Excerpts from the transcript of Raghuram Rajan’s lecture at the Watson Institute for International and Public Affairs, Brown University, U.S., on October 16:
We are in a very worrisome place in India today. Growth has slowed considerably, the fiscal deficit is large, leaving little room to do something about growth, and there’s rising debt levels in many areas in the Indian economy, some of that distressed. India’s an economy which for 25 years has been growing at 7 percent; what we see today is much slower growth, and if we are to believe Arvind Subramanian’s work, perhaps even lower than the headline numbers that we see.
We were growing really fast before the Great Recession and then 2009 was a year of very poor growth, we started climbing little bit after it but since then, since about 2012, we’ve had a steady upward movement in growth going back to the pre-2000, pre-financial crisis growth rates and then since about early. And then since about mid-2016 we’ve seen a steady deceleration and now the latest numbers were 5 percent for the last quarter.
Investment has been falling steadily in the Indian economy ever since probably the global financial crisis, but it’s been falling steadily actually from a few years after that. Consumption has been relatively strong and holding up, but more recently consumption has also been falling. Most recently, consumption is falling rapidly.
Commercial vehicles are a good proxy for industrial demand and cars are good proxy for urban demand. You see all of them tanking; tanking to the extent of 30-40 percent levels of negative growth. A lot of it is because of a shortfall in credit availability to households as well as households themselves postponing consumption.
When you look at the trade balance – what you see is that in the years of strong growth, India’s exports were growing, in fact growing faster than GDP. Exports rose as a share of GDP. Over the last so many years, they have been growing slower than GDP growth and therefore falling as a fraction of GDP. This is true when you even take out oil – that’s the numbers on the right-hand side are non-oil exports and you see that has been falling.
The fiscal is also a source for concern. India’s fiscal deficit to GDP is officially 7 percent; that’s the sum of the state government’s fiscal deficit and the Central government’s fiscal deficit. But the reality is, this fiscal deficit conceals a lot. The headline number conceals a lot.
What is less noted, but something that the Auditor General has pointed out in India is, there’s a lot of borrowing which is going off-balance and which is not being counted in the fiscal deficit. For example, the Food Corporation of India is essentially a department of the government. The Food Corporations borrowing should be thought of as part of the fiscal deficit but is off-balance and you can see that’s skyrocketing over the last couple of years from about 0.7 percent of GDP to 1.1. Point four percentage points of GDP are buried in food corporation of India’s borrowing.
Similarly, the National Highway Authority of India – you see borrowing there go up from 0.2 percent of GDP to 0.7 percent of GDP; another 0.5 percentage points of GDP. Now, add these, you get one percentage point of GDP that is not counted in the fiscal deficit but is actually part of the fiscal deficit.
The rising non-performing assets means that banks need recapitalisations. You’re seeing the non-bank financial companies – they are in trouble and they may need some state support. You’ve got rising healthcare commitments. We have a whole new healthcare programe, Ayushman Bharat, which is being rolled out. As it rolls out, it will require more resource.
These are all contingent liabilities. We don’t account for them well in the budget, but they hit future budgets. Contingent liabilities are rising which leads respectable investment banks like JP Morgan to put the actual fiscal deficit as somewhere between nine and ten percent of the GDP. That’s a large number.
It’s especially large in India because we brought inflation down. In the past when inflation was available as the inflation tax, you could inflate away your debt and that helped make your finances look a lot healthier. Today, with inflation so low, it’s much harder to do that. You actually cannot inflate away your debt that easily, and therefore that’s a source of concern. Our fiscal is tighter than the similar numbers would be in the past.
Now, let me go on to debt and distress. One of the worrying things about the recent environment is that household savings are falling. Households are saving less. Indian households are natural savers and the fact that they are saving less should be one source of concern. Why aren’t they saving more? Because after all, Asian economies grew on the basis of strong savings invested well. Savings are falling over the last few years, but increasingly, you’re seeing that also reflected in higher debt levels.
Household debt levels are increasing by about nine to ten percentage points of GDP over the last four or five years. Households are borrowing much more and saving less. That’s not a good combination. That means, they did not have a whole lot of debt earlier, so they started from a low base but they’ve borrowing quite rapidly and that has to be an additional source of concern.
You can see emerging signs of distress. For example on the corporate side, if you look at credit rating companies, credit rating companies will give you ratios of the number of credit upgrades to credit downgrades and so the lower this number is, the more stress your corporate sector has. This level of stress is at a six-year high.
