GS Paper: Indian Economy

Context

Domestic demand must play a greater role in India’s growth story.

Recovery in the Indian economy

• Sub-5 per cent growth rate: India’s fourth-quarter GDP growth (the calendar year 2019) printed another sub-5 per cent growth rate.
• Favourable base effect: It would have been lower had it not been for the large downward revisions to previous years’ GDP that statistically boosted the last quarter’s growth rate because of favourable base effects.
• The decline in GDP stabilised: Policymakers and the market heaved a sigh of relief that the relentless decline over the last three years at least seems to have stabilised around 4-5 per cent.
• Why some countries prefer sequential growth rate: Because year-over growth rates are so strongly affected by what happened a year ago, most economies (including China) instead publish and conduct policy discussions based on sequential quarterly growth.
  • Better sense of momentum: Sequential growth rates provide a much better sense of the momentum and turning points in activity, which are critical to deciding whether, how much, and when the economy needs policy support.
• The magnitude of recovery: The growth momentum rose, albeit modestly, from 3.8 per cent in the third quarter of 2019 to 4.1 per cent.
  • Non-farm and non-governmental GDP recovery: More importantly, non-farm and non-government GDP (the closest approximation to non-farm private-sector GDP) bounced much more sharply from 1.6 per cent (and no this is not a misprint) to 4.4 per cent in the fourth quarter.

What is the dominant narrative of the slide in growth?

• The deceleration in sequential terms: With the revised data, we now know that annual growth over the last four years has slowed from 8.3 per cent to 7 per cent to 6.1 per cent to 4-5 per cent.
  • The decline in non-farm private GDP: In sequential terms, the deceleration was far more dramatic, especially in non-farm private GDP, which after hitting a run rate of 13 per cent in the first quarter of 2016 fell to 1.6 per cent by the third quarter of 2019.
  • The dominant narrative of the cause of slide: The dominant narrative is that India’s woes are just an unfortunate and unintended consequence of demonetisation, the shift to a national GST, and the credit squeeze caused by the bad debt in banks and non-banks.
  • The dominant narrative on recovery: With a bit more fiscal support, some monetary easing, and extended regulatory forbearance to help banks work out their bad debts, these headwinds will fade and India will likely be back to its winning ways.

Why real cause of the slowdown lays somewhere else?

Following factors suggest that answer lies somewhere else.

• Disruptive but not the drivers of the slowdown: While it is undeniable that facts stated in the dominant narrative had been disruptive, they couldn’t be the drivers of the decline.
  • Slide in growth started even before demonetisation: India’s growth had been sliding since the second quarter of 2016; nearly 6 months before demonetisation and a year before the GST was introduced.
  • By the third quarter of 2016, non-farm private sector growth had already slid to 3.5 per cent.
  • Bad debt problem predates slowdown: Although bad debt hit the headlines in 2016, the overleverage had already begun to tighten bank lending since 2014.
• Fall in corporate investment- inexplicable cause: More inexplicable is the argument that falling corporate investment is the main culprit for the slowdown.
  • It is true that corporate investment is no longer running at the heady 17 per cent of GDP of the pre-global financial crisis (GFC) days but at a much more sombre 11-12 per cent.
  • However, this outsized adjustment had already taken place by 2010 and since then, corporate investment has flatlined at current levels.

The answer lies in globalisation

It is obvious once one eschews India’s exceptionalism and accepts that it is just another emerging market economy that grew on the coattails of globalisation with the minimal reforms. Globalisation has largely determined India’s fate.

• Growth in corporate investment and exports: Contrary to a widely held misperception, India is and has been for a long time far more open to the global economy than believed.
  • Rise in corporate investment from 5 to 17%: The limited liberalisation of 1991-92, coupled with the corporate restructuring in the late 1990s, spurred corporate investment to rise from 5-6 per cent of GDP in the early 2000s to 17 per cent of GDP by 2008.
  • Increase in exports: Almost all of this expansion in investment was geared to produce for exports, which grew at an astonishing pace of 18 per cent per year-over-year in this period as global trade expanded at breakneck speed with the entry of China into the WTO in 2001.
  • 12% of GDP to 26% of GDP: Exports as a share of GDP more than doubled from 12 per cent in the early 2000s to over 26 per cent by 2008.
  • Slow growth in private consumption: In contrast, private domestic consumption, which is considered to be India’s great strength, grew only at 6 per cent annually, less than the growth rate of the economy, such that its share in GDP fell from 63 per cent to 56 per cent.
  • The engine of the Indian economy- Export: Since 2012, global trade has floundered and with that so has India’s economy.
  • Indeed, the entire rise and fall of investment, including the quarter-to-quarter twists and turns in it, can be almost fully explained by changes in exports.
  • The Indian economy has long been flying on one engine – exports — and that is now spluttering.

