The Pincer Movement

Indian manufacturing is being attacked from both directions: weak domestic demand, and increasing cost of production. Here are some good and bad ways to fight back.

Writing in November last year, I had made the following observation: “It is true that the current shortage of currency in India is temporary, and it is hoped that the economy will bounce back once liquidity conditions improve. But by that time, the velocity of money will slow down because people will hoard cash rather than spend it, an output gap will develop, deflationary expectations will have set in and the economy would be in a slowdown mode.”

Growth slowdown is no longer a prediction; it is not something you say with lots of qualifications. It has become an established empirical fact. Even the economists who vigorously argued against the possibility of slowdown have grudgingly conceded it.  Now, equally vigorously, they are telling us how to reverse it. Be that as it may, if application of first principles could clarify things yesterday, it can clarify a few things even today.

Collapsing Investment: credit-constrained or stressed margins?

In  December 2015, the Reserve Bank of India (RBI)  initiated its Asset Quality Review (AQR) exercise, which was aimed at cleaning up hidden non-performing assets (NPAs) in banks’ balance sheets. Almost simultaneously,  growth rates came under stress. This association, it is suggested, implies that poor supply of credit is hobbling the Indian corporate sector. Recapitalizing banks will kickstart the process of recovery.

Looking at data, one gets a different picture altogether.  In the 78th round of the Industrial outlook survey, conducted by RBI for the quarter April-June 2017, merely 6.1 percent of respondents were pessimistic about the availability of finance from banks, while 21 percent were optimistic about it. Similarly, 23.5  (9.5) and 9.5 (3.7) percent of respondents were optimistic (pessimistic) about the availability of finance from their own sources and from abroad respectively. In all cases, more respondents were positive than negative about the prospect of obtaining finance. Assuming that expectations and assessments are grounded in present experience, credit availability does not seem to be  constraining entrepreneurs’ investment decisions.

So what exactly are businessmen worried about? Mainly the increasing cost of raw material. A whopping 47 percent of respondents expect that cost of raw material will go up in near future (that is, worsen); only five percent of respondents believe it will come down. Twenty eight percent of respondents believed that profit margins will decline, while merely fifteen percent were optimistic about improving margins. Chief Statistician of India TCA Anant too held higher input prices as one of the two major factors responsible for lower GVA growth. There is plenty of anecdotal evidence suggesting that high raw material cost, with the resultant declining profit margin, is part of the slowdown story.

Before you dismiss the survey as subjective and perceptional, let me add that these numbers can be corroborated by hard data. In the fourth quarter of FY 2015-16, the operating profit of non-financial, non-government listed companies grew by 16.9 percent (year-on-year), even as topline growth was a measly 2.3 percent. The reason was the collapse of raw material cost (-7.2%). In contrast, in the fourth quarter of FY 2016-17, operating profit grew at a sluggish 2.8 percent, even as sales clocked a healthy 7.2 percent. Again the culprit was a sharp spike in raw material and fuel and power cost (15.4 % and 15.6% respectively).

But why is cost of production increasing so much, especially when domestic demand is weak?  Part of the answer lies in the revival of global growth. The International Monetary Fund (IMF) tracks the global prices of energy minerals and eight core metals. The composite index of all primary commodity prices tracked by IMF shows that commodity prices bottomed out in January 2016 and sharply rebounded thereafter. Given the trade and arbitrage linkages, co-movement of domestic prices  is entirely expected.

In other words, in the last few quarters Profit and Loss account of Indian manufacturing sector has come under a kind of pincer movement. A pincer movement is a military maneuver in which forces simultaneously attack both flanks of an enemy formation. Similarly, profitability in manufacturing sector is being squeezed due to a weaker domestic demand on the one hand and increasing cost of production due to global recovery on the other.

By itself, neither factor can fully explain slowdown. A slowdown story that is based solely on the weaker aggregate demand can neither explain decent topline growth nor the fact that capacity utilization is up (howsoever slightly). Equally, in the absence of a demand shock, firms will have enough bargaining power to pass on the elevated resource cost to consumers. It is the combination of the two that explains the reduced profitability and lack of appetite for credit and investment.

Bank recapitalization: to do or not to do

If the above analysis is correct, then a number of corollaries follow.  One of the biggest policy challenges right now is whether banks should be recapitalized or not. Bank recapitalization is fiscally costly. Besides, it creates moral hazard as taxpayers are essentially subsidizing and insuring bankers’ poor judgment, and even their collusion with borrowers.

