As prospects of global economy are mired in pandemic and war, leading to not only supply side disruptions but also an erratic demand recovery, stagflation (low growth, high inflation) has become one of the biggest concerns for most central banks today. Divergent vaccination progress among advanced and emerging economies, inability to cater to pent up demand due to labour and raw material shortage, reduced industry profitability due to high commodity prices are some of the reasons which have contributed to supply side shocks. Demand recovery has been strong but erratic due to multiple waves of infection and the Russia-Ukraine war.

Slowing growth amidst high inflation and record debt-to-GDP levels have become a talking point for many think tanks. Estimating global growth among such uncertainties is daunting.

Despite being bystanders in geopolitics, emerging market economies (EMEs) are likely to be impacted due to spill-over effect. Apart from factors plaguing global growth (supply chain disruption, high commodity prices), growth in EMEs is also facing additional headwinds from the classic capital flight issue - high inflation -> capital outflow -> weakening currencies -> increased debt overhang.

Many are betting on India being uniquely positioned to continue its growth trajectory over the next two years even as global growth slows down. However, with RBI working on its policy mandate to control inflation and having increased repo rates by 140 bps so far in 2022, inability to deliver strong fundamentals to back this exuberance could lead India astray from the growth trajectory.

What does history tell us?

Over the last 20 years, there have been four previous instances when RBI has increased repo rate. These are as follows:

Dot-com bubble (2001): Policy action was to control economic overheating driven by ripple effects of dot com bubble in the US. Headline inflation during this period was low at around 4% and is therefore not comparable to the macroeconomic scenario today.

Real estate bubble (2004-08): Real estate bubble in the US increased global demand of goods. India’s growth was aided by boom in exports which grew from 14.9% of GDP in 2003 to 24.1% of GDP in 2008. In order to control export driven economic overheating and inflation, the central bank increased policy rates (repo rate). Since India was growing at a healthy growth rate of around 8% p.a. over the last 5 years and inflation was demand driven, it is not comparable to the current situation which is plagued by supply side shocks.

Stimulus of 2010-11: India witnessed ‘artificial’ strong post-recession recovery. GDP growth increased from 3.1% in 2008 to around 8% in 2009 and 2010. This was driven by fiscal and monetary policy support provided at the time. Government infused $37.2 billion (3.5% of GDP) while RBI’s excessive and unorthodox monetary easing led to additional liquidity infusion of $112 bn (around 9% of GDP). However, India’s liquidity fuelled growth engine soon faltered as growth dipped to 5.24% in 2011 on account of lower industrial output due to drop in investment and rise in global commodity prices (see graphic below). These supply side shocks coupled with excessive fiscal stimulus increased India’s fiscal deficit to 6.5% in 2010 from 2.5% in 2008 and external debt (as % of GDP) spiked by around 550 bps in 2013 viz. a viz. 2010 (see graphic below). As a result, India found itself dealing with two issues: (i) supply side shock coupled with lower aggregate demand (stagflation-like) and (ii) poor fiscal prudence resulting in a debt overhang. Given that this period was impacted by supply side shocks, it would serve as a benchmark to the current macroeconomic situation.

Image : Amit Sharma

Liquidity pull-back (2018): In anticipation of inflationary pressures, RBI hiked repo rate by 40 bps and cash reserve ratio (CRR) by 50 bps to pull back liquidity from the market. However, since COVID struck soon after, the policy rates were sharply reduced without giving enough time for the rate hike to trickle down. Hence, this brief period of rate hike is irrelevant for this analysis.

How is India placed in the current macroeconomic environment?

With Indian economy in the third straight quarter (Jul-Sep’22) of inflation higher than RBI’s target of 2-6%, the RBI governor would need to explain the reasons for missing inflation target to the Finance Ministry along with the steps that monetary policy committee (MPC) will take to bring inflation down within target range. This means RBI is unlikely to go easy on inflation over the next few quarters. Higher repo rate hurts growth as the cost of borrowing and savings increases which encourages industries and individuals to borrow less and reduce output thereby impeding demand as well as employment (which in turn brings inflation down).

Despite the challenges, expectations from India to sustain around 7% growth rate over the next two years is on account of several fundamental factors which favour India at a time when most other EMEs are struggling.

Domestic demand driven economy: Over the last decade, India has largely transformed into a domestic demand driven economy. The share of net domestic consumption (as % of GDP) has increased from 35.4% in 2012 to 46.5% in 2020 while the share of exports (as % of GDP) has reduced from around 25% to around 20% during the same period. GDP per capita has also increased from $1,444 to $2,277 (2021) at 5.2% CAGR (includes COVID period) which signifies increase in consumption capacity of the population.

Moreover, favourable demographics shield India from global demand shocks as the working age population drives output as well as demand. As of 2021, around 67.5% of the total population (900 million) was in the working age group (15-64 years) which is higher than OCED (Organization for Economic Co-operation and Development) average of 64.7%. India’s working age population is expected to further expand by another 100 million by 2030 – 24.3% of incremental global workforce.