What are the prospects of taking the economy back to its high growth path

• Unlikely: So will the nascent recovery strengthen and take the economy back to its high growth path? Unlikely on current policies.
• COVID-19 factor: In the near term, as in now widely feared, the COVID-19 outbreak could turn into a pandemic, sharply reducing global demand and trade.
  • With that, even expectations of a modest 2019-20 recovery to 5.25 per cent growth are under threat.
• Backlash against globalisation: Over the longer term, it is unlikely that global trade will return to its pre-Global financial crisis growth rates not only because supply chains have stopped expanding in the absence of any material technology breakthrough, but there is also a growing political backlash against globalisation in the developed market that has led to increased trade barriers.

Way forward

• Search for new sources of growth: India too, like other emerging market economies, needs to face up to the reality that it can no longer depend on global trade to be the only growth driver. Instead, it needs to search and find new sources of growth and that starts with recognising and accepting reality.
• Let domestic demand play a greater role in the economy: Policymakers need to stop thinking about India as a perennially supply-constrained economy focusing almost all policies and reforms to easing these constraints. Instead, it is time to let domestic demand play a greater role in India’s growth story.
• Policy changes: The above factors mean that India Inc. needs to shift from producing what foreigners want to produce what residents can afford, it also means that policymakers have to reverse policies that have so far forced households to keep increasing savings (for retirement income, children’s education, healthcare, and housing) through a web of financial repression, regulatory distortions, and public spending choices.
  • It means redesigning India’s infrastructure to look more inward and less outward.
  • Reduce out of pocket expenses: Increasing public provisioning of healthcare and education, reforming insurance regulations to reduce out-of-pocket expenses and eliminating financial repression to raise returns on retirement savings.
  • Merely tinkering with macroeconomic policies will not be enough.

Context

The focus in the near future should to increase investments and facilitate credit for funding these productive assets so that India’s potential output growth can steadily rise.

Growth prospects of India

• The NSO forecast at 5%: The latest data from the National Statistical Office (NSO) retained India’s economic growth forecast at 5 per cent for the current financial year.
  • Growth has dropped from 6.1 per cent in the previous year.
• Fall in nominal GDP: More strikingly, nominal GDP growth has decelerated from an average of 11 per cent during 2016-17 to 2018-19 to 7.5 per cent this year.
  • Lower inflation added to the volume slowdown.
  • The value of India’s GDP for FY20 is estimated at around $2.9 trillion.

Input and output side growth prospects

• GDP is estimated from both output and demand lenses, using specific economic indicators as proxies for activity in specific sectors.
• Output side: From the output side, sector-wise estimates were as following-
  • Agriculture sector growth was revised up to 3.7 per cent (up from the 2.8 per cent previously).
  • Agricultural production is expected to improve based on the third advance estimates of the rabi season crops, as well as higher horticulture and allied sector output (livestock, forestry and fishing), which now is significantly larger than conventional food crops.
  • Industrial activity was lowered to 1.5 per cent (from 2.3 per cent earlier).
  • The key concern regarding the continuing slowdown is the increasing weakness in the industrial sector (particularly of manufacturing, whose growth has progressively fallen from 13.1 per cent in FY16 to 5.7 per cent in FY19, and plummeting to 0.9 per cent in FY20).
  • Services output remained largely unchanged at 6.5 per cent.
• Demand-side: From a demand perspective, the obverse side to the manufacturing slowdown is the even sharper drop in fixed asset investment growth — down sharply from an average 8.5 per cent during FY17 and FY19 to -0.6 per cent in FY20.
  • The causes for this contraction needs to be understood in detail, and we will return to this.

