And this is mostly because India’s policymaking framework has long been outdated by economic reality.

The biggest dissonance between the context in which India’s policy debate has been and is being conducted and reality is that India is far more open than believed.

The ‘Closed Economy’ Myth

There is an entrenched and widespread belief among analysts and policymakers that India is a closed economy. On the real side, domestic drivers—consumption and investment—are seen as more important drivers of growth than exports, and on the financial side, India’s much-vaunted regulatory and capital controls are believed to protect it from global shocks.

Nothing can be further from the truth, in my opinion. Let me start with the real side of the economy. There is virtual consensus among the same analysts and policymakers that corporate investment drove much of India’s high growth over 2003-08. The liberalisation of 1991-92 coupled with the corporate restructuring in the late 1990s spurred investment to rise from 5-6 percent of GDP in the early 2000s to 17 percent of GDP by 2008. But it takes two to tango. The increase in investment also produced a lot of widgets that someone had to consume.

Despite the proliferation of shopping malls in every nook and cranny of India, it wasn’t domestic consumption that absorbed the rise in production, as widely believed. It was exports.
People cycle home from work past a shopping mall in Gurgaon, on September 11, 2004. (Photographer: Amit Bhargava/Bloomberg News)
People cycle home from work past a shopping mall in Gurgaon, on September 11, 2004. (Photographer: Amit Bhargava/Bloomberg News)
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Exports grew at an astonishing pace of nearly 18 percent per year. Private consumption, on the other hand, grew at less than half that pace, such that its share in GDP fell from 62 percent to 57 percent. To put this in perspective, around 37-40 percent of India’s manufacturing even today is destined for exports, and exports’ share in India’s GDP is the same as in Indonesia and twice that in Brazil. The subsequent decline in investment is also widely accepted as the key reason behind the trend slowdown in growth. But corporate investment had plunged way back in 2009, flat-lining at around 12 percent of GDP since then.

If one simply charts investment and exports as shares of GDP from the 1990s, barring the period of corporate restructuring over 1999-01, the two lines are virtually indistinguishable. Indeed, this is the same for India’s GDP growth and that of world trade, except for brief periods such as the slowdown and recovery over 2013-15 related to the Taper Tantrum, and over 2016-18 because of demonetisation.

This correlation is the same for most emerging market countries. Global trade has been the lifeblood of emerging markets, just as it has been for India. Like its peers, India too took the easy route of liberalising external trade and minimal financial and regulatory changes needed, to ride the globalisation wave.

None of the hard labour and land reforms were undertaken, and extensive financial repression continues to subsidise corporates and the government with cheap rates of funding at the expense of households.
Workers fill bags of tea in a storage area in the Dibrugarh district of Assam. (Photographer: Sanjit Das/Bloomberg)
Workers fill bags of tea in a storage area in the Dibrugarh district of Assam. (Photographer: Sanjit Das/Bloomberg)

Over the past two decades, the yield on 10-year government paper – let alone the RBI’s policy rate – has never exceeded India’s nominal growth rate.

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Allergic To Every Bug

Private investment in India has floundered not because funding costs are too high or banks are hamstrung with bad loans or the exchange rate is too appreciated, as is collectively bemoaned. It is because exports have languished and, as Rathin Roy of the Prime Minter’s Economic Advisory Council recently argued, the wealthiest 5-10 crore households, who have the requisite purchasing power, do not consume much of the goods or services that India Inc. produces. But global trade has not only languished since 2012 – it is also unlikely to recover to its past pace with the maturing of supply chains and the rise of anti-globalisation politics. Thus, hopes of spurring investment and growth by turning India into a global industrial hub appear somewhat doubtful given these headwinds and the excess capacity in global manufacturing.

In financial markets, every time the world sneezes, India catches a cold. It happened in 2008 when Lehman Brothers collapsed; in 2011 during the European sovereign debt crisis; in 2013 when hit by the Taper Tantrum; and in 2018 when dollar funding costs tightened abruptly.

Consider what happened in the Lehman crisis. On Sept. 12, 2008, the call money rate in India closed at 6.15 percent. That weekend Lehman collapsed. By the following Wednesday, the call rate had jumped to over 13 percent.

In Indonesia, which has a far more open capital account, the interbank rate barely moved in the first week of the crisis.

The Dow Jones ticker in Times Square displays news about Lehman Brothers  in New York on Sept. 10, 2008, days before its bankruptcy filing. (Photographer: Jeremy Bales/Bloomberg News)
The Dow Jones ticker in Times Square displays news about Lehman Brothers in New York on Sept. 10, 2008, days before its bankruptcy filing. (Photographer: Jeremy Bales/Bloomberg News)
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Outdated Policymaking

Accepting the reality that India is more open than believed, however, casts doubts on the efficacy of most of the suggested macroeconomic policy measures or reforms. If the decline in investment (and consequently of growth) is structural and due to global factors and not because of a temporary slowdown in domestic consumption or high funding costs, then fiscal, monetary, or regulatory easing cannot do much. In fact, this has been the policy response over the past few years, with no meaningful upturn in investment or growth. Let’s not forget that India pursued the same type of policies, as being advocated now, in the years prior to the crises of 1981-82, 1991-92, and 2013.

Thinking of India as an open economy overturns the underlying policymaking framework since India’s independence. As long as one cares to remember, India has been seen as a supply-constrained economy with structurally high inflation and a nagging current account deficit. Polices and reforms, almost exclusively, have been geared to ease these constraints.

This singlemindedness was fine when there was sufficient foreign demand to buy what India Inc. produced. Not any longer.
Trucks are loaded with iron ore at a  mine in Kheonjar, Orissa, on Sept. 19, 2007. (Photographer: Adam Ferguson/Bloomberg News)
Trucks are loaded with iron ore at a mine in Kheonjar, Orissa, on Sept. 19, 2007. (Photographer: Adam Ferguson/Bloomberg News)

While no country with $1,800 per capita annual income has managed to sustain high growth without relying on exports, given the global headwinds, the bias of policies and reforms need to shift towards supporting more domestic demand. This requires doing the hard things for which a new consensus across the private sector and all levels of government needs to be built to redesign India’s infrastructure to look more inward and less outward - increasing public provisioning of healthcare and education (even at the cost of capital spending) and changing health insurance regulations to reduce forced savings by households to meet their high out-of-pocket expenses, and eliminating financial repression to raise returns on household investments and retirement savings.

It is also critical to restructure agriculture urgently, which is still India’s largest employer and is now facing its worst terms of trade (measured as earnings from farming versus spending on non-agricultural consumption) since 1966. This requires aiming policies and reforms (not just in agriculture or ancillary industries but also in infrastructure design, healthcare, and education) to explicitly raise agricultural labor productivity, which is the only sustainable way to increase farm income.

The old order has changed. But instead of reading the writing on the wall and adapting to the new reality, policymakers in India and the other emerging markets (barring China) continue to hope that globalisation’s gravy train will return and they can escape doing the hard reforms. This could end up in tears.

Jahangir Aziz is Chief Emerging Market Economist at J.P. Morgan Chase. Views are personal.

The views expressed here are those of the author, and do not necessarily represent the views of BloombergQuint or its Editorial team.