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Growth Recession: J curve of Institutional Reform

26-Feb-2020Arvind Virmani

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This paper analysis the collapse of GDP growth in 2019-20, tracing it to institutional changes introduced between 2014-2019. Though many of these changes are designed to improve the efficiency, long term productivity and equitable growth of the economy, they have negative effects in the short term, which we term the “J -curve of Institutional Change”. Awareness of these potential negative effects and preemptive policy actions to address then can help minimize them. The paper also offers policy suggestions on how to address them, now that they have already occurred, along with suggestions to accelerate growth.

1. Introduction

India’s economic growth (GDPMP at 2011-12 prices) reached a peak of 8.9% in fourth quarter of 2017-18, close to the previous peak of 9.3% in first quarter of 2012-13. Since then the growth rate has declined steadily for six quarters to reach 4.2% in Q2 of FY 2019-20 (Figure 1). The downward break in growth during 2019-20, was somewhat surprising as Quarterly (yoy) growth in fourth quarter of 2018-19 at 5.8%, was only marginally below trend. Till Q4 of 2018-19, the decline of 3.1 per cent point in GDP growth rate, closely mirrored the four-quarter, 2.9 per cent point decline in Growth rate from the previous peak of 9.0% in 2015-16 Q4 to 6.1%in Q4 of 2016-17. Though some macro-economic analysts predicted a decline of growth in Q1 of FY2020 and/or H1 of FY 2020, none predicted the extent of the decline.[1] To that extent there was no domestic or external shock like the Global Financial crisis in 2008, that could be linked directly and obviously to the crisis. This paper explores the underlying causes and reasons for the GDP growth deceleration, with a view to deriving policy solutions that can reverse the decline and put GDP growth firmly back on a trend growth of 7.5% to 8%.

Several Institutional reforms were introduced during 2014-15 to 2018-19. One of the most important institutional changes that have occurred since 2014 is what may be termed the Campaign against “Black money” or against Corruption. The origin of this campaign was the public & political perception of an increase in Governmental corruption in Delhi which started in 2009 by filing of a PIL in the Supreme Court by lawyer Ram Jethmalani on unaccounted money in foreign tax havens, and crystalized in the Anna Hazare movement in early 2011.[2]This perception heightened during 2010-2014 as details emerged on possible distortions in policy decisions (e.g. Spectrum auctions, Coal leases, Air India’s rights as National airline, lending by Public sector banks). Black money is traditionally also linked to tax evasion and corruption in the tax bureaucracy, and in corruption in Govt expenditures, programs and project of the Government and with investment in land and Real Estate. The 2009 PIL and the 2011 Protests and agitations against corruption, came to a head when the previous govt was defeated in the election and the Supreme Court Ordered the Union Government to set up a Special Investigative Team (SIT) on Black money.

India has long been a Dual economy characterized by a Documented and an Undocumented segment. The former is referred to by different names like, Formal, Organized (Corporate/Govt-Public Sector) and is relatively large scale, modern (manufacturing, mining, rail & air transport, Hotels, financial services, Utilities). The latter is referred to as Unorganized or Informal Sector and is characterized by relatively smaller firms (SSI, traditional Household enterprises) and is predominant in Real Estate & construction, wholesale & retail trade, minor minerals, road transport & services, Restaurants& traditional hotels, Agriculture. It is also characterized by fewer Government controls and regulations and lower voluntary tax compliance. As the line between the Black and Grey economies is opaque and diffuse, the overlap between the “Black” and “White” economies can be considered as the Grey economy. The fruits of tax evasion and corruption in the “White” economy, usually enter the “Black” economy and Black money is often converted into white through various Grey channels (Virmani (2002)). Since the liberalization and reforms of the 1990s the Grey or Multi-colored may have expanded, consisting of dark areas of the White economy [Public Sector Banks and Financial institutions, Unregulated or partly regulated elements of Finance (e.g. ND-NBFCs), and Public-Private-Partnership Infrastructure, Professional services] and elements of Black economy trying to service the formal economy (e.g. sales & service of large firms).

Figure 1: Quarterly Growth (YoY) of GDP and GVA at constant 2011-12 prices

Source: Authors calculations, based on National Accounts Statistics

The central thesis of this paper is that economic and institutional reforms designed to eliminate corrupt practices, increase the costs of corruption and tax evasion and reduce the size of the Black & Grey economy have, in the absence of sufficient incentives to stimulate the economy, have resulted in a collapse in Growth. To put it a little differently the downward pressure on the Black economy has not been compensated by sufficient incentives to induce a shift into the White economy, resulting in an overall deceleration. Changes in Monetary policy Institutions,[3] such as Inflation targeting, MPC, regulatory tightening) acted as negative shocks for the real economy; A sharp tightening of monetary policy and Banking-Financial regulations, interacted with a legacy of loose monetary policy and regulatory forbearance, to amplify the downward part of the J curve of institutional change.