In other words, the upgrades to downgrade ratio is at a six-year low. We’re as bad as we were at that point where we were starting to grow again. So, stress is piling up in the system probably as a result of ‘low demand slow earnings growth’ and difficulties in serving the servicing debt.
Let me talk a little bit about what the roots of the problem are. We’ve really had no significant continued reforms in India to propel economic growth since 2004. That is the year the NDA that under Atal Bihari Vajpayee lost the election.
We had first reforming Congress government in the early 1990s, followed by a number of coalitions followed by the BJP government. That 15-year period from the early 1990s to 2004 was a period of significant reforms where we cut down our tires, become a more real open economy and even did some privatizations under the budget by the Government. That was also a period where growth was not that strong, but it created the environment for really strong growth.
The problem with the Vajpayee government was that, even by the end of its term, we still hadn’t got to the spectacular growth we saw in the next three or four years afterwards. At least the experience of growth amongst the broader people was not that strong, and so the Vajpayee government’s campaign for re-election in 2004, which was based on India Rising simply didn’t catch hold and they lost narrowly to the Congress.
Congress came in with a coalition government which had the communists in it and really could not continue the reforms that the NDA had started, because simply there wasn’t that much consensus within the coalition partners. Nevertheless, there was an explosion in investment, and what you can see here is the rise in new projects announced as we go into three-four-five, just before the financial crisis you have a substantial explosion in projects announced. Strong growth and many of these projects were completed on time. There was strong infrastructure investment and strong growth.
The collateral effect of that sprung growth was, it put a lot of pressure on resource allocation, including the institutions to allocate resource: A lot more need for land, lot more need for iron ore, a lot more need for coal, lot more need for spectrum. One of the consequences of the strong growth was a series of corruption scandals which came to light in UPA to the second term of the UPA government.
The UPA got what it thought was a boost at the end of its first term to a massive farm loan waiver. My suspicion is, populist measures were an important factor in their re-election and so when UPA 2 came into power. Further reforms were stymied despite their ability to do further reforms by the fact that they really believed it was not from growth, but from these populist policies, that they had gotten re-elected, and the emphasis was much more on populist policies in UPA.
The net effect was right through UPA 1 and UPA 2, they were relatively few of the growth enhancing liberalising reforms, especially because in UPA 2 even the reforms they wanted to do like the goods and services tax (GST) were stymied by opposition protests which grew louder and louder as some of these corruption scandals came to light. So, UPA 2 was essentially a period where we didn’t have significant growth enhancing reforms – we had a lot more spending, especially on distribution of stuff such as food security, and inflation started going through the roof.
Inflation started going through roof in part because of strong demand but in part also because we saw increasing supply bottlenecks being created in the economy. Because land acquisition got much harder, many of the bureaucrats, because of corruption scandals, became much less willing to put out for fear that they would be held up by investigative authorities.
The bankers who were really quite willing to lend in the phase before the financial crisis when projects were doing really well, now became a little more risk-averse also for fear that if loan went bad, they get hauled up by the investigative authorities. So, essentially, the economy started slowing down considerably post-financial crisis. Macro-stability was a great concern at this time and India had basically all the bats – high levels of inflation, high physical deficits and not-so-strong growth.
At which point there was a course correction in the Congress government. It started the process of fiscal consolidation. Chidambaram came back to the finance ministry.
India was one of the fragile five that time and we lost capital very quickly. The government listened at that time and transformed to focus much more on macro stability: Bring the fiscal deficit down, try and enhance growth, try to whatever reforms were possible. At that time, I think the Reserve Bank of India also joined in to bring down inflation into making that a focus.
Move forward from the UPA 2- to Modi One. As it came in, it started implementing some important reforms on the macro side, on the sectoral side, and to some extent, on the household and populace side. We brought inflation down in India from the double-digit levels.
Unfortunately, it has been a mixed bag. It has been a mixed bag because, on the one hand, we haven’t been able to revive investment. We haven’t brought investment back. A lot of the promoters who started projects in the past are now highly stressed with high levels of debt. They simply cannot start new projects and banks are anyway not interested in lending to them.
Even old projects haven’t been brought down significantly. The reason they are stalled is because promoters have lost interest. Now, one of the successes of both the old UPA government as well as the NDA government was essentially giving the RBI a free hand to bring down inflation. That has been a success.