Comfortable external debt-to-GDP ratio: As of June 2022, India’s external debt-to-GDP ratio was 19.9%. It has come down significantly by around 400 bps from the peak of 23.9% in 2014 after India’s battle with high inflation, low growth environment in 2011-13. To provide some context, it peaked at 38.7% in 1991 when India witnessed balance of payment crisis. According to an article by RBI, a non-linear (concave) relationship exists between external debt and GDP growth with maximum growth estimated at external debt levels of around 23.5%. This gives India sufficient room to promote growth by enhancing debt by around 3 percentage points ($90 bn of additional external debt) which was absent in 2011-13.

Right utilisation of government debt: The financial stability report published by RBI talks about India’s high government debt to GDP ratio of 89.4% as of March 2021 needs to be brought down to 66% over the next five years to secure India’s growth prospects. While reducing government’s debt burden is important, but it is imperative to look at how this debt is being utilised – capital expenditure to fuel future growth or revenue expenditure to manage government’s expenses. Over the last 3 years, government has increased the share of capital expenditure (see chart below) which will contribute in improving output (GDP),thereby making higher debt sustainable.

Sustained profitability of India Inc.: Based on RBI’s June 2022 financial stability report, listed non-financial private companies have managed to maintain healthy operating margins despite rising input costs by exercising pricing power and passing on the increased costs to customers.

As of FY22, India’s corporate profit to GDP ratio attained 11-year high of 4.3% and capacity utilisation also picked up to 75.3% above the long-term average of 73.7%. The sustained profitability and high-capacity utilisation signal investment revival which will support economic growth.

Potential challenges that lie ahead for India…

While the above factors bode well for the economy in the medium term, sustaining growth will depend on how India manages some of the structural changes that are taking place in the economy and are independent of current geopolitical issues or tactical policy decisions.

Declining fertility rate: While the current demographic dividend is encouraging, data suggests that India might be at the inflection point as its share of youth (<= 29 years) is likely to decline from 52.9% in 2021 to 42.9% by 2036. Moreover, India’s fertility has declined significantly from 3.24 children per woman in 2001 to 2.18 children per woman in 2021. As India's per capita income increases, the fertility rate will also come in line with other OECD countries (1.59 as of 2020).

Therefore, the healthy domestic demand that we see supporting India’s growth story today will wither in long term as India joins the big boys’ club. To address this, India will have to increase its reliance on export of manufactured secondary goods and services.

While the second chart suggests that exports as % of GDP have declined over the last decade, looking at how the composition of exports has changed becomes important. Increasing the proportion of secondary/tertiary products (high margin products) will reduce India’s trade deficit and substitute domestic demand in the long run.

Over the last 15 years, India’s merchandise export basket has moved from around 60% in traditional mainstays like Agri products, Ores & Minerals, Gems/Jewellery etc. in 2006 to 60% in secondary/tertiary group like engineered goods, petroleum products, chemicals etc. in 2021.

However, the export basket still lacks consumer goods especially electronics ($2 trillion market/year) which needs to be focused upon going forward. While the problem has always been known, the challenge is effective policy implementation which aids electronics manufacturing.

Jobless growth: India’s promising growth has not translated into creation of sufficient employment opportunities which is clearly indicated by declining labour force participation trend over the last decade, from 53.5% in 2010 to 45.6% in 2021. Labour force participation rate tracks number of people in labour force as a percentage of working age population.

Jobless growth has also been the prime contention of former RBI governor Raghuram Rajan. In order to sustain the GDP growth and enter the league of advanced economies, India needs to generate more jobs and stop migration of skilled labour force. Inability to effectively employ the largest youthful population leaves enough potential for a social unrest.

While the government has made efforts, but poor infrastructure, poor education system and job training means degrees are often considered worthless by employers. In large-scale surveys, employers have said that less than half the college graduates entering workforce are employable. Over the next decade, India needs to invest significantly in training its youth and enhancing their skillset to keep up with the technological advancements that the world is undergoing. At the same time, there is a need to promote entrepreneurship, improve business climate and further scale up the share of budgetary capital expenditure to create more jobs especially in tier 2 and 3 cities, which will drive the next phase of growth for India.

Rethinking monetary policy objectives: The central objective of India’s monetary policy is inflation targeting. However, an article by monetary policy department of Riksbank (Sweden’s central bank) suggests that inflation targeting does not take unemployment and production sufficiently into account which is important for EMEs. This raises the need for a dual mandate. The dual mandate will define objectives for price stability along with maintaining sustainable growth and high rate of employment. Such a policy will especially be effective in scenarios where the economy is trying to recover from supply side downturn. While maintaining economic stability is already a part of monetary policy ‘strategy’ for most central banks in OECD countries, but in the absence of a well-defined mandate, policy actions need to be such that price stability is not prejudiced. On the other hand, the US Federal Reserve which follows dual mandate puts the objectives of employment and price stability on an equal footing. Therefore, India’s policy makers need to debate whether having inflation targeting as the sole metric to measure central bank’s success is the best way forward or having a dual mandate works better.

As India completes its 75 years of independence, a lot of learnings lie in the journey that this great nation has undergone. From being an underdog in the pre-1991 era, to becoming a celebrated pillar of the global economy, India has managed to create a launch pad that will drive its next phase of growth. However, breaking out into the league of advanced economies will require not just planning and intent but also addressing the implementation shortfalls that India has been a victim of.

For a diverse nation like India, the essence of growth lies in inclusion which will go a long way in maintaining the secular and democratic fabric that our leaders have carefully woven.

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