The solution therefore lies in incentivizing the formal economy and slowing/halting any further measures against the black economy till growth is restored to its earlier levels. Macro-economic factors which have had a net negative effect on the white economy and regulatory changes that triggered the collapse, will also have to be addressed to accelerate the restoration of growth. Otherwise the J curve effect of institutional changes is likely to be much more prolonged than the J curve effect of policy reforms.

Virmani (2009, 2012) proposed the, “J curve of Policy reform”, also termed the, “J curve of Growth & Productivity”, to explain the lag in response of GDP growth to the major policy reforms during the 1990s, by analogy with “J curve of Trade”. In this paper we explore the nature and lags in response of Economic Growth to institutional reforms, what one may term the “J curve of Institutional Reform”, by analogy with the earlier one. To recall the definition given by Nobel Prize winning economist, Alfred North, “Institutions are the humanly devised constraints that structure political, economic and social interaction. They consist of both informal constraints (sanctions, taboos, customs, traditions, and codes of conduct), and formal,” including laws, & rules. Economic Policy reform is often also closely linked to Economic laws, rules and procedures and the economic institutions which implement these laws, so in some cases policy reform and institutional change are two sides of the same coin.

Another, more conventional explanation for the Growth slowdown is that the Design of Policy and the Timing and Phasing of policy reforms, which is critical for maximizing its benefits and minimizing the collateral damage, was poor. The reform of the monetary policy framework had been under discussion for a decade, but its design did not take account of the limits imposed by the underdeveloped, incomplete, fragmented and dualistic financial system, in which, (1) transmission of repo rates was slow and incomplete, even to the formal economy, (2) Monetary & Credit instruments were still needed to speed transmission through the formal financial system & propagate its effects to the informal economy, (3) There was inadequate good quality data to construct forward-looking forecasting models for effective use of policy tools that act with a lag of 1-2 years. (4) Growth fluctuations were still driven by supply factors like monsoon rains. (5) A dual mandate, like that of the US Fed, which may have been more appropriate (given point 4) wasn’t considered.

Consequently, the introduction of Inflation targeting starting in 2013-14, led to large, sudden, shift from lose money to excessive tightness. This was accompanied by stricter regulatory norms and a tightening of their enforcement was which shocked the entire financial system, by exposing, hidden NPAs. The independent introduction of a much heralded and essential, Bankruptcy Code (IBC), resulted in a further tightening of the Credit system as the effects of these measures, propagated into the non-banking companies (NBFCs), resulting in a boom & bust (bankruptcy). The interactive effects of these policies was-not accounted for in the timing and phasing of their introduction. Nor was the interactive effect of these policies with Fiscal (FRBM) and Tax policies (GST, Income tax increases) considered.[4]

The next section provides the Economic Background and legacy of past actions and inactions from 2009-13. Section 3 outlines the Institutional changes and reforms since 2014. Section 4 provides a data-based analysis of the assertions made in section 3 and explores the consequences. Section 5 provides policy solutions for dealing with Growth recession and exploiting opportunities for accelerating growth back to its full potential. Section 6 concludes the paper.

2. Economic Background & Legacy

The economic reforms of the 1990s &early 2000s reached fruition in the mid-2000s. These reforms, aided by a favorable global environment, lead to the fastest growth that Indian economy had ever seen (8.8% during 2003-4 to 2007-8)[4]. When the Global Financial Crisis struck in 2008, GDP growth collapsed in H2 of 2008-09, to 1/3rd to 2/5thof the average. Economic growth was quickly restored in FY10, to its earlier range (8.5%), through a combination of fiscal, monetary and credit measures.[5] Left-Socialists in and outside UPA became over optimistic about the Indian economy, assuming that enough had been done to raise the growth rate of the economy permanently to the 7.5%-8% range and it was time to reorient govt policy sharply towards Social Welfare schemes and Projects,. Macro policies therefore reverted to the philosophy of the 1980s, including fiscal expansion to fund low quality social schemes, loose monetary policy and telephone banking through the Public Sector banks. Growth was pumped-up during the next two years (FY11, FY12), to an unsustainable average of 7.6%per annum.[6]Corruption allegations reached many sectors of the economy in the Union list, which were earlier relatively free from corruption. Ever-greening of NPAs in Real Estate & Infrastructure became endemic and, as a result, there was danger of another Balance of Payments Crisis (BOP) crises in 2012. Growth subsequently (FY12 & FY13) collapsed to an average of 4.9% per annum.[7]

A clear shift in approach was heralded by the Bureaucratic-Socialist policies and approach of the Sonia Gandhi led National Advisory Council. This included the Right of Children to Free and Compulsory Education (RTE) Act, 2009; National Food Security Act, 2013 (Cereals); The Right to Fair Compensation and Transparency in Land Acquisition, Rehabilitation and Resettlement Act, 2013and the Companies Act, 2013(w/o Bankruptcy provisions).In each case some weakness in approaches& procedures raised by Economic reformers, distorted by 1980s style Bureaucratic Socialists, into a Bureaucratic Control nightmare. Not surprising the Corruption associated with 1980s Bureaucratic Socialism returned with a Vengeance, and for the first time became as visible in the Union Government as it had been in the States. This led to a counter reaction. A Public Interest Litigation (PIL) was filed by Jethmalani, Divan & Gill (+3) in 2009 on Black Money in foreign banks.[8] Based on this PIL the Indian Supreme Court Ordered the setting up of a Special Investigation Team (SIT) in July 2011. In the mean-while Shri Anna Hazare went on a protest fast in April 2011 and launched an agitation demanding the introduction of the long pending Jan Lok Pal Bill.

