Number of words: 1,537

A year ago, the International Monetary Fund’s (IMF) mission chief for India, Mr Ranil Salgado, described the economy as “an elephant that has started to run”. India’s economy was growing at more than 8 per cent, which made it the fastest-growing major economy in the world.

But it would seem the elephant has gone back to its leisurely stroll. This year, India’s growth has gone downhill, slowing sharply to just 5 per cent in the quarter ended June – the lowest since 2013.

Few observers saw it coming. As recently as July, India’s official economic survey predicted 7 per cent growth for this fiscal year (ending March 31, 2020), adding that the outlook for the economy “appears bright with prospects of pick-up in growth in 2019-20 on back of pick-up in private investment and robust consumption growth”.

The IMF had forecast growth for this fiscal year at 7.3 per cent. In a July update, it revised this down to 7 per cent. Private economists have cut their forecasts to 6 per cent to 6.5 per cent.

But all those estimates may prove optimistic. The short-term prognosis doesn’t look good. Investment is slowing.

Growth in agriculture, manufacturing and exports has stalled. Auto sales are down 23 per cent compared to a year ago, leading to almost 300 car dealers closing shop. About 300,000 jobs have been lost in the auto industry alone. Overall, unemployment hit a three-year high of 8.4 per cent last month.

India’s property market is in a slump. More than half of Mumbai’s newly built luxury apartments are unsold; thousands have been abandoned, unfinished. After peaking on May 23, following Prime Minister Narendra Modi’s landslide re-election victory, India’s stock markets have tanked around 7 per cent, with foreign investors pulling out some US$10 billion (S$13.8 billion) in June and July alone. The rupee has weakened.

How has all this happened? How can a major economy slow down so much, so broadly and so fast?

UNINTENDED CONSEQUENCES

At least part of the story relates to some of India’s recent economic reforms which, although well-intentioned, turned out to have unintended consequences.

One of these was demonetisation – which was more a systemic shock than a reform. On Nov 8, 2016, the government abruptly withdrew currency notes of 500-and 1,000-rupee denominations without providing for adequate replacement notes, ostensibly to flush out “black money” or undeclared earnings. The result was mayhem across the country, with long queues outside banks for weeks, as people tried to replace their soon-to-be-worthless currency notes with new ones.

ST ILLUSTRATION: MIEL

The after-effects of demonetisation rippled through the economy. Sectors that depended on cash, such as agriculture, unorganised retail and small-scale industry, suffered huge income losses. Consumer confidence took a hit. The situation stabilised within six months, but the priority for many households and businesses was to rebuild their balance sheets and recover losses rather than invest or spend on big-ticket items. The seeds of a longer-term slowdown had been sown.

Another major reform was the introduction of the goods and services tax (GST) in July 2017, which was arguably India’s biggest tax reform.

This had the virtue of collapsing 17 indirect taxes and 23 other levies into a single tax. But India’s GST was complex, with five different tax rates for different categories of goods and services, ranging from zero to 28 per cent. While potentially far-reaching, the introduction of GST disrupted business activities. Compliance, which requires extensive computation and the electronic filing of returns, was a problem for small businesses in particular. This affected supply chains: Compliant companies avoided doing business with non-compliant companies because they wanted to input tax credits to lower their own tax burden. So compliance failures led to massive losses for thousands of small companies.

Another major reform, launched in 2016, was the introduction of an Insolvency and Bankruptcy Code (IBC), which has shaken up India’s corporate and banking sectors. Thanks to reckless borrowing in the past for various projects that have mostly either stalled or failed, corporate India has about 13 trillion rupees (S$249 billion) of distressed assets, and banks’ non-performing loans (NPLs) are about 10 per cent of total advances (compared with 2 per cent in 2010-11) – more than 70 per cent of which are held by public-sector banks.

Before the IBC was introduced, company owners would pressure the banks to keep rolling over their dud loans, or take writedowns, while continuing to cling to their companies. This “extend and pretend” routine went on for years, and NPLs only got worse. There was no smooth enforcement mechanism to enable banks to get their money back.

