India’s economy is in a cyclical funk, weighed down by rising bad debt, anemic credit and falling private investment. Growth is at its slowest for three years after weakening for five successive quarters to 5.7%, with little sign of an imminent pick up. Even foreign portfolio investors, who have poured more than US$26bn into India this year betting on its strong macro fundamentals, are beginning to waver. With the general election in 2019 now on the horizon, the government needs to kick-start growth without shattering its hard-won reputation for fiscal continence.
Last week a former finance minister in prime minister Narendra Modi’s own party attacked “the mess” it has made of the economy, pointing to the “unmitigated economic disaster” of demonetization and the havoc caused by the “badly conceived and poorly implemented” goods and services tax. “The wings have fallen off our plane,” responded the opposition leader, Rahul Gandhi, gleefully. Both had good reason to exaggerate the problems facing the world’s seventh largest economy, which the Asian Development Bank still believes will grow at 7% this fiscal year. But policymakers now believe a fiscal stimulus is needed to pull India out of its slump.
So far, finance minister Arun Jaitley has refused to say what the stimulus will consist of—only that he must find a balance between additional spending and maintaining fiscal prudence. He is likely to focus on relatively low-cost infrastructure spending, particularly in rural areas, which can be delivered more quickly than large capital projects. This could stimulate demand both for heavy industrial products like steel and cement, and for goods and services provided by smaller firms. As part of its “pro-poor mantra,” the government is also gearing up to provide electricity to the 40mn households that are still not legally connected to the grid.
Jaitley has little room for maneuver: the government has budgeted for a fiscal deficit of 3.2% of GDP this year, down from 3.5% in 2016-17 but above its original target of 3%. Early hiccups with the rollout of the GST, while entirely expected, have cut tax revenues. Meanwhile, rising global oil prices could limit the government’s ability to keep high taxes on petrol and diesel, which have helped it to whittle down the fiscal deficit since 2014. In any case, India’s credit rating would not survive a budget blowout: it currently carries the lowest investment grade rating and cannot afford to be cut to junk status, which would send foreign investors scurrying for the door. Even talk of a stimulus has pushed up bond yields over the past week.
All in all, it’s hard to see how the government can spend more than an extra 0.3% of GDP, which would maintain the deficit at last year’s level. Yet whether such a modest stimulus can spark the economy into life is far from clear. Meaningful demand is unlikely to return until India begins to solve its “twin balance-sheet problem”—the conundrum by which banks saddled with nearly US$200bn of souring debt are in no position to lend, while over-indebted firms are too scared to borrow. Despite the central bank’s mandate to force the biggest defaulters into bankruptcy, there is still no plan to inject fresh capital into the banking system.
The fundamental question hanging over the economy is whether it is merely experiencing short-term pain as it adjusts to much-needed structural reforms, or whether it is mired in a deeper malaise that could take two or three years to shake off. Despite fair criticisms over their implementation, both demonetization and the GST are much-needed attempts to bring cash into the formal economy and expand India’s puny tax base. Modi’s government has also overseen a new bankruptcy law, greater opening to foreign direct investment, inflation targeting and fiscal devolution. All of these moves should put long-term growth on a more solid footing.
Until late summer, markets unquestionably bought this bullish structural story while largely ignoring cyclical weakness. But after a winning streak that saw equity indexes reach record highs and foreigners exhaust rupee-denominated bond quotas, sentiment is turning. Investors are finally tiring of overpriced stocks and the slow recovery in corporate earnings, while the rupee has begun to weaken after gaining 6% against the US dollar this year. That is good news for India’s struggling exporters, but bad news for foreign bondholders.
Udith and I continue to be long-term India bulls, but we cannot ignore the seriousness of the cyclical downturn. We have predicted that investment will begin to revive in 2018-19, and we may still be proven right. With elections looming in early 2019, Modi’s government must do all it can to get the economy moving over the next 18 months. But its admirable reluctance to blow the budget, even while contemplating a fiscal stimulus, means that the stench of underperformance will hang over India’s funky economy for at least the next year.
This article originally appeared at Gavekal Research.