RaboResearch - Economic Research

Flat tire or engine failure? How serious is India’s economic slowdown?

Economic Report


Also published on Bloomberg/Quint, January 13, 2020

  • After years of outperforming its emerging market peers the Indian economy has been running out of steam
  • The question is if this slowdown is cyclical or structural in nature. To answer this question we have developed an endogenous supply-side model for the Indian economy
  • We think it will be difficult for the economy to exceed 6% growth in the next couple of years
  • Investment in human capital and innovation is necessary to foster Indian future economic growth. In a scenario where both policies are intensified and implemented, average annual growth would end up a staggering 5ppts higher than in our baseline

After years of outperforming its emerging market peers the Indian economy has been running out of steam. With five consecutive quarters of lower economic growth and the very weak GDP print of 4.5% for fiscal q2, it is safe to say the economy is going through its most serious economic crisis since taper tantrum. The crore rupee question is of course: is the slowdown cyclical or structural in nature? To illuminate our take, we make the comparison between the Indian economy and a moving vehicle. We first conduct a vehicle inspection, review the recent repairs of engineers Modi M.E. and Das M.Tech, and finally, define several options how to enhance future vehicle performance. Our goal is to determine whether India is coping with just a flat tire (i.e. cyclical headwinds) or systemic engine failure.

Vehicle inspection

For vehicle inspection purposes we have developed an endogenous supply-side model for the Indian economy. This model enables us to break down our car into its vital components:

  1. Labor: without people to operate our vehicle, we wouldn’t get very far. The number of drivers is determined by the total people available in India (i.e. the working-age population), their willingness to drive (i.e. participation rates) and how many hours they are able to do so (hours worked per worker). Finally, not everyone that is volunteering to do some driving is able to find a spot behind the steering wheel and is forced to sit in the back (i.e. unemployment). There are also quite a few people driving the car without getting noticed (i.e. the informal economy), but unfortunately we are not able to consider their contribution in our inspection.
  2. Capital: to get a car running, one of course needs a set of wheels, an engine, a chassis, bodywork and a windshield. Moreover, software and IT hardware needs to be installed, e.g. GPS, an electronic braking system or air-conditioning. And external capital is important: infrastructure, traffic lights, etc.
  3. Total factor productivity (TFP): this indicator measures engine efficiency, as TFP is an indicator of the level of technology in the broadest sense of the word. For instance, people without a driving license (i.e. human capital) can try to get the car moving, but this might prove difficult if they don’t know how to operate a clutch. Moreover, TFP is dependent on foreign knowledge to enhance the performance of the car (i.e. foreign knowledge spillovers), which generally finds its way India via foreign direct investment (FDI). Of course, Indian engineers need sufficient knowledge themselves in order to use and integrate foreign knowledge to enhance the Indian car; so absorption capacity is very important. Another factor of importance is quality of regulation (i.e. institutional quality), which enables safe travels. We refer to this report for a complete overview of all determinants of TFP in our model.

What are the current vehicle specifications?

Figure 1: India’s structural growth rate is not expected to exceed 6%
Figure 1: India’s structural growth rate is not expected to exceed 6%Source: Rabobank, Macrobond, Penn World Tables, various sources

Based on our vehicle inspection, we think it will be difficult for the economy to exceed 6% growth in the next couple of years (Figure 1). Keep in mind that Figure 1 does not illustrate Rabobank’s official economic growth forecast for India, but shows our assessment of India’s growth potential, which is stripped of cyclical movements.

If we take a closer look at the underlying components, we expect that labor contribution will be limited to 1 percentage point (ppts) in the next couple of years due to unfavourable trends in participation rates. And although these participation rates are likely to recover over the course of time, in the medium term India won’t be able to benefit from its population dividend the way it did in the past. Growth of the working-age population exceeded 2ppts in the previous decade but has already declined to less than 1.5ppts. So population growth will not drive the Indian economy as it used to.

We adopt a relatively optimistic assumption that capital can contribute to GDP growth by 2ppts to 2.5ppts on an annual basis. If, however, India’s unresolved balance sheet issues weigh on investment (as India’s former Chief Economic Advisor has argued), our capital deepening scenario might be too optimistic and annual economic growth could end up somewhere around 5% on average.