Now, under the IBC, the balance of power has shifted in favour of creditors, which can file insolvency claims against indebted companies. If the claims are accepted by specially created tribunals, company owners will lose control of their companies, which can be liquidated in nine months if the owners don’t pay up or find a buyer.

The IBC has had teething problems. Big corporate defaulters, such as Essar Steel, which owes more than US$7 billion (S$9.6 billion) to lenders, resorted to litigation to prevent their companies from being taken over or declared insolvent. Some of these cases have dragged on for almost two years – far beyond the nine-month deadline. But the government has kept plugging the loopholes that company owners have been exploiting, and the IBC has started to produce results.

Finance Minister Nirmala Sitharaman said that as of June 30, 475 companies were liquidated and 221 cases were either settled or withdrawn. Average loan recoveries since 2017 are about 43 per cent, compared with 23 per cent from 2007- But the biggest achievement of the IBC has been its impact on corporate behaviour. It has alarmed many indebted company owners who, fearful of losing control of their empires, have started paying off debts and reaching settlements with banks. But that has also meant lower corporate investment, adding to India’s economic slowdown.

Growth also took a hit from another source: India’s non-bank financial companies (NBFCs). These so-called “shadow banks” can’t take deposits but provide funding for vehicle purchases, construction and infrastructure projects. They in turn get funded by banks, as well as mutual funds which hope to make good returns from their loans to NBFCs. But one of the big flaws in these companies’ business models is that they often use short-term loans to fund long-term projects – which can work in good times but can be disastrous during downturns, like now, when borrowers can’t repay.

In September last year, one of India’s largest NBFCs, Infrastructure Leasing and Financial Services, defaulted on some 910 billion rupees of its debt.

This sent shock waves through the credit markets, leading to a freeze in lending to NBFCs, which were then forced to slash funding to vehicle dealers and buyers as well as property developers.

The latter were also hit by another Modi-era reform, the Real Estate Regulation Act (Rera), which was introduced in May 2016. Among other measures, the Rera prohibited developers from diverting money collected from one project to other projects, or other uses.

While this was a sensible move that protected property buyers, it made developers more dependent on NBFCs even for working capital needs – this, at a time when NBFCs were starved of funding.

India’s NBFC crisis, which remains unresolved, has sent the auto, real estate and construction industries into a tailspin, leading to closed car dealerships, abandoned property projects and bankrupted construction firms. It has also dried up much consumer lending, adding to the demand recession that lies at the heart of the country’s economic slowdown.

PALLIATIVES

Caught by surprise by the extent of the slowdown, India’s government has recently rolled out a series of palliatives. The central bank has cut interest rates four times this year, and will probably cut more.

The Finance Minister has announced measures to ease the liquidity squeeze on NBFCs, boost exports, increase

funding for the beleaguered real estate sector, recapitalise public sector banks and merge weak banks with stronger ones.

Many commentators in India say this is not enough. They are calling for a new wave of reforms to fix India’s poor

education system, legal system, obsolete land and labour laws and to cut costs and taxes. These reforms may come – India’s policymakers are wise to them – and will boost the economy’s longer-term prospects.

But in the short term, the government’s priority is to fix India’s faltering growth.

Ironically, this is partly the result of recent reforms, most of which were badly needed. India needed a GST to simplify and broaden its tax base. It needed a new bankruptcy code to cleanse its corporate sector of crony-capitalist practices that threatened its banking system. It needed to protect property buyers from malpractices by unscrupulous developers.

But these reforms, which have created much collateral damage, have come at the price of lower growth in the short term. This is a price worth paying.

Over time, the reforms will pay off. India’s corporate and consumer behaviour will change as people adapt. As a new normal sets in, the economy will gradually recover. The elephant will run again.

Excerpted  from Economic Affairs: The Indian elephant is slowing but it will run again.