This is Part 6 of our series, 2017 in Review, and focuses on macroeconomic trends. Here are Parts 1, 2, 3, 4 and 5.
It seems rather difficult to fill up the highlights reel of India’s macroeconomic performance for 2017. Nothing exceptional happened and it was an year of mediocrity at best. Growth tapered and saw a slight uptick, inflation was largely within bounds, there was a single change in the policy rate by the central bank, our external sector performed no miracles, investment dipped, and government overspent. Nothing extraordinary here. End of article.
Oh, wait. The GST was passed with unprecedented fanfare for a tax reform. Quite easily, the biggest policy reform of the year, the Goods and Services Tax (GST) came into force on the 1st of July, 2017. The aim is to subsume the various indirect taxes levied by the state and the centre and create a single, unified market in India. A single GST replaced several existing taxes and levies which include: central excise duty, services tax, additional customs duty, surcharges, state-level value added tax and Octroi. Other levies which were applicable on inter-state transportation of goods has also been done away with in GST regime.
No one can actually deny the benefits of a single, unified tax code for the country. In fact, the GST was long overdue. It was initially proposed in 2000. As expected with any reform of this scale, there was initial confusion and costs of switching to a new tax regime. One way that the high initial compliance cost could have been decreased was to have a longer transition period between the two regimes, like Australia, which took three years. A bit late for that now, though. Nevertheless, it would be wrong to begrudge a major tax reform some initial teething problems and increased compliance cost, as long as the long term benefits outweigh the short term pain. But, does it?
Getting the GST passed in India was always going to be an herculean task. It required 29 states, 2 Union Territories, and the Union Government to get on the same page. With such complex negotiations, some amount of compromise was inevitable. Unfortunately, the compromises were made on the basic structure of GST, and we ended up with a structurally flawed version of the tax code. To begin with, a tax structure that boasts of simplicity of a uniform tax rate ended up with four slabs and 3 rates of cesses. This led to problems of classification. Is Kat-Kat a chocolate or a wafer? This question is important because the two categories have different tax rates (Amit Varma and Vivek Kaul discuss this here). It also led to significant lobbying to be included in a lower tax rate bracket.
There’s also the problem of compliance – a company is expected to file around 37 returns a year. Then, there is the horror of tax terrorism. The GST has an anti-profiteering clause attached to it. Any firm that does not pass on the benefits of reduced tax rates on their items to the consumers can be hauled up by the National Anti-Profiteering Authority. Corporates are justifiably scared by the potential of witch hunting by taxmen. As a New Year’s gift, the authority issued anti-profiteering notices to a McDonald’s franchisee, Lifestyle, and a Honda dealer. The bigger issue is that the experience of anti-profiteering clause in many countries have been a disaster.
The two-headed monster
Rearing its ugly head(s) again this year was the twin balance sheet problem. It seems that no one has told the Indian corporates and the banking sector that the country is clocking six percent plus growth year on year. They are behaving as though the country is mired in deep recession, instead of being one of the fastest-growing, emerging economies. Firms are cutting back investment and refusing to borrow or spend, and bank lending to industry has actually shrunk for the first time this year. At the heart of the problem is bad debt.
Let Arvind Subramaniam, the Chief Economic Adviser, take over:
Briefly, the TBS (twin balance sheet) challenge refers on the one hand to: overindebtedness in the corporate sector which makes them unable and unwilling to borrow, depressing the demand for spending and investment; and on the other hand to stressed bank balance sheets especially in the public sector banks (PSBs) that make them unwilling and unable to supply credit to finance spending by the corporate and household sectors. The TBS clogs the economy, depriving it of demand and the lubrication that oils and feeds that demand.
The total Non-Performing Assets (NPAs) of Indian banks, both public and private, stood at around eight lakh crores. The NPA ratio – the percentage of bad loans – increased to 10.2 percent in June this year compared to 8.4 percent last year. The public sector banks account for nearly 90% of the bad loans in the country.
On the other front, India’s corporate debt rose to a seven year high in March 2017. What’s particularly alarming is the report that, “More than a fifth of large companies did not earn enough to pay interest on their loans and the pace of new loans fell to the lowest in more than six decades,” according to Thomson Reuters.
The end result: low private investment and laggard GDP growth for India. Private capital investments contracted 2.1% in the first three months of this year. The gross fixed capital formation has been steadily falling since 2011, when it was 33.4% of GDP to 26.9% this year.