Inflation is low and has stayed low for a considerable period of time. The RBI also undertook a series of reforms- for example, opening up branching, licensing, improving retail electronic payments. We now have a state-of-the-art payment system of retail payments called the Universal Payment Interface which actually is better than many places in the world. These were all small level reforms.
But one of the big concerns was, as projects initiated fell, there were also a whole lot of old projects which were stalled and getting into distress. Bad loans started building up in bank balance sheets. That’s what you see here. The NPAs of public sector banks started rising. The problem with banks when they start seeing bad loans is there’s a temptation hide them, to push them under the carpet, especially if the bank CEO has a short horizon.
Now, the classic way of dealing with this is: force them to recognise, force them to start dealing with these loans and working them out with the promoter so that they can be put on track. In the meantime, recapitalize the banks so that they have enough capital to make few loans where lending is necessary. Now, bank recapitalization has been halting. The government has taken some measures but typically been a little behind the curve.
What the government did which was very important was pass the Insolvency and Bankruptcy Act. One of the problems in India in the past is, some of you in India know is that it’s very hard for a lender to recover money from a borrower because there’s no way of essentially forcing the borrower to pay up. We had a bunch of Acts passed. But every time we had an act passed, it worked initially. The Insolvency and Bankruptcy Act was an attempt to try and force the borrower to repay their lenders and not have the lenders go from pillar to post in trying to look for their money. Initially it worked in putting the fear of God in borrowers and forcing them to repay.
More recently, however, it seems as if it’s going the way of the old Acts. The promoters have figured out how to end-run the banks, and the judiciary has also intervened in a way as to make it longer and longer and possibly impossible. So, unless we do something about the Insolvency and Bankruptcy code, it will go the same way as the older reforms. It will be essentially gamed to ineffectiveness.
What also has happened in India and the financial sector is that, we’ve had the public sector banks getting into trouble. Because they got into trouble, their lending started slowing down significantly. The private banks and non-bank financial companies have lent much more.
The private banks have been relatively careful about their loans. A lot of their loans are retail loans. The non-bank financial companies were also generally careful about retail loans, but one source of lending has been a lot more problematic for them – which is they lend to developers who built out some of these projects.
Those developers have gotten into trouble because of the slowdown in the retail sector and as a result, the non-bank financial companies also had incipient loan losses on their balance sheet. This came to a head when a big non-bank financial company IL&FS essentially imploded in September 2018, and as a result of that, non-bank financial companies found it hard to get credit. A lot of them have gotten into deep trouble since because not only do they have little access credit, but they have loans building up on their asset side which are going from bad to worse.
So, this is broadly legacy problems piling up. We’re not able to clean up the projects that are stuck, we’re not able to clean up the banks fully but that process is underway, non-bank financial companies have filled the breach but are also starting to get into a little bit of trouble.
Two big actions also happened over this time which created significantly more problems for the system. The first is, out of the blue, India demonetised 87.5 percent of the currency. Now, essentially what happened was the government said that Rs 500 note and Rs 1,000 note are no longer valid. What happens when you demonetised 87.5 percent of the currency? Basically, people don’t have currency to do transactions. Some of it was replaced; but it was replaced slowly. It took 3-4 months to replace it entirely.
In that period, the informal sector basically didn’t have money to do its transactions. These are people who don’t use credit cards, don’t have checks and essentially a whole lot of them got into trouble. It’s hard to measure the damage that was done to the informal sector because we really don’t collect statistics of them, but the anecdotal evidence is, a lot of people went out of business and there are actual studies which show it now that especially new rural areas.
Real estate is one sector that is especially focused in cash and this sector was weakening. With demonetisation, it got into trouble. That also spilled over to the developers who had built this real estate and then further to the non-bank financial companies. Measures of how much the set back growths vary from 2 to 3 percent of GDP for a couple of quarters to 2 to 3 percent of GDP on an annual basis.
This is all using stuff we can measure. What is harder is to think about the stuff we can’t measure. If you look at employment numbers, for example, put out by the Centre for Monitoring Indian Economy (CMIE), unemployment went up significantly possibly close to demonetising.
The second big blow was the Goods and Services Tax. Demonetisation was introduced without substantial preparation. I say substantial because we know there wasn’t enough currency printed to replace the currency that was taken out. You had to print it full speed for the next four months. Typically, you don’t do such things. You typically when you demonetise, have the money ready to roll out on the day you demonetise. That was not done suggesting the timing was chosen for other reasons than everybody was fully prepared.
That leads to the next issue which is, we had the rollout of the Goods and Services Tax. This is a wonderful concept. Demonetisation was misguided in concept. It was not a thing which either affected its aims — which was to bring down black money or what became a later aim which substantially increased the level of electronic payments or substantially formalise the economy. What it did was, create a lot of pain in a very short period of time especially for the poorer informal segments of the economy. It was brilliant politically though, because the government won the UP election. It was sold politically very well but it was not an economically well-thought-out idea.
The goods and services tax was the next big reform and it is something that the UPA government has been pushing and gone through because the BJP had opposed it then. The BJP took it on and to its credit managed to push it through as a constitutional amendment. It was a sound concept but again, initiated without enough preparation. The computers weren’t ready for the volume of transactions which means right off the bat you had to say “Don’t do this. Don’t do that. We are going to simplify the forms”.
There is a lot of back-and-forth which essentially undercut compliance, and the constant fiddling with the rates, I would presume, also created uncertainty. One could argue that some of the recent fall in demand, for cars for example, is because people are still trying to figure out. Are they going to reduce the tax? The goods and services tax on this from 28 percent in order to enhance demand? If so, I don’t want to buy now, I want to wait till they’ve reduced it.
The issue of trade and investment has been a focus of the Modi government, a good and necessary focus. However, what trade and investment needs really is an increase in the ease of doing business because, ultimately, you get more trade if you have more efficient firms who are able to produce both for the domestic economy and internationally. Here again, what one would want for is a slashing in some of the old regulations that holdback firms and focusing on improving the ease of doing business.
There’s been some attention but largely focused on the World Bank indicators of the ease of doing business rather than the actual conditions in India on what prevents businesses from working easily. So, as a result, we haven’t got that significant boost so far in business opening because in fact it may not have become that much easier for businesses to operate in India. One of the recent concerns has been on tariffs and taxes.
If you want more trade, you should bring down your tax, because today the way trade happens is through global supply chains moving goods back and forth. In order to move goods back and forth across borders, you need low and stable tariffs. Instead, what we have is high in fluctuating tariffs in certain areas; not all areas but certain areas. And that becomes a concern for business.
What will the tariff be next month? If in fact I open a business here, India is not part of any significant global supply chains and that makes it a problem if India wants to increase its exports. Similarly, taxes, the recent cut in corporate taxes is beneficial in attracting firms to India, but what firms worry about is not just the level but the changes. Is this going to change? Am I assured that when I put my investment in India, it will stay at 15 to 17 percent?
Unfortunately, in India, we have a history of going back and forth, some of which was reflected in the recent budget in taxes on foreign investors. So, we need to have a process where if we stabilise rules and regulations and taxes and tariffs, if we want to attract new companies into India.
That is one reason why if you look at the level of foreign direct investment, despite the emphasis on ‘Make in India’, you see in the last four years the level of foreign direct investment hasn’t changed very much. We get about $40 billion. In comparison, Brazil gets $90 billion in FDI.
We are starting to assemble more cell phones in India, and this has gone up. If you look at the cell phone imports, they have come down significantly and that’s not because we are buying fewer cell phones, but because we’re importing that. And if you look at exports, that have gone up. So, India is starting to export cell phones that it assembles in India.
The problem, however, is, it’s largely just assembly because one of the counter parts to the increasing cell phones is the fact that you look at electronic components, we’re importing far more. In other words, we are doing assembly now that’s not to be sneezed at we did do assembly before and doing assembly today is a good thing but it’s not value-added assembly. It’s basically importing the components and putting them together.
China is moving out of textiles. Who is taking its place? India has moved up from about 3 percent of world exports in textiles to 3.3 percent. But it’s over a period of nearly 20 years. On the other hand, if you look at Bangladesh, it’s gone from 2.6 to 6.4 percent. If you look at Vietnam, it’s gone from 0.9 to 6.2. So, Vietnam and Bangladesh are absorbing the textile market while we have plenty of people to work and we’re not getting any of the textile market. That suggests we are still not seen as an export friendly place. Our businesses are not doing as well as they should.
When a country grows richer, the taxes actually go up because people move into higher tax brackets and can pay more and especially with all the reforms this government has done, we should see higher taxes instead real taxes actually have actually fallen as have nominal taxes of this period. So, that’s something of concern, basically, signs of deep malaise: Growth is significantly lower, the fiscal space is narrowing, debt and distress is growing, India is losing its economic way. The reason is, we are centralising power without a persuasive economic vision, and if we do this, we risk wasting the demographic dividend.
Click HERE to read full lecture