The FRBM which expired in 2008-9 and was deliberately held in abeyance to restore growth in 2009-10 was not re-introduced by the Government in 2010-11 or in next 3 years. After the financial Crises hit the Indian economy in August 2008, automatic stabilizers were given full play, the agriculture loan write-offs which had been introduced in the 2008-09 budget at the last minute were accelerated to put income in the hands of farmers and indirect taxes were reduced in the 2009-10 budget to provide a fiscal stimulus to the economy. The Central fiscal deficit therefore rose to 6% of GDP in 2008-09 and 6.5% of GDP in 2009-10. The Post-GFC Fiscal stimulus was not reversed after restoration of GDP growth to normal in 2010-11. Despite a windfall from spectrum auctions in 2010-11 the fiscal deficit averaged 5% in the next four years, 2% points above the FRBM limit of 3%. Anti-reform tax measures, like retroactive taxation and taxation of unrealized capital gains of Startups as accrued income, were introduced, which undermined the incentives for FDI and entrepreneurship.

The Monetary – Credit Policy, which was consciously loosened During September 2008 to 2009, with the real repo rate reduced to negative -6.8 in FY10, to keep the economy from collapsing under the global financial shock. However, it remained relatively loose after the crisis had passed, with negative real repo rates of -2.7%, real monetary (base) growth of 8.3% and Real Bank Credit growth of 10.1% per annum during FY11+FY12. Public Sector Bank (PSB) credit, which had expanded in real terms at almost double the Growth rate of GDP during the boom of 2003-2008 rapidly turned risky, as growth collapsed in FY13 (average 4.9% for FY13+14). This was compounded by the earlier forced-lending by Public Sector Banks for ‘Public Goods Infrastructure’ and the rapid return of Telephone-Banking (after relative decline in 1991-96)[9], particularly with respect to ever-greening of Real Estate Loans.

A combination of excess demand and supply constraining policies resulted in a bubble followed by bust. Inflation rose to a peak of 16.3% in January 2010 and remained high for the next three years, reaching a sub-peak of 12.6% in November 2013. The Current Account Deficit (CAD) worsened to -4.3% of GDP in 2011-12 and further to -5.2% in 2012-13, reaching a trough of 7.3% in Q3 of 2012-13. GDP growth was therefore on steroids during this period (despite high oil prices), building up Non-performing assets and unrecognized Fiscal problems beneath the surface. Some Macro control was established by bringing the Fiscal deficit down to 4.9% in 2012-13 and 4.5% in 2012-13, from 5.9% in 2011-12 & tightening monetary policy by raising real repo rates to -2.0% (from -2.7% in FY10-11)), and contracting real money supply by -2.4%(from 8.3%), this reduced the Current Account, despite a bank credit real growth of 6.0% (down from 10.1%).

India’s Net International Investment position worsened from a pre-Global Financial Crisis (GFC) trough of -8.4% of GDP in Q1 of 2007-8 and a post GFC level of -10% of GDP in Q3 of 2009-10, to -21.8% by Q1 of 2014-15.[11]

3. Institutional Change & Reform: J curve

Several steps were taken in 2014-15 and 2015-16 to address the weakness in the Economy, which started surfacing with the growth slowdown during 2012-13, 2013-14, starting with the breaking of Policy Paralysis (Administrative-political gridlock in decision making) and the announcement of economic reforms.

Policy related Corruption was addressed though several policy and institutional changes: Auctions were introduced for Telecom Spectrum, Coal and Minerals. De-control of petrol and diesel prices and switch to direct transfer of LPG subsidies are structural reforms that will have long term benefits. The Government moved quickly to moderate the inflation in cereals prices, by selling grain from stocks, which were 2x to 3x levels recommended by earlier Technical Committees on Buffer Stocking. It also supported and implemented the CAACP’s recommendations to moderate the pace of MSP inflation, which was driving food/agriculture prices. A unified National Agricultural E-market was initiated. Central Govt. encouraged States to liberalize labor exit policies, promising speedy approval of legal changes that required Central Government approval. Rajasthan, Madhya Pradesh and other States have already taken advantage and observed an acceleration of employment growth.[10] LPG subsidy was rapidly linked to Aadhar and paid through bank accounts. Universalization of bank accounts through the Jan Dhan scheme is also being seeded with Aadhar.

There are, however, three broad sets of institutional changes, which laid the ground for the current slowdown: The Campaign against Black Money, Change in Structure of Monetary policy and Financial Regulation Institutions & Governance and Fiscal Policy approach.