Private consumption- a significant driver of growth

• Private consumption at 60% of GDP: The other significant driver of growth in India has been private consumption. For perspective, the share of private consumption had averaged 59-60 per cent during FY16-FY20.
• Government consumption 10% of GDP: Reflecting the higher spending over the last couple of years, the share of government consumption in GDP has risen from an average of 10.5 per cent of GDP over FY12-17 to almost 12 per cent in FY20, resulting in the share of total consumption above 70 per cent.

Drop in the share of nominal investment

• Drop from 39 % to 30 % of GDP: The really remarkable trend, though, as noted above, is the share of nominal investment in GDP progressively dropping from 39 per cent in FY12 to 30 per cent in FY20.
• Is it a good sign? Part of this is actually good, reflecting higher Capex efficiency.
  • Slowing household consumption: One narrative underlying the contraction in fresh Capex in FY20 was slowing household consumption growth, which, in nominal terms, fell from an average 11.6 per cent during FY16-19 to an estimated 9.1 per cent in FY20.
  • Disproportionate contribution to lower growth: Though the deceleration prima facie does not seem significant enough to result in a broader economic slowdown of the current magnitude, the high share of household consumption has contributed disproportionately to lower growth.
  • Fall in capacity utilisation: A direct fallout of this is that seasonally adjusted capacity utilisation (based on RBI surveys) had shrunk from 73.4 per cent in the first quarter of FY20 to 70.3 per cent in the second quarter, and this is unlikely to have improved materially in the second half of the year.
  • This is one of the reasons for the low levels of fresh investment.

Reduced flow of credit to the commercial sector

• Impediment to growth revival: The other cause of the low Capex, more from the supply side, is a much-reduced flow of credit to the commercial sector, and this remains the proximate impediment for growth revival, with signs of risk aversion in lending still strong despite the recent measures by RBI to incentivise credit to productive sectors.
  • Funds from selected sources, over April-January FY20, was only about Rs 9 lakh crore as against Rs 15 lakh crore in the corresponding 10 months of FY19.
• Bank credit lowest in three months: Growth in bank credit (which is still the largest source of financing) till mid-February 2020 was down to 6.3 per cent — the lowest in three years.
  • Even this is almost wholly driven by retail credit; incremental credit to industry and services over this period was negative.

Investor confidence and coronavirus factor

• A bright feature of the economic environment: One bright feature in this economic environment is strong foreign investor confidence in India, reflected in both FPI equity and FDI flows.
  • Many borrowers have used offshore sources to refinance or pay down domestic bank loans and debt.
  • A global risk-off environment might restrict even this channel in the near future.
• Robust corporate bond issuances: Domestic corporate bond issuances have also remained robust, although the dominant set of borrowers still remain public sector agencies and financial institutions.
• Coronavirus factor likely to moderate the gains: Monthly economic indicators suggest that the growth deceleration has likely bottomed out in the third quarter.
  • The bet has been on reducing inventories and the consequent production ramp-up to replenish stocks. However, the evidence on this is mixed.
  • The coronavirus effects, both concurrent and lagged, will also moderate some of the emerging positive effects of counter-cyclical policy measures of the past six months.
  • If the outbreak does not abate over the next month or so, the complex supply chains of intermediates sourced from China will run dry and add to the already weak system demand.
• Growth prospects in the next few weeks: Surveys indicate that both business and consumer confidence, which while improving, remain muted. A growth revival, hence, is likely to be only very modest over the next few quarters.

Conclusion

A $5 trillion economy by 2025 is still a worthwhile target and aspirational; coordinated strategies, policies, execution and institutional mechanisms will be needed to move up to a sustained 8 per cent plus growth consistent with achieving the target. The focus in the near future should to increase investments and facilitate credit for funding these productive assets so that India’s potential output growth can steadily rise.

Context

It is now beyond obvious that India cannot revive its economy without increasing public spending, and so increasing its fiscal resources is essential. Among other measures, this requires urgent adoption of legislation and institutional reforms to end financial opacity.