Though terribly late, the government has finally taken complete cognisance of this problem. To mitigate the stressed bank balance sheet, the government announced a 2.11 lakh crore capital infusion into banks, mostly through recapitalisation bonds issued by the union government. Despite the perennial problems of moral-hazard persisting, this move is largely inevitable to revive the banking sector and private investment. The government also passed the Bankruptcy and Insolvency Code late last year to help deal with NPAs. The RBI, in June 2017, identified 12 large loan accounts, which made up 25% of the current NPAs, to be taken up under the Insolvency law.
However, none of this will mean anything in the future, if true reform is not taken up. Banking reform is long and complex, and out of the scope of this piece. However, consider this: of the top 20 banks with the largest NPAs, 18 of them are public sector banks. Shouldn’t we revisit the idea of nationalised banks, which was implemented in 1969?
While the macroeconomic indicators are far from stellar, they are not entirely dismal either. GDP growth rate was a decent 6.1% in Jan-Mar quarter and further declined to an alarming low of 5.7% in June. It slightly recovered to register 6.3% in September. The growth rates are far from the heady days of 9% recorded in 2004-2009 and is likely to stay around 7% for the next two quarters. GST and demonetisation have had a big negative impact, but, to attribute the slowdown in growth entirely to these two factors would be wrong. Growth has been slowing down since the first quarter of 2016, when the twin balance sheet problem mentioned above started becoming pronounced.
Industrial growth has been largely on a downward spiral. In the April to June quarter, the manufacturing sector expanded by just 1.2%, compared with 5.3% in the previous quarter and 10.7% a year ago. This was the worst quarter for Indian manufacturing in five years. It did recover slightly in the next quarter though. Despite excellent monsoons, agricultural output growth rate has been faltering. It has posted 2.5%, 2.3%, and 1.7% this calendar year.
In fact, much of the growth has come from reckless and unsustainable government expenditure this year. Just in the first half of the 2017-18 fiscal year, the government’s fiscal deficit is 112% of the target. Incredible the revenue deficit (the worst kind of deficit) is 152% of the initial budgeted amount. Overall, we are sure to breach the 3% fiscal deficit target this fiscal year. The most important reform here is to create an independent fiscal council that can monitor government expenditure. Setting up a Fiscal Council can be one of the big structural reforms that the government can take up to make the Fiscal Responsibility and Budgetary Management Act effective. It can prevent the launch of populist schemes that have long term negative effects on the economy and instead ensure rule based policy.
Inflation has largely been in control throughout the year and RBI has done well to keep it within the boundaries set by the inflation targeting framework. The highest rate of inflation was in November, when it reached 4.9%. On the external front, growth in exports was an impressive 12% (between April and November). However, imports also surged, leaving a current account deficit of $100 billion, roughly 1.8% of GDP. The increasing foreign capital flows, both long term foreign direct investment and short term portfolio investment, has compensated for the current account deficit. The foreign exchange reserves crossed the four billion dollar mark this year.
The real problem: JOBS
On most macroeconomic fronts, India is just managing to chug along. However, where we are desperately failing is in job creation. The real concern, which has been a recurrent theme for the last 15 years, is that India is just not creating enough jobs, commensurate with the number of people entering the workforce. By some estimates, India needs to create around 20 million jobs per year. We are struggling to create even 1 million. This gap leads to high unemployment, underemployment, and social and political unrest.
Labour data is hard to come by in the country. Radhicka Kapoor of ICRIER has compiled data from multiple sources and presents the most damning statistics on employment. Total employment in the country actually fell between 2013 and 2016 (from 480 million to 460 million). In the same period, manufacturing jobs fell from 51.4 million to 48.1 million. For 2015-16 to 2016-17, jobs created in the manufacturing sector was a paltry 300,000. This sluggish pace of job creation is, without doubt, the biggest challenge facing India at the moment.
It is hard not to conclude that 2017 was an average year, at best, and probably the biggest highlights are the missed opportunities. China is where it is today largely because it could manage sustained economic growth for over three decades. Each year that India is not growing at 9% or higher is a year that can be counted as a missed opportunity. It is surprising that when jobs is the need of the hour, labour reform is not even on the agenda. One can only wonder what would be the case if the immense political capital that had been spent on demonetisation last year and the botched GST this year had been spent on long term structural reforms in the product and factor markets. It is just not good enough to have a year where nothing terrible happened.