3.1 Black Economy

The campaign against Black Money started soon after the formation of the new Government at end May 2014. It was focused on accumulated of untaxed Asset in the form of undeclared foreign holdings and Bank accounts, domestic Real Estate and cash holdings, moving progressively from the first to the third.

A Special Investigating Team (SIT) on Black Money was notified by the Union Government in June 2014, under the direction of the Supreme Court of India.[11]Several other changes in laws, rules and procedures directed at the holdings of “unaccounted assets (black money)” followed. Prominent among them were, the, “Black Money (Undisclosed Foreign Income and Assets) and Imposition of Tax Act, 2015, in July 2015, [12] the “Real Estate (Regulation and Development) Act 2016(RERA)”in May,[13]the “Benami Transactions (Prohibition) Amendment Act, 2016in November 2016,[14] and culminating in the Demonetization on November 8, 2016.

By definition of Black Assets, it’s very difficult to get direct evidence on the effect of these measures on Black Economy.[15]The best available indicator is the trend in Housing Prices, particularly those in Delhi, Mumbai the financial capital and the other metros Calcutta, and Chennai. The index of House prices in Delhi, adjusted for general inflation, have clearly flattened out since Q4 of FY2015 (Figure 2). The trend growth of House prices has also declined at all India level and in Mumbai, Calcutta and Chennai. Real house prices have decelerated all India (average) from 8% during 2010-14 to 4.7% per annum during 2014-19, decelerating from 15% to 4.9% in Delhi, from 8.3% to 4.9% in Mumbai, from 14.4% to 4.3% in Calcutta and from 8.3% to 4.3% in Chennai. One of the implications of the reduction or elimination of the black premium in house prices is a wealth effect on private consumption demand in the black economy.

Another indicator of Black money is Gold purchases. As there is little production of Gold in the country, import of gold in USD, is a good measure of Gold purchases. Figure 3 shows that gold imports jumped sharply during FY11, FY12, FY13 during the period in which corruption allegations ballooned. It then dropped sharply in FY14 below its long-term linear trend. It has since flattened out completely during the period in which the anti-corruption campaign picked up steam and has not grown since, remaining in a narrow range since (figure 3).

Digitization of the economy, which started in the 2000s has continued, with rate of growth (as measured by the log difference) continuing at a steady pace, with some disruptions. This includes the spread of Point of Sale terminals for credit and debit cards and the Volume and value of card and mobile banking payments. Mobile banking volume is one of the few modes of payment, which has shown an acceleration in the rate of growth in last few years, though the rate of growth of the value of transaction has declined. This suggests that mobile banking is spreading to rural and poorer areas where transactions value is smaller and the density of banking facilities is lower.

Figure 2: Quarterly Index of Real House Prices (using all India CPI as deflator)

Source: Calculations based on House price index from RBI Data Base

It was assumed by many observers that the suppression of the black economy would lead to a shift of economic agents to the white economy. This has happened to some extent as evidenced by the increase the number of potential taxpayers voluntarily filing income tax returns. The volume of However, the other assumption that the increase in the White economy would more than offset the decline in the black economy has been belied, creating downward pressure on overall GDP growth.

Figure 3: Gold Imports (US$ mi)

Source: Authors calculation based on DGCIS data obtained from RBI data base

3.2 Financial Policy & Regulation

The monetary policy framework and the framework for Non-performing loans & debt default, has been transformed during 2014-19 (FY15-19). This includes the setting up of a Monetary Policy Committee, tightening of Bank NPA regulations and the passing of the IBC.

The new Companies Act missed a golden opportunity to introduce bankruptcy provisions to facilitate the exist of non-performing promoters and companies. Fortunately, this was rectified by the incoming government, by one of the most important reforms of the decade, the passing of the “Insolvency and Bankruptcy Code (2016)in May 2016.[16] This law (IBC) represented a major change in the exit policy for Companies and in the legal framework for recovering & resolving Non-Performing loans (NPAs). We hypothesize that, like the J curve of Policy Reform, Productivity & Growth,[17] there is a J-curve of Institutional Reform and Growth. When a major institutional change like the IBC is legislated, and the rules regulations and procedures to implement it are under construction, there may be an initial worsening of economic growth and productivity as the system learns and adjusts as do the economic agents affected by it. Thus, productivity may decline initially, before gradually recovering and exceeding earlier levels and helping accelerate Growth. The situation can become even more complicated, when there are other institutional reforms causing collateral damage to the financial system and the economy.

A new RBI Governor, who had previously recommended the introduction of Inflation targeting, was appointed in August 2013. He immediately set out to lay the grounds for introduction of such a framework, while introducing elements of inflation targeting into the RBIs processes and procedures and his own monetary policy decisions.[18] A formal transformation of the Monetary policy framework took place in June 2016. The informal system, controlled by the RBI Governor, was replaced by a formal system of Inflation targeting and a Monetary Policy Committee (MPC) was set up to implement it.[19] A target of 2% to 6% CPI inflation was set (4%+/- 2%), with the MPC, headed by Governor, mandated to achieve it. This resulted in a sharp tightening of monetary policy, with the rise in the Real repo rate from -2.0% in FY13+FY14 to +1.9% in FY15+FY16 and further to an average 2.3% in FY17-FY19. This was accompanied by heightened volatility in base money growth.