The opacity in the data

• Unlikely Budget estimates: The Union Budget was presented, based on numbers for revised estimates for the current year and Budget estimates for the coming year that the Finance Ministry itself knows are
• Where else the opacity in data extends: The opacity of data also extends to cross-border movement of funds generated through a range of activities, including tax evasion, misappropriation of state assets, laundering of the proceeds of crime, and bribery.
  • Even here, India still has a lot to do, as confirmed by the recent publication of the Financial Secrecy Index by the Tax Justice Network, a U.K.-based financial advocacy group.
• Financial Secrecy Index rank: On the surface, India has managed to reduce its contribution to global financial secrecy, with its rank falling from 32 on the 2018 index to 47 in 2020.
  • But this is partly because the new edition of the index covers more countries than it did two years ago.

Transparency Reforms by the government

• Arrangement with Switzerland: It is true that the government has adopted and supported a few transparency reforms, such as the automatic exchange of tax and financial information with other jurisdictions, like Switzerland.
  • What the arrangement with Switzerland mean? If an Indian citizen has an account with a Swiss bank and has a balance over a certain threshold, this information will be sent to the Indian tax authorities automatically.
• Beneficial ownership register: The government did create a beneficial ownership register- which would allow the identification of the beneficial owner of an asset regardless of whose name the title of the property is in.
  • Exemption making the law weak: The law is weak since it exempts a lot of people at the discretion of the authorities.
  • Also, this register is not accessible to the public.

Making multinationals and the super-rich pay their fair share of taxes 

• Need to do more: Stopping the financial haemorrhage and making multinationals and the super-rich pay their fair share of taxes requires much more.
• Capital flight and consequence for the country’s development: Capital flight out of India by Indian elites and foreigners alike has been undermining our country’s development for decades.
  • Outdated international system: An important part of these flows is the result of artificial profit shifting by multinational companies taking advantage of an outdated international tax system.
• How the multinationals shifts profits? These multinationals may be making profits in India but can easily declare those profits in a low tax jurisdiction like Hong Kong and justify that transaction as a payment for the use of a patent.
  • The magnitude of loss-$27.5 billion: According to one estimate, this strategy represented a loss of $27.5 billion in 2014 for the Indian government, up from $142 million in 2000.

Onshore financial services and issues with it

• Paradoxical decision: Three years ago, the government took the paradoxical decision to set up onshore international financial services in the country.
  • This is how the International Financial Services Centre in the Gujarat International Finance Tec-City (GIFT-City), Gandhinagar, emerged.
  • It was modelled after offshore financial centres such as Hong Kong, Singapore, the City of London and Dubai.
• Increasing the possibility of regulatory arbitrage: While this has not created much employment, it has led to growing possibilities for regulatory arbitrage by financial firms, with potentially very problematic consequences.

The issue with the policy of tax incentives

• Little evidence of attracting investment: The government keeps granting tax incentives on a discretionary basis, even though there is little evidence that these incentives attract investment.
• What factors matters for investment: Recent research by International Monetary Fund, factors such as-
  • Quality of infrastructure.
  • A healthy and skilled workforce.
  • Market access and-
  • Political stability matters much more.
• Consequences of the policy-reduction in tax revenue: The massive reduction in corporate tax rates has thus far not led to any increase in private investment.
  • But it has meant a significant reduction in tax revenues, with devastating consequences.
  • Implications for health, educations etc.: Reduction in tax revenue translates into a lack of resources for education, healthcare, food and nutrition and infrastructure.
  • Low tax-GDP ratio: India is already an outlier among similarly placed developing countries with its low tax-GDP ratio of 18%.
  • Making the budget dependent on indirect taxes: The government budget is also highly dependent on indirect taxes like the Goods and Services Tax which are regressive and hit ordinary citizens harder.

Way forward

• Legislation to end financial opacity: Adoption of legislation and institutional reforms to end financial opacity- including, for example-
  • Opening the beneficial ownership register to the public and-
  • Stopping the creation of onshore tax havens is the need of the hour.
• Opening the debate on how to make the multinationals pay their fair share: The Government of India must also assume a more vocal role in the international debate about how to make multinationals pay their fair share of taxes.
  • This means continuing to appeal for a United Nations tax body, which is much more legitimate than the Organisation for Economic Co-operation and Development (OECD).
  • The issue with the OECD’s proposal: The OECD’s proposals, published at the end of 2019, are neither ambitious nor fair enough.
• Explore the possibility of going alone: If the organisation continues to remain deaf to the demands of developing countries, India must be prepared to go it alone, thinking unilaterally about how to make multinationals pay what they owe.

