While volatility of growth has increased after the reforms, the basic character of business cycles, post-Independence, has not changed.
It is said that he who does not remember the past is condemned to repeat it.
Commentaries on India’s current growth slowdown are very similar to those that appeared after the slowdown of the late nineties.
Then too, it was said India was incapable of growing at a higher rate; the slowdown had basically reverted growth to its ‘true’ lower trend.
Now, it is being said the higher growth that followed from 2003 to 2010 was an unsustainable aberration caused by the global boom and excess liquidity flows to emerging economies. The critics of this view, in turn, hold that the current slowdown being experienced by India has to do with internal problems, and not any global shocks.
Either way, they show the infeasibility of higher growth!
But the fact is even in a slowdown, the growth rates in India today exceed the earlier so-called Hindu rate of growth of 3.5 per cent or so. While the volatility of growth has, no doubt, increased after the reforms, post-Independence growth cycles still have similarities. Understanding these is educative.
India’s slowdowns have been triggered mainly by supply shocks. In the early years, these were largely on account of monsoon failures, which used to lead to large government spending. Since the Reserve Bank of India was then obliged to automatically finance government deficits, this spending used to be accommodated. But that would usually be followed by a severe tightening, thereby hitting industry just as input prices tended to rise.
Something similar happened as oil price shocks became important, from the 1970s onwards. Since the increases in global oil price were not immediately passed through to consumers, government deficits would rise and these would be monetised. At the same time, private spending would be squeezed, while the period of monetary tightening that followed would also be used for some pass-through of oil prices.
So, costs would rise for industry, just when demand fell.
What these types of supply shocks did was raise costs at all levels of production, even though firms continued or may have continued to have excess capacity.
The supply shocks, in other words, would shift up or to the left an elastic supply curve, rather than shift to the left an inelastic supply curve.
Economic liberalisation and reforms stopped automatic monetisation, forcing the Government to borrow at market rates. Investment, too, was now largely a private sector activity, as growing deficits, poor returns from past investments, and pre-emption of expenditures by subsidies and other recurrent spending reduced public investment. Simultaneously, the growing share of retail and housing loans increased the sensitivity of consumption to interest rates. As a result, growth and investment became doubly sensitive to these rates.
Interest rates were gradually freed, but in thin money markets, proved to be volatile. In the late nineties, as capital flowed out after the East Asian currency crisis, a liquidity squeeze, aggravated by sharp increases in policy rates, resulted in high and sticky loan rates.
The investment cycle collapsed and took five years to recover, the impetus for which came from softening global interest rates and an effective public road building programme.
At the same time, since overcapacities tend to get built up during booms, it makes private investment inherently volatile. In the latest boom phase, loan rate volatility was somewhat reduced because of improved articulation of market segments. Also, maturing of institutions such as the liquidity adjustment facility allowed more policy fine-tuning in response to shocks.
But volatility in interest rates still came from large corrections in policy rates due to the unprecedented shocks associated with the global financial crisis of 2008. The same crisis was also preceded by a sharp rise in world food and oil prices — canonical supply shocks in the Indian context.
The Government responded to the 2008 crisis by reversing fiscal consolidation to create a fiscal stimulus after global export and domestic private demand fell.
But government-supported expenditures also raised the demand for food, whose prices were already high, even as restrictions of various types on farm trade prevented an appropriate supply response.
Also, increased risk aversion on the part of overseas investors from the euro crisis led to forex outflows, putting pressure on the rupee and raising the price of imports. The cumulative impact of all this was that demand fell for industry as rates rose, just as input costs rose. This, plus the excess capacity built in the previous boom, inhibited fresh investments. Problems in land acquisition and in the allocation of other natural resources only compounded the situation, affecting investments in infrastructure and adding to the supply bottlenecks in the economy.
Thus, we have all the components of pre-reform growth slowdowns in the current episode — high food and oil prices, large fiscal deficits, and demand squeeze on industry. The difference is that the demand squeeze has come now predominantly through interest rates.
It is regarded as a puzzle that despite low industrial growth and excess capacity for a year, core inflation remains above 5 per cent. But costs are high and mark-ups on costs are often countercyclical — these being raised to spread fixed costs when capacity utilisation is low.
It is possible to target policy properly to match the structure of the slowdown. The administrative hurdles that restrict investment, especially in areas where there are shortages, must be lifted. The composition of Government expenditure, too, must change from creating demand in sectors where increase in supply is disabled, to releasing supply bottlenecks.
Critical and focused action in these directions is the type of countercyclical policy that is feasible and could be effective. As costs and inflation come down, falling interest rates would provide further boost to recovery.
India’s potential rate of growth has risen, but the correct policy combination required for stabilisation of business cycles has not been implemented.
(The author is Professor of Economics. IGIDR, Mumbai. firstname.lastname@example.org)