The  sole justification of bank recapitalization is that it is expected to boost GDP growth. As the old Keynesian saying goes, you can take a horse to the water but you can not make it drink. If the corporate sector has stressed P/L accounts due to extraneous reasons then its appetite for loans (except for balance sheet evergreening) will be limited and supply of credit will not be a binding constraint. In this case, it is difficult to justify  bank recapitalization in a cost-and-benefit analysis.

Exchange rate devaluation: a non-solution

The foregoing analysis also turns the demand for weaker rupee on its head. If corporate margins are under stress due to high input cost, then a weaker rupee will actually worsen the situation. First, imports, including primary commodities and intermediate goods, will become more expensive. Second, even domestic producers will be incentivized to  export their products, creating  domestic shortages. Third, it seems positively perverse to devalue currency precisely at the moment when the global economy is taking off.

Fiscal stimulus: perish the thought

In an ordinary situation, the call for fiscal stimulus may be justified. But we do not live in ordinary times. Even as there are no immediate plans to capitalize banks, it is possible to imagine scenarios where the government has to bear the bulk of NPA losses. That is why IMF defines NPAs as the  contingent liability of the public sector. For a country with large contingent liabilities, a stable fiscal condition is a prerequisite for a stable banking and financial sector. The cost of fiscal adventurism may be too high.

After the global financial crisis, rating agencies and foreign investors have become averse to tail risk. Consequently, their risk models penalize interaction of fiscal deficit and contingent liabilities heavily. Fiscal indiscipline may lead to widening of risk premia, creating all kinds of complications in macroeconomic management.

Let the cash flow

Normally, currency with the public grows in double digits annually. In some years (1993/94; 1994-95), it even crossed 20 percent.  This year too, currency held by public should have grown by around 10 percent. Instead, it declined by 20.3 percent.  Such a shortfall is bound to have economic consequences. First, as cash is an interest-free instrument. there is a direct fiscal cost associated with loss of seigniorage. Second, stock of currency lubricates transactions in the cash-intensive informal sector. When the stock of cash is down, they suffer. My point is that the process of remonetization is far from complete. Reversing some of the steps that dis-incentivize use of cash use may be the simplest way of boosting aggregate demand without jeopardizing  fiscal targets.

Make the GST growth positive

Introduction of GST is the most important economic reform of the decade. Unfortunately, some of its features like inverted duty structure may worsen current problems. Besides, its architecture needs rethinking from the transaction-cost perspective. International experience shows that informational requirements to implement GST scale quadratically with the number of tax-slabs. If a two-slab system requires four pieces of information for assessment, a five-slab system will require (roughly) twenty five. This will be a nightmare for the taxpayer, a nightmare for the assessing officer and a nightmare for the system administrator.

If GST has to be growth positive then the number of slabs should be reduced to a maximum of three. There can be one rate for necessities, raw materials and merit goods, another one for normal goods and one penal rate for luxury and sin goods.

Even better, make the entire exercise formula-based (say, on the basis of estimated income elasticities and externalities) and task a professional body or an institution (say, NIPFP) to make recommendations. A norm can emerge where the GST council accepts those recommendations unless it has a specific and compelling reason to not do so. Otherwise, political bartering and lobbying will render the entire system unworkable.

Look beyond the headline GDP numbers

GDP is a wonderful summary statistic. It summarises in a single number the economic activities of 1.3 billion Indians. If it sounds too good to be true, then it is. One of the blind spots of GDP calculation is the poor measurement of the contribution of informal sector. But an informal sector that employs about seventy-five percent of Indian workers is clearly relevant for social welfare and political economy.

Economy and polity do not exist in silos; they interact. When the median voter is in pain, she will demand palliatives and ultimately get it. It may be a debt waiver, price ceiling or a cheaper home loan. As Raghuram Rajan has convincingly argued, it was precisely such a palliative—relaxation of prudential norms in sub-prime housing finance– that ultimately led to the global financial crisis. As these ‘fault lines’ and ‘hidden fractures’ are the biggest downside risk to economic stability, the best way of ensuring sustainable GDP growth may be to occasionally look beyond it.

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About the author

Avinash M Tripathi

Avinash M. Tripathi is an Associate Research Fellow (Economics) at the Takshashila Institution. His research interests include competition policy and financial risk management. He prefers a profound answer to a silly question rather than the other way around.