Context

The Indian government has set itself a big target, namely, that the Indian economy will have an aggregate income or gross domestic product (GDP) of $5 trillion by 2024-25.

Lack of clarity

• There is little effort to take it beyond a slogan.
• When it comes to targets and aims pertaining to the economy, it is important to have-
  • The officials and advisers go beyond the headline.
  • To lay out the details and the road-map for the target.
• Matter for investors: For international observers and particularly investors, not to see these details creates doubts about professionalism.

What growth rate is required to reach that target?

• How long will it take to achieve the target at the present growth rate?
  • In 2018-19, India’s GDP was $2.75 trillion.
  • India’s latest official growth rate happens to be 5 per cent.
  • Target will be reached in 2032-33: Continue in the same fashion to compute the size of the GDP and it becomes clear that the target of $5 trillion will be reached not in 2024-25, but in 2032-33.
• What is the required rate? Set the target as $5 trillion dollars for 2024-25 the required rate turns out to be 10.48 per cent or, approximately, 10.5 per cent.

Why 10.5 rate is an ambitious target?

• The only example of any nation growing for six consecutive years at an average annual rate of over 10.5 per cent was China from 2003 to 2009.
• Can India achieve this rate?
  • From 1947 till now, India’s economy grew at over 10 per cent only twice — in 1988-89 and 2007-8.
  • Of these, the first may be dismissed because the previous year the economy had grown very slowly, by 3.5 per cent.
• What we can learn from the past growth rate?
  • The only example to learn from: The only example from which we can learn is the remarkable growth in 2007-8, made all the more remarkable by the fact that India had been growing well for several years, starting from 2003.
  • And from 2005, India was actually growing over 9 per cent.
  • What factors played the role in high growth?
  • This was a period of professional fiscal policy and steady effort at building infrastructure.
  • India’s economy was making big news in the international media and investment poured in.
  • India’s investment-to-GDP rate climbed to an all-time record of 39 per cent.
• Current investment-to-GDP ratio: Our investment-to-GDP ratio has crashed to 30 per cent and this takes time to re-build.
  • If we can get back to a growth rate of 7 per cent we will be lucky.

Can inflation make the target achievable?

• Combination of real growth and inflation can make it possible: Virtually all serious commentators agree that in purely real terms, the $5-trillion target is unreachable.
  • But maybe we can make it by a combination of real growth and inflation.
  • How the combination will work? One way India can get to the target is if alongside say 7 per cent growth, India has inflation of say 3.5 per cent.
  • Then India’s nominal GDP growth rate will be 10.5 per cent.
• Why the inflation argument is flawed?
  • The five trillion target is in dollar terms.
  • Inflation will lead to depreciation: Typically, if India has higher inflation than the US, the rupee would depreciate vis-à-vis the dollar to account for that.
  • For the sake of pure arithmetic, assume US inflation is zero, India’s inflation is 10 per cent, and India’s real growth rate is 0.
  • In that case, in rupee terms, India’s economy will grow by 10 per cent. But how much will India’s economy grow in dollar terms?
  • The answer is zero.
  • Why is it so? This is because the rupee will typically depreciate by 10 per cent to match the inflation differential, and so the larger GDP of India in rupee terms, when converted to dollars will show no growth.
• The other possibility of achieving the target?
  • What if the dollar loses value? But this should immediately make it clear that there is another way of getting to the target.
  • This can happen if the US dollar loses value.
  • We can then get to the target of $5 trillion because that will mean less in real terms.

Conclusion

There are two routes to achieve the target of $5 trillion: A huge policy initiative to boost real growth or the luck of dollar depreciation. The luck of dollar would mean nothing for us in the real term so the best course of action for the government is to seek the first option and try to achieve it.

Context

Even as the 31-month-old GST evolves, the debate on its success rages on. Many have argued that GST is losing its sheen and needs a complete overhaul while others contend that the new tax system is on course and the trials and tribulations were not unexpected.

Analysis of GST collection

• 39% increase over the average of the base year 2015-16: The average monthly GST collection for the period August 2017 to January 2020 stands at Rs 97,188 crore which is an impressive 39 per cent increase over the average monthly collection of subsumed taxes in the base year 2015-16, at around Rs 70,000 crore.
• The average growth rate of 9.7% per year: This is an average growth rate of 9.7 per cent over the almost 4-year period post-2015-16 and a compounded growth rate of 8.55 per cent.
  • Though less than 14% but not insignificant: This compounded growth rate is not insignificant even though it is just about 0.61 times the very ambitious 14 per cent rate of growth promised to the states before GST rollout.
• Perception of infectiveness due to ambitious 14% promise: The average growth rate of the collection in 18 non-special category states (accounting for the bulk of the revenue) during the 3-year period immediately preceding GST stood at around 8.9 per cent.
  • Thus, if the perception about the effectiveness of GST has not been very encouraging, it is only in the context of the very ambitious 14 per cent compounded annual growth rate promised to the states.

Reasons for tepid growth in GST collections

• The overall economic situation in the country: The revenue performance of GST during the current fiscal year is not out of sync with the overall economic situation in the country.
  • The growth rate in tax yield at 4.69 %: Accordingly, during the 10-month period ending January 2020, the growth rate in tax yield was 4.69 per cent.
  • The relatively tepid growth was primarily due to a negative growth of 4.03 per cent in September-October 2019.
  • After the dip in September-October 2019, GST collections rebounded and this is a reminder that one need not write GST off in a hurry.
• Complacency in the states due to 14% promise: Complacency in the states on account of assured 14 per cent growth cannot be ruled out.
  • States were jolted with the delay in compensation for August-September 2019 and resorted to vigorous monitoring of compliance and action against toxic and unverified credits, circular trading and tax evasion which had resulted in unmatched credit claims of around Rs 50,000 crore.

Two suggestions as corrective measures

• The GST Council deliberated on the recent trends in revenue collection and was cognizant of the need for corrective measures. Two options were suggested. One was the “big bang” approach-
• Big Bang approach: It involves an overhaul of-
  • The legal framework.
  • Processes and systems and-
  • Re-writing GST almost de novo.
• A steady-state approach: A “steady-state” approach involved-
  • Incremental reforms.
  • Solving problems as they arise.
  • Plugging loopholes.
  • Improving the compliance environment through increased monitoring with better tools.
• The Council chose the second approach and the signs are already showing.

The steps taken-

• Red flag reports: The GSTN has developed red flag reports based on GSTR-1, auto-generated GSTR-2A, GSTR-3B and the national e-way bill system.
  • These reports identify non-filers so that action can be taken against active taxpayers who defaulted in filing returns.
  • Till November 2019, around 6 lakh dealers had defaulted in furnishing one or more returns from July 2017 involving estimated tax liabilities of around Rs 25,000 crore.
  • Increase in the filing: An SOP has been developed for proceeding against such return defaulters and this has helped increase the percentage of filing which has contributed to revenue.
• Making Aadhaar mandatory: To further the ease of doing business, it was decided to grant registration without physical verification and a system of deemed registration was put in place.
  • Spot verification has unearthed non-existent dealers and led to the cancellation of around 1 million entities.
  • It has now been decided to mandate Aadhaar authentication for taking new registration and thereafter the existing registered taxpayer population would have to undergo Aadhaar authentication in a phased manner.
• Use of analytical tools: Advanced analytic tools are being used to unravel complex networks of firms created just for generating credit and these analyses are being strengthened through machine learning and AI.
  • An all-India offence/enforcement database is being built.
• System of data exchange with other agencies: In order to identify dealers posing a “hazard” to revenue and do a 360-degree profile of risky taxpayers, a system of regular data exchange with banks, CBDT, ED, RoC and other agencies is being put in place.
  • Fraudsters will find it almost impossible to game the system.
  • The new return system set to roll from April 1 is expected to curb incidences of unmatched turnovers and utilisation of un-validated.
• System of e-invoicing: In order to validate and improve the quality and fidelity of invoice reporting and return filing, a system of e-invoicing is proposed to be implemented in a phased manner beginning April 1.
  • This will begin with taxpayers with turnovers exceeding Rs 500 crore and will auto-populate e-way bill generation and filing of Anx-1 in the new return system apart from validating credit flow from taxpayers.

Conclusion

These measures will effect qualitative improvement to the compliance eco-system which will not only lead to an improvement in the collection but will also make life easier for taxpayers and tax authorities alike.