Nips 'n' tucks to fix cyclical slowdown

It’s become common practice nowadays to tom-tom the latest high frequency economic indicators as proof of the structural slowdown in India’s economy. According to naysayers, in a developing economy like India, there’s no room for auto or consumer discretionary goods’ sales to slump into negative territory. “India’s economy has a structural problem and the government must stimulate the economy” or so the rhetoric goes. 

The Federal Reserve Bank distinguishes between structural and cyclical changes based on whether monetary and fiscal policies can offset the decline in output and employment (FRBSF Economic Letter dated June 11, 2012). In India what we are currently facing is a crisis of confidence perpetuated by a variety of factors. In our view, the country’s structural fabric is intact and a mix of measures -- partly from ongoing resolutions and partly guided by government action -- can help arrest the current cyclical slowdown. 

Now let us consider a hypothetical economy where credit does not exist and the only way to grow income is when (a) a higher number of people work; and (b) when people work more efficiently. Let’s call it the structural fabric of that nation. Extrapolating these in India’s context we see that labour force participation is about 500 mn and over the next three decades, it is set to add over 200 mn to the working age population (UN World Population Prospects 2019 edition). Clearly, the number of people available to work is rising. Regarding point (b), the creation of hard (roads and electricity infrastructure) and soft (mobile telephony and data networks) assets should boost efficiency. To us, India appears to be on a sound structural footing.

Let us overlay credit on this hypothetical economy. People borrow more when economic activity is booming, eventually going overboard such that debt outpaces income. They essentially borrow from their future self and unless credit is put to productive use, future consumption must be pruned to repay the loans. This deleveraging cycle is accompanied by spending cuts, deflated asset prices and fall in incomes. This is where it gets interesting for India.

Over the past 13 years, India’s end-use of credit has been extremely non-productive. Between 2006 and 2019, its total system credit jumped by about 9x to over Rs 100 trillion. (Total system credit is banking system plus NBFC minus bank lending to NBFC). During the same period, non-performing loans (NPA) catapulted by Rs 11.5 trillion. In a steady-state, banks earn about 2.5 per cent return on assets (pre-tax and pre-provisioning) by deploying 12 per cent of loans as capital. The rise in NPA has wiped off 70 per cent of all banking sector’s earnings for these years or nearly the entire banking system’s capital. This clearly is unproductive use of credit.

The problem has been accentuated by the phenomenal rise and subsequent collapse of non-banking finance companies (NBFC). Between 2014 and 2019, NBFC accounted for 33 per cent of credit growth (13 per cent of system credit in 2014). In 2019, they accounted for 40 per cent of new retail loans and had 56 per cent share of retail loans to new-to-credit customers (FIBAC 2019 annual benchmarking and insights report). The IL&FS default resulted in a freeze in credit markets and NBFC were forced to scale back, triggering an unprecedented liquidity crunch. Systemwide credit has been in surplus for over four months now, but banks have been wary of lending it and NBFC are unable to do so. This has depressed asset prices and created negative wealth effect, which is further impacting consumption.

The bigger question is, what will pull India out of the current logjam? 

We believe, the ongoing resolutions at NCLT and outside it should bring back confidence; banks could start lending to a broader borrower base. Ideally, the government should have accelerated capital spending, but limited fiscal room (taxes may not rise the budgeted 18 per cent risking 3.3 per cent gross fiscal deficit), even after accounting for higher dividend from the RBI, prevents it from doing so. 

The good part is that borrowing rates for top corporates have fallen by over 100bps over the past three months despite limited transmission of rate cuts by banks. Also, the government’s recent demand-boosting move for autos, promise of measures in housing sector and a general ‘we-care’ attitude will definitely help. 

Besides these demand-boosting measures, a lot of feel-good announcements could also help. For example: (i) commitment to fill all vacant government jobs, over say the next one year; (ii) withdrawing litigation outstanding for more than a decade where the government has lost at the tribunal level; and (iii) quickly releasing arrears outstanding at all levels of government/quasi-government institutions. 

A crisis of confidence does not always need more money thrown at it; an assurance that ‘we are here to help’ will go a long way.

The author is a co-founder of Buoyant Capital; tweets @BuoyantCap