Why is India’s GDP slowing down?

The GDP growth rate of India declined to a three-year low of 5.7 % in the March-June 2017 quarter. It was 6.1 % in the last quarter (Jan-Mar 2017).

This is the slowest growth rate recorded in two years and has led India to lose its status as the world’s fastest-growing major economy to China. The economists have attributed this slowdown to Demonetisation and GST.

• Demonetisation was a negative shock to the economy and wiped out 84 % of the cash in circulation overnight. (Read: Demonetisation Explained)
• Uncertainty caused due to GST led to de-stocking of goods ahead of its implementation on 1st July 2017. Manufacturers/ traders were unsure as to the tax impact of GST on the goods that were manufactured/ bought prior to the GST regime but remained unsold. They started destocking or reducing the amount of stock. Hence, the manufacturing slowed down. (Read: GST explained)

This slowing GDP cannot be explained solely by the disruptions caused due to GST and Demonetisation. This is because the GDP has been continuously declining since the last quarter of 2015-16 (Jan-Mar 2016), much before demonetisation was done. (as can be seen from the table.)

There are four constituents of GDP as per the expenditure method. Theoretically, the total expenditure must be equal to the total output of goods and services produced in the economy. (Read: GDP Explained)

GDP = Consumption expenditure + Investment (Private) + Government Expenditure + (Exports-Imports). There has been a slowdown in all of these sectors

There has been a slowdown in all of these sectors

Consumption: Consumption is the main driver of Indian economy. The growth rate in consumption declined to 6.6 % in April-June quarter 2017 (Q1) from 8.6 % in April-June quarter 2016. Part of the reason is that consumer demand was hit as demonetisation caused a cash crunch in the economy.

Investment: Private Investment is measured by the variable Gross fixed capital formation (GFCF). GFCF as a percentage of GDP has been declining for 5 years now. It grew at a rate of 29.8 % in Q1 as compared to 31 % last year. The credit flow to the industry has also slowed down due to the Twin balance sheet problem. (Read: The Twin Balance Sheet Problem Explained).

The Government must take steps to resolve the twin balance sheet problem to effect a strong recovery in the Private investment.

Government: The Government expenditure has also slowed down. There is a little scope to increase it without breaching the fiscal deficit target.

Net exports: There has been an export stagnation and exports grew at 1.2% last quarter. Export is essential to GDP growth.

Structural reforms will have to be undertaken to enable a robust growth in exports by improving productivity. In this regard, the RBI can also intervene to keep the appreciating exchange rate of the rupee in check which has made imports cheaper and exports more expensive in relative terms.

Interest rate: Interest rates are high in India. A rate cut is necessary to make borrowing easier. Theoretically, there is a negative relationship between interest rates and GDP. Therefore, the RBI has to cut interest rates to increase GDP in the economy.

Surjit Bhalla has argued that the cause of the GDP decline is the interest rate policy of the RBI. Inflation is down by 700 basis points since 2013 and the RBI has cut the interest rates by only 200 basis points.

The GDP decline has persisted despite conducive macroeconomic fundamentals namely low inflation, low fiscal deficit, low Current Account Deficit, high foreign exchange reserves, stable currency and steady foreign inflows.

The Government has announced a stimulus package to boost India’s growth. But, the details of the package haven’t been finalised yet.

References:

//indianexpress.com/article/opinion/columns/gdp-growth-inflation-demonetisation-its-interest-rates-stupid-narendra-modi-govt-real-effective-exchange-rate-indian-economy/