The regulatory system for Banks was simultaneously tightened, particularly for Public Sector Banks (PSBs) which were known to have accumulated hidden NPAs as a result of forced lending to Infrastructure and “Telephone Banking” practices. The implementation of existing norms started from 2015-16, with the declared NPAs of Public Sector Banks jumping from 5% on March 31, 2015 to 9.3% on March 31 2016, led by an increase in Nationalized Bank NPAs. A Prompt Corrective Action (PCA) framework for (Public Sector) Banks was introduced in April 2017(revision).[20] Real Interest rates rose, Real Credit growth declined progressively and Base Money growth Very volatile-amplifying risk instead of reducing it! An unanticipated consequence of all these actions was to worsen the Bank NPA problem, lead to a substitution of NBFC credit for Commercial bank credit, leading to a default by the ILF&S and triggering a further decline in GDP growth.

3.3 Fiscal Policy

From the first budget for 2014-15, the Government announced its intention to control the Fiscal Deficit, with an initial step of reducing the gross fiscal deficit from 4.5% of GDP in 2013-14 to 4.1% of GDP in 2014-15. The Fourteenth Finance Commission was tabled in Parliament on February 2015.[21] It implemented the Finance Commission’s recommendation of a record 10% increase in the devolution from 32% to 42%. It re-iterated the 3% targets of the FRBM, but also gave an option for setting Debt/GDP ceilings to replace the GFD/GDP targets. The govt adopted the fiscal recommendations of the 14th FC and started implementing them from 2015-16 budget. An FRBM review Committee was set up in 2016 and its report submitted in January 2017.[22] Further actions followed in 2017-18 budget, and the, “Fiscal Responsibility and Budget Management (amendment) Act, 2018” was passed in April 2018.[23] One consequence of all these institutional changes on the fiscal front was to discipline the Union Govt. Given the initiation of new expenditure programs, it pressured the Government to raise tax revenue collection. Consequently, the promised introduction of Corporate Tax reform was delayed and stretched out. A Long Term Capital gains Tax was introduced. A number of new Cesses& surcharges imposed. Each measure was driven by the goal of bridging the shortfall of tax revenues from targets set for achieving the glide path of the Central Fiscal deficit. A reduction of Personal Income tax rates was not enough to offset the negative effect of these measures. The surcharges imposed in 2019-20, triggered a loss in confidence and a GDP Growth decline in Q1 2019-20.

The Constitutional amendment to replace 10s of Union and State Indirect taxes by the Goods and Services Tax (GST) was the most important economic amendment of the constitution since its promulgation. A GST council with representation of all the States was created to take major decisions relating to the GST. In the effort to get approval of this major constitutional amendment, the need for creating a professional advisory group to analyze economic implications of alternative tax structures and suggest efficient design was neglected. Consequently, the GST introduced on April 1, 2017 was highly complex, difficult to comply with, monitor and enforce. Even today, there are 10 different rates cum surcharges/cesses, 25 different rates of Compensation Cess and over 25 different types of exemptions.

As a direct consequence of this complexity, piecemeal efforts to simplify it, and adapt rules and procedures, revenue estimates have fallen short of targets. The Unemployment rate, which had continued to decline after de-monetization despite a fall in GDP growth during H1 of 2017, reached a trough of 3.4% in July 2017, and rose progressively to reach 5.8% in March 2018 and 7.1% in March 2019 (~= to October 2016 rate).

Other reform measures such as Aadhar linked Direct Benefit Transfers and subsidies for LPG were also introduced to reduce leakages and attain more effective targeting of Government expenditures. The effect of all the reforms in Fiscal Deficit, Expenditures, GST and Income tax initially had a positive effect on animal spirits; the earlier Euphoria was followed by a loss of confidence, as the J curve of GST complexity became apparent, in the form of low revenue growth. The experience of 10s of countries which have introduced simple single rate or few rate VATs with limited exemptions, shows that the J curve effect of the introduction of the GST would have been far smaller if a simple rate structure had been introduced from the beginning.[24]

4. Economy in FY 2020

GDP growth averaged 7.1% per annum during 2012-13 to 2018-19. GDP Growth declined by (-) 0.3 per cent point to 6.8% in 2018-19 and then collapsed by -2.3 per cent points to 4.8% in H1 of FY20 (Table 1). From the demand side the greatest contributor to the collapse of GDP in H1 of FY20, was Gross Fixed Investment followed by Private consumption. Part of the collapse was a base effect, with both Private consumption and fixed investment growth having accelerated in 2018-19 above the average growth during FY13-18. The collapse occurred despite an increase in Net exports (exports-imports), after a decline 2018-19. The increase in Government consumption in H1 FY20, was insufficient to offset the decrease in private demand (table 1). On the supply side the main driver of the collapse was the deceleration in Manufacturing by -7.7 per cent points (from FY13-19 average) to -0.25%. The deceleration was broad based, with the significant exception of GDP from Construction (Table 1). This suggests that the decline in investment was driven by investment in machinery and equipment and likely relates to a loss in confidence.

