India’s economy isn’t doing well during Prime Minister Modi’s second term.
Major economic indicators released recently point to a major slow-down that parallels that of the early 1990s. Real GDP is growing at 4.5%, the lowest in the last five years. Production of industrial goods is flat, while the production of investment goods is declining (again, the worst showing in the last five years).
Then there’s the unemployment rate, which reached an all-time high of 8.50 in October.
These are dismal numbers for a large emerging market economy, which was growing at brisk rates a couple of years ago.
Still, there is one bright spot: the equity market, which is rallying to new highs.
But that won’t last long if the economy continues to falter. Listed firms are part of the economy, and their shares will eventually follow their pace.
What’s going on with the Indian economy? The country’s two major key drivers, exports and investments have decelerated, following the Global Financial Crisis (GFC).
That’s according to a recent working paper from the Center for International Development at Harvard University, titled “India’s Great Slowdown: What Happened? What’s the Way Out?”
“Export growth slowed sharply as world trade stagnated, while investment fell victim to a homegrown Balance Sheet crisis, which came in two waves,” writes Arvind Subramanian and Josh Felman, authors of the paper. “The first wave—the Twin Balance Sheet crisis, encompassing banks and infrastructure companies—arrived when the infrastructure projects started during India’s investment boom of the mid-2000s began to go sour.”
Nonetheless “the economy continued to grow, despite temporary, adverse demonetization and GST shocks, propelled first by income gains from the large fall in international oil prices, then by government spending and a non-bank financial company (NBFC)-led credit boom. This credit boom financed unsustainable real estate inventory accumulation, inflating a bubble that finally burst in 2019.”
It’s well-known what happens to an economy when a bubble bursts. “Consequently, consumption too has now sputtered, causing growth to collapse” add Subramanian and Felman. “As a result, India is now facing a Four Balance Sheet challenge—the original two sectors, plus NBFCs and real estate companies—and is trapped in an adverse interest-growth dynamic, in which risk aversion is leading to high-interest rates, depressing growth, and generating more risk aversion.”
What’s the Modi government been doing to avert the situation? Several things according to Udayan Roy, Professor of Economics at LIU Post. Like a large cut in the corporate tax, and the resumption of the Privatization of Public Sector Units.
Meanwhile, the Reserve Bank of India (RBI) has eased monetary policy by cutting its main interest rate by 135 basis points.
That’s one of the largest cuts in India’s history.
But these measures haven’t been working, due to a “credit crunch,” according to Roy.
“The monetary transmission mechanism has broken down,” he says. “Even though the RBI is trying to pump money into the economy, lending is not growing (because a business doesn’t want to borrow; there is no demand for loans because the prospects look uncertain). Investment is stagnant.”
And that makes the current situation strangely very similar to the US after the global financial crisis, according to his theory.
“After the global financial crisis of 2008-09 ended, Indian banks began giving loans liberally to infrastructure-building firms,” Roy explains. “These projects ended up unsuccessful and the infrastructure companies began to fail. They could not repay their loans. So, the banks cut back on lending. This began to hurt investment and exports.”
Simply put, monetary easing doesn’t work under these conditions.
What’s the solution? “The government will have to find a way to make the banks and the NBFCs less afraid to lend,” he says. “That’s the only way out.”
This means that Prime Minister Modi has a hard job ahead in his second term.