GDP Growth Slowdown: When A Repo Rate Cut Isn’t Enough

The sub-6 percent growth in gross domestic product for the fourth quarter of 2018-19 strengthens the case for a rate cut by the Reserve Bank of India in its upcoming meeting on June 6. A rate cut, however, it is likely to have a limited impact. There is a combination of cyclical and structural elements to this slowdown that requires a whole package of responses from the RBI and the new government. A repo rate cut can, at best, play a peripheral role.

A comprehensive model for economic growth was somewhat absent from the last government's policy agenda. NDA 3.0 needs to put one in place and find answers to some difficult questions. Does a fiscal constraint prevent us from following the China model of state-led growth?

For starters, we identify three policy priorities for the new government.

Consumption Stalling

The first critical issue is muted consumer demand. Despite low inflation, consumption growth has lost its bite. From 8.2 percent growth in 2016-17, consumption growth averaged at 7.7 percent over the last two years. Our domestic demand proxy indicator (average of growth in major demand-side indicators) shows a rather sharp fall more recently, with demand growing by a meagre 2.8 percent year-on-year in the last six months compared to 8 percent previously.

Over the past few quarters, this decline has become broad-based. While earlier the slowdown was limited to rural consumers, urban consumers are now tightening their purse-strings. Urban core inflation (measures the non-volatile part of inflation) works as a useful demand proxy. This has steadily declined from 6.5 percent in August 2018 to 4.5 percent in April 2019. Passenger car sales, another demand indicator with an urban bias, have declined by 2 percent, on average, since August 2018. This decline has been partly driven by the credit crunch faced by the non-banking financial sector, which accounts for close to 18 percent of the system-wide credit.

The liquidity crunch in the system is not just impacting consumption; it is also holding back an investment recovery.

They had borrowed from NBFCs often pledging shares for loans that they used for personal investment in infrastructure and other assets. This is winding down now.

NBFC Freeze

Banks have been reluctant to lend to NBFCs as the perceived systemic risk—post the IL&FS crisis in August last year—has risen. Bank credit growth to NBFCs declined to 12 percent quarter-on-quarter in March 2019, from over 30 percent a year ago. Given the credit crunch and high cost of funds faced by NBFCs, they are now unwilling to roll over debt to these promoters. Promoters have no option but to use free cash flows of their core companies to pay back debt or face the risk of their pledged shares being sold at firesale prices. 

When free cash is used to service debt, the first victim is capex.

The solutions to this range of problems are fairly obvious. The credit constraint that is affecting both consumption and investments needs to be addressed. A template on agricultural revival is in place but has to be implemented effectively. Also, the RBI needs to revive confidence in NBFCs. However, as with all policy prescriptions, things are easier said than done.

The only relatively quick solution that could address a plethora of problems is financial system liquidity. Despite the substantial infusion by the RBI through open market operations and dollar swaps, money continues to remain tight. Furthermore, the transmission of recent rate cuts has been limited and the real interest rate in the economy remains high. For instance, the yield for a AA corporate bond is close to 9.3 percent, implying a real interest rate of close to 5 percent. Thus, while monetary policy should remain expansionary in the conventional sense of policy rate cuts, the bigger challenge is to ensure ‘transmission' to actual lending rates. For this, ensuring a steady supply of long-term liquidity becomes imperative.

Despite the RBI's apparent reluctance, directing liquidity to cash-strapped NBFCs might not be a bad idea.

This could slow deleveraging down, make credit available to the retail segment and breathe life into the market for instruments like commercial paper. If banks have to compete with money market instruments, they could lower lending rates and facilitate transmission in the process.

Trade War Upside

The third and last issue that requires policy attention is foreign trade strategy. A slowdown in global growth and rising trade protectionism have driven the share of India's exports to GDP from 25 percent in 2013-14 to 21 percent in 2018-19. Faltering growth in major trading partners such as the United States, Europe, and China are likely to further increase this decline.

However, the U.S.-China trade war also presents some opportunities for India. Given India's export mix and competitiveness, it can gain from trade diversions as a consequence of tariff hikes. 

This number could increase if India becomes an integral part of an alternative global supply chain. Aligning the Make in India program with a revamped foreign trade policy to capture export market share could be helpful.

The gains from a push to exports cannot be overstated. Our calculations show that, ceteris paribus, a rise in the share of exports to GDP from 21 percent in 2018-19 to 25 percent in 2023-24 (the share last recorded in 2013-14), could alone increase GDP growth to an average of 8 percent over the next five years.

The government and the RBI clearly have their work cut out.

Abheek Barua is Chief Economist and Sakshi Gupta is Economist, at HDFC Bank. Views are personal.

The views expressed here are those of the authors and do not necessarily represent the views of BloombergQuint or its editorial team.