The effect of the Global situation has been to make international Trade a dampener of growth during FY13 to FY19 with an average growth of Net exports of Goods & Services of -28.4 i.e. Imports net of exports grew by 28.4% (simple average; table 1). Many economists have attributed this to an overvalued rupee. Though the REER (RBI 36 country) appreciated by an average 1.2% per annum from FY13 to FY18, it depreciated by 4.4% in FY19, correcting most of the overvaluation as measured by this indicator. Consequently, the situation has reversed in FY20 with Net Exports of Goods and Services increasing by 23.2% in H1 of FY20. The collapse of GDP growth in FY20, cannot therefore, be attributed directly to external conditions, even though it had a negative effect on GDP growth during FY13 to FY19.

Table 1: GDP Growth and Contribution to Growth

Source: Authors calculation based on National Accounts Statistics, DOS, GOI, base 2011-12.

The IIP for manufacturing shows that the decline in H1 of FY2020 was very broad based, with only a few exceptions like Basic metals, Pharma, Other manufacturing, Tobacco & food products and wearing apparel, with the first three recovering from a decline in FY2019 (Table 2). Of the 2.3% decline in IIP during H1FY20 manufacturing contributed 1.9% points. In broad sub-categories, 1.3% was due to consumer durables and 1.1% due to capital goods. Consumer non-durables in contrast recovered from a decline in FY19, except for Textiles & Furniture, while decline in Capital goods production was sharp and broad based (Table 2). Within manufacturing Motor vehicles contributed 1.05% points, with a decline of (-)14.7% in July 2019 (yoy) and the index reaching a trough of 93.2 in October 2019, a level of production close to previous troughs of 90.9 in December 2016, 91.8 in November 2015 and 89.4 in November 2012.[27]

Table 2: Index of Industrial Production (base 2011-12): Growth Rate

Source: Authors calculations based on IIP data from Ministry of Industry

4.1 Monetary Policy Tightens Sharply

The change in Monetary policy regime is starkly revealed in Table 3, with real interest rates on Repos, one-year Govt Securities and Call Money all changing from negative during FY09 to FY14 changing sharply positive during FY2015 to FY2019.The increase in real rates from FY2014 to FY2015 was 3.2% for Govt Securities (1-year) and 3.5% for bank loans. But this was not the end of the tightening. Real rates continued to rise till FY2019 increasing by 0.4% for Bank credit and by 1.4% points for one-year Government Securities, driven by a further increase of 0.8% in Real Repo rates. The Transmission rate from Repo rates to loan rates, however fell sharply to~0.4from ~ 0.9%. The rising trend in real rates and the tightening of Bank NPA norms has been accompanied by a decelerating trend in Bank Credit to Commercial sector (Figure 5). Real annual non-food credit growth decelerated from an average of 6.6% during FY09 to FY14 to 4.8% during FY2015 to FY2019, driven by a deceleration of 10.3% points in credit to manufacturing and 17.9% points to infrastructure. Real Credit growth to Construction, Housing and personal loans however accelerated, offsetting some of this deceleration (Table 3: BCCS =Bank credit to Commercial sector).

Table 3: Real Credit growth & Interest Rates (%)

The tightening of NPA norms for Scheduled Commercial Banks was reflected in the sharp rise in declared NPAs on audited balance sheets, which rose sharply from FY2016 to FY2018 before plateauing out in FY2019. Declared NPAs of SCB increased from 4.3% in FY2015 to 7.5% in FY2016, 9.3% in FY2017 and 11.2% in FY2018. Most of this driven by the increase in NPA’s of Public Sector Banks from 5% in FY2015 to 14.6% in FY2018 (Table 4).


Source: RBI database

The NPAs of Public sector Banks (PSBs) are on average 3 times that of Private Banks during FY2016 to FY2018. This additional NPAs can be attributed to a combination of inefficiency and corruption associated with PSBs.[25]

As Non-Bank Financial companies (NBFC(D)s were not the target of the tightening norms, they borrowed from the debt markets as well as the Commercial banks, to increase their lending to Households at an average annual rate of 21% during FY14 to FY18. The Credit was directed towards real estate developers as well as household borrowing for housing, autos and other Household purchases. The default of IL&FS in FY19 heightened uncertainty, risk perception and risk perception relating to all financial institutions including Co-operative Banks. The systemic effect of IL&FS default on other NBFCs, led to a collapse of NBFC credit by 30-40%. By September 2019, however, NBFC credit was back in positive growth territory. Given the peaking of the Scheduled commercial Banks NPAs at 11.2 by 2017-18and decline to 9.1% of GDP in 2018-19 (Table 3), they stepped in to fill some of the gaps, as reflected in the acceleration in real credit growth above the trend in figure 3 and 5.4% (5%) point acceleration of growth in FY19 above the previous four-year average (Table 3). However, overall credit growth remains subdued in FY20 because of the clogging of credit channels due to uncertainty and heightened risk aversion, despite actions taken by the Government with regards to capitalization of Public Sector Banks, setting up mechanisms for last mile completion of housing projects and RBIs regulatory “Jaw- Boning”, based on informal Asset Quality Review of NBFCs.

Figure 4: Growth of Bank Credit & Real Repo Rate

Source: Authors calculations based on RBI data.

Real growth of base money has been on a flat trend for over a decade despite two severe shocks. The first arising from the Global Financial Crises which hit the country in August 2008 resulting in non-positive growth during three quarters (Q4 FY9 to Q2 FY10) and the Demonetization in November 2016, resulting in non-positive growth of Monetary base during four quarters(Q3 FY17 to Q2 FY18). Real growth of Reserve money averaged 1.6% per annum during FY10-FY14 and 3.6% per annum during FY15-FY18. It has accelerated in FY19 to 16.3% to offset the effect of risk aversion on investment and consumption.

4.2 Uncertainty and Risk Perception

The NSE’s VIX index shows a downtrend in uncertainty during FY2011 to Q2 of FY2020. There was however, a spike in H2FY2019 and H1FY2020, after which it returned to the downward trend (Figure 5).[26] The spike coincides with the period in which the ILFS crisis started and led to a credit default. The Consumer confidence index in contrast shows a rise in confidence declining trend in confidence from Q2FY15 to Q3 FY16 and then a declining trend which was accentuated in Q2 &Q3 FY2019(Figure 6). Though the trend in investor and consumer confidence and investor uncertainty diverged for much of the period, the two have moved in a consistent direction since the NBFC crisis started. Thus, the NBFC crisis was a critical element in the decline in GDP from Q3 of FY2019 onwards, as it heightened uncertainty and risk aversion. Given the heightened risk perception, the tax proposals in the 2019-20 budget led to a loss of confidence in the government, and RBIs ability and will to sort out the problems created by the institutional changes and reforms. The loss of confidence and dampening of Animal spirits triggered a broad-based collapse of GDP growth in Q1 FY2020.

Figure 5: NSE VIX Index of Uncertainty

Source: National Stock Exchange (NSE)

The Net International Investment Position of India (NIIPI) is another indicator of India Risk in a Global context. NIIP as a % of GDP was on a down trend from -7.5% of GDP in Q1 of 2009-10 to -21.8% of Q1 of 2014-15 i.e. India risk increased sharply post-Global Financial crisis. The policy and institutional reforms carried out since then, led to a slow but steady improvement to -18.9% of GDP by Q2 of 2018-19. It has since given up the gains to end at -21-5% in Q2 of 2019-20, close to the levels at start of this FY2015.

Post budget actions taken by the Government and the RBI (i.e. during 2019-20), have restored confidence and reduced uncertainty to its trend (Figure 5). Thus, a stabilization and perhaps a modest upturn of GDP growth can be expected by end of FY2020, unless the supply disruptions emanating from China, because of the Corona Virus (SARS CoV 2), add significantly to the uncertainty.

Figure 6: Consumer Confidence Index (RBI survey)

Source: RBI Consumer Confidence Surveys, different years

4.3 Fiscal Deficits

The fiscal deficit (as a % of GDP) which was on a clear downtrend during the 2000s, because of adoption of the FRBM target of 3% and the acceleration in the growth rate of the economy, rose sharply in 2008-09 the year of the Global Financial Crisis(Figure 7). Though fiscal discipline had weakened even before the Global Financial crisis (with announcement of a farm loan waiver), a deliberate decision was taken after the crises to accelerate the loan waiver as it was the quickest way to get money in the hands of individuals and counter the fall in income and expenditures. Therefore, Revenue expenditure increased sharply from 11.9% of GDP in 2007-8 to 14.1% of GDP in 2008-9 & 2009-10 (Table 5). This was accompanied by a reduction in tax rates to ensure wider distribution of incomes and consumption to offset the declines due to the GFC. This was reflected in the decline in the reduction in corporate income taxes and Excise revenue by 0.2% of GDP each in 2009-10(Table 4). These Fiscal policy actions raised the Central Government Fiscal deficit from 2.5% of GDP in 2007-8 to 6.0% in 2008-9 & 6.5% of GDP in 2009-10 (Figure 7).

Table 5: Fiscal Variables (% of GDP)

Source: Fiscal Accounts of the Union Govt, RBI database.

Contrary to the advice of the CEA at the end of 2009, the Fiscal deficit was not brought back to FRBM target levels, despite a restoration of GDP Growth to pre-crisis levels in 2010-11. The tax cuts were not reversed in 2010-11 and despite a windfall from Spectrum auctions, the fiscal deficit was at 4.8% and then rose back to 5.8% in 2011-12 after the windfall dis-appeared and corporate income and excise tax revenues tax revenues fell further (table 5).Fiscal prudence was restored during 2014-15 to 2019-20, with an average expenditure of 11.2% of GDP down from an average of 13.1% of GDP during 2009-10 to 2013-14 and an average of 12.4% during the previous five years. Consequently, the Fiscal deficit of the Union Govt averaged 3.6% of GDP during FY15-19, down from 5.3% in the previous five years and from 3.9% of GDP in the five years prior to that (Table 5).

Figure 7: Central Govt Revenue Expenditure & Fiscal Deficit (% of GDP)

Source: Fiscal accounts of the Union Government

4.4 Agriculture Growth & Rural Wages

Several economists have argued that Agricultural distress is a major factor in the reduction of GDP growth in H1 of FY 2020. Agriculture growth has, however, been on a long-term declining trend since 1980, with the linear trend line declining from a little over 4% to a little below 3% in 2013-14 (old series). Agricultural Growth indeed accelerated during the five year period, 2009-10 to 2013-14, to an average 4.3% per annum, before returning to its long-term trend with an average growth of 2.9% during 2014-15 to 2018-19. This happened despite two successive droughts in FY15 and FY16, a phenomenon which seems to repeat every 7 years or so (Table 1). Growth during FY2019 was only marginally lower than the average. The growth in H1 of FY2020 has been about 1% lower than the average, but this can only explain a GDP growth deceleration of 0.2% points.

As the new series (base 2011-12) separates Agriculture into its two components, Crops and livestock (for the first time), one can now see that in the last six years the former grew an abysmal 0.6% per annum, while the latter grew at an average 8% per annum. GDP from Non-crop Agriculture &Allied grew at an average of 6.2% per annum. Thus, during 2011-12 to 2017-18, Crop agriculture, whose share in Agriculture & Allied GDP was 65% contributed only 25% of the growth, while Animal husbandry, whose share was 22%, contributed 55% to the growth (of A&A GDP). It is therefore apparent that Crop agriculture and the policies used for decades to support, protect and promote it need to be thoroughly reviewed and revised. More particularly, the Wheat-Sugar-Rice model of agricultural growth and the policies that have supported it for decades have reached a cul-de-sac (dead-end). Low productivity and high cost (despite substantial input subsidies), make exports unviable/unsustainable, while domestic consumption demand has run up against sharply reduced income elasticities of demand. So, the result of higher growth in these three commodities is either falling prices or accumulating stocks resulting in rotting food and rising interest costs of storage. These funds could be better used to directly protect farmers and promote A&A growth.

A complete transformation of the policy framework for crop agriculture is essential. The price increase in crop agriculture as measured by its GDP deflator, fell to 1% in 2017-18 from 8.1% average in the double drought years and 5.8% in the subsequent two years of normal monsoon recovery. Price inflation was close to zero in 2018-19 with many crops showing an unprecedent decline in prices (ie deflation). The CPI (rural) for Sugar, pulses and Fruits showed a decline in prices in 2018-19.Prices of sugar have declined despite subsidized export of 16.1 MT in 2012-13, 11.1 MT in 2013-14 and 18.9MT in 2014-15. Stocks of wheat and Rice which were 207 lakh MT at the end of FY04, grew to 356 lakh MT by FY09 and to 495 lakh MT by FY14. They were 727 lakh MT by FY19 end. These stocks have therefore grown by an average annual rate of 11.8%, 6.8% and 8% during these three five-year periods. Note that this growth is despite the subsidized export of 29.5 lakh MT of wheat in 2012-13 and 26.7lakh MT in 2013-14. Offtake as a percent of Stocks has declined from 0.69 to 0.47 in the last decade, indicating that stocks are hugely in excess of any possible contingency. [27]

Another hypothesis that has been advanced by economists for the sharp decline in GDP is a decline in Private consumption due to a lack of growth in rural wages. There was a big change in methodology and an expansion in the occupations for which rural wage data is collected, starting from November 2013, which needs to be carefully accounted for. Figure 8, which plots the real average rural wage growth rate, using rural CPI as deflator, shows that there was a big upswing in growth rates from around July 2010 to around October 2013. Separating the available growth rates into three periods shows that the growth rate of real rural wages averaged 0.2% per annum from June 1999 to June 2010, accelerated to 8% per annum during July 2010 to October 2013 and then slowed back to 0.7% per annum (Table 6).

Table 6: Real Rural Wages and Agriculture growth

Source: Calculations based on Labor Bureau, Govt of India, obtained from RBI database

Correlating these changes with agricultural growth discussed earlier, we find that the changes correspond broadly to the temporary acceleration GDP growth from agriculture (Table 6). The fact that in the November 2014 to August 2019 period the deceleration in real wage growth is more than in Agriculture GDP, suggests that there may be additional reasons (some of which we have discussed earlier). We delve deeper into the rural wages in the new detailed series which started in 2014 by dividing them into four sub-categories: Crop Agriculture, non-crop Agriculