Economic Slowdown: Structural, Cyclical or Structural & Cyclical?

There has been a lot of discussion over the last few weeks regarding the economic slowdown that India is currently experiencing. There seems to be some disagreement with regards to whether the slowdown is structural, cyclical or both.

Dr Rathin Roy of the National Institute of Public Finance and Policy argues that India is currently facing a structural demand problem.

Despite the disagreement with regard to the contours of this slowdown, we all can agree that we’re in the middle of a growth recession where our growth rate has systematically reduced over the previous three quarters.

In all probability, Quarter 1 and Quarter 2 figures for the current financial year are likely to continue with this trend — as per my forecast, Q1 will be at 5.0–5.4 per cent and Q2 will be at 5.2–5.6 per cent.

The important question that needs to be addressed is whether the growth slowdown is structural, cyclical, both, or is it a structural demand problem.

There is no doubt that the present slowdown is a classic demand crisis and when one of India’s leading FMCG producer says that it is finding it hard to sell a five-rupees biscuit packet then we must be alarmed.

Make no mistake, what we have is a classic demand crisis and fiscal and monetary hawks will do us no favour if they continue to tread on the same path and keep prescribing their rigid norms.

In fact, it may well be the case that it is their rigidity that may have led us to the current situation.

Before getting into policy prescription mode, one must appreciate the gravity of the current economic slowdown. The fact that global economy is simultaneously slowing doesn’t help our case either.

However, our slowdown has more to do with domestic factors rather than external influences, at least for now. Therefore, revival of growth rates is possible, provided we fix these factors.

Whether one classifies the slowdown as cyclical or structural depends on what the trend growth of the economy is assumed to be. The concerns regarding comparability of data and the lack of a comprehensive official series going back all the way to 1990 complicates the issue of identifying our trend growth.

However, irrespective of the trend rate of growth, the present slowdown is cyclical for now. This follows from the fact that the growth rate was indeed lower than the trend rate of growth (whether we assume it at 7 or 7.5 per cent) but there’s little evidence as of now to suggest that the trend has also reduced over the last year.

This does not imply that the trend will not reduce should the slowdown persist. Therefore, though at an aggregate level the slowdown is cyclical as of now, there are reasonable risks of it turning into a structural slowdown.

The fact is that we’ve had too tight a fiscal and monetary policy over the last couple of years, and such policies during the process of structural reforms and a broken banking system have done more damage than any good.

There were suggestions of a fiscal expansion in 2017 to revive economic growth. In fact, Dr Srinivas Thiruvadanthai had outlined the need for the same in this article where he argued that reforms will not kickstart the economy in the short-term.

It is macroeconomics 101 that reforms, especially structural reforms have a positive impact on growth rate over the medium term while in the short run there are two tools — fiscal and monetary policy — that can be used to stimulate the economy.

Nevertheless, we didn’t have a fiscal expansion in 2017 and followed the business-as-usual approach. The 2018 Q1 growth figures were high and we thought that growth is finally back on track and fiscal and monetary policies continued just as before.

A steep rise in real interest rates from 2018 Q2 onwards combined with fiscally tight polices and what we achieved is a growth fall from 8 per cent in Q1 to 5.8 per cent in Q4.

Clearly, we need counter-cyclical policies to provide some relief to the economy, and the understanding that a demand crisis is best managed through expansionary fiscal policies.

However, there is a strong case for the sharp reduction in interest rates as we face the twin challenges of extremely high real policy rates and of transmission of these cuts on to lending rates.

There is a strong and urgent need to aggressively reduce lending rates while the MPC (Monetary Policy Committee) can further reduce our real repo rates and bring them in line with global emerging-market levels.

The present slowdown is also part-structural but the structural slowdown is limited to certain sectors rather than across the economy.

For instance, the real estate sector has failed to impress since the last five years and, despite reforms like RERA (Real Estate Regulatory Authority Act), we continue to see huge exposure of banks to rising inventories in India’s top cities.

Part of the problem is of product differentiation and miscalculation on part of builders in terms of the demand for luxury housing. However, this has persisted for over five years and there seems to be no resolution in sight.

The experience of the real estate sector perhaps reflects the inability of reforms alone to work in terms of revival of sectors. This does not mean that reforms are not important — in the long run it is only through reforms that a country can sustain a high growth rate.

However, reforms require the necessary condition of sound macro-policies in place. Structural reforms have great long-term potential but they also have short-term transition costs and therefore, they should be accompanied by accommodative macro policies.

It is precisely here that we made an error as the government undertook a series of structural reforms with tight monetary and fiscal policies at a time when the corporate sector was struggling.

Counter-cyclical policies will be important towards reversing the current slowdown, and the process of reforms should continue over the next few years. Sector-specific reforms combined with factor market reforms and accommodative macro policies will go a long way in accelerating our growth rate.

The focus should be towards immediate economic revival towards 7–7.5 per cent growth rate and in the medium term it should be to have a trend growth rate of 8–8.5 per cent.