The repairs by engineers Modi and Das

Engineer Modi has been working around the clock to patch up the clapped out car. Measures that for instance have been taken are the renewal of the government vehicle fleet, the launch of the Pradhan Mantri Kisan Samman Nidhi scheme of INR 750bn, the merger of ten state-owned banks into four entities, and finally the significant cut in corporate tax rates. With a contribution of government consumption of 1.9ppts (the quarterly average over the last five years was 0.8ppts), the government’s hand could already be seen in the GDP print for fiscal q2. And we do see some green shoots in high-frequency data as well, such as private consumption indicators, PMIs and a recovery of the external sector. However, from a more structural angle, engineer Modi has only spent limited time and resources on modifying more fundamental parts of the car (e.g. land and labor reforms). The problem is that Rajya Sabha (India’s Upper House) has refused to provide him with the tools to make these adaptations. And although Modi’s NDA seems to be on course for a majority in Rajya Sabha by late 2021, it remains to be seen if he is willing to pick up the tools needed to refurbish the car.

Engineer Das’ nitroglycerin boost had little impact

Figure 2: A broken transmission mechanism
Figure 2: A broken transmission mechanismSource: Macrobond, RBI, Rabobank

Meanwhile, engineer Das M.Tech added 135 basis points of nitroglycerin (in the form of policy rate cuts) to the fuel tank in 2019. Unfortunately this failed to kick-start the engine, mainly because the transmission to the engine had broken down due to a ruptured fuel pipe (Figure 2). This rupture was partly caused by the government itself, tapping fuel from the car to plug its own (fiscal) deficit.

Indeed, one reason why the RBI’s aggressive cutting cycle has not translated into lower lending rates is that commercial banks are increasingly competing for savings with the government’s small savings scheme (SSS), which generally offer a higher deposit rate (8%) than commercial banks (roughly 7%). In the current fiscal year, SSS raised 10% of net time deposits raised by commercial banks, which explains why banks are reluctant to lower lending (and deposit) rates, as this would definitely increase switching behaviour by clients. So unless the government fixes the fuel pipe rupture, actions by engineer Das to get the fuel (i.e. credit) pumping again are likely to be in vain.

How to enhance performance?

So what options are left? Money for new repairs has been depleted and both engineers basically did everything within their reach to revive short-term growth. Which is why it’s important to shift the focus to the medium- and long-term and start rebuilding the fundamentals of the car. We already touched on the need to tackle land acquisition issues and labor market rigidities. But there are many more challenges: ongoing woes in the banking sector, inefficiencies in the F&A sector and problems on the housing market.

Alongside these reforms, India needs to focus on enhancing the technology of its car. The car currently is running on a heavy capital-intensive engine which is burning a lot of fuel. Adopting more enhanced technologies and at the same time switching to an electric vehicle or a cost-efficient hydrogen-powered one would not only crank up the vehicle’s performance but would also be less damaging to the environment.

How to achieve this? As 2018 Nobel Prize winner Paul Romer already argued back in 1990: start educating those engineers! Improving the level and quality of the labor force would not only enable India to adopt more advanced technologies from abroad, but ultimately is the sine qua non to generate global cutting edge innovations in all sorts of technological areas on Indian soil. There is still plenty of room to enhance human capital, as many emerging market peers are doing much better (Figure 3). And of course, it is unlikely that a human capital agenda would raise much political resistance in Rajya Sabha.

The gains, are substantial according to our calculations. Raising human capital towards levels that South Korea was able to realise in the 80s and 90s would already push growth well above 9% (see Figure 5). If India were to launch an innovation agenda as well it would create opportunities for FDI. Both elements are important to benefit from foreign knowledge spillovers which would significantly increase productivity in India. In combination with the Korea human capital agenda, these policies would boost economic growth in the second half of this decade towards 12% (Figure 4).

The policies described above need time to feed into the economic system: our model shows that a human capital impulse takes four years to result in higher economic performance. So, policymakers: put on your boiler suits and start implementing those policies as soon as possible.

Figure 3: Start educating those engineers!
Figure 3: Start educating those engineers!Source: Penn World Tables, Rabobank, Macrobond
Figure 4: Growth over 10% not possible? With the right policy it is
Figure 4: Growth over 10% not possible? With the right policy it is Source: Penn World Tables, Rabobank, Macrobond
Hugo Erken
RaboResearch RaboResearch Netherlands, Economics and Sustainability Rabobank KEO
+31 6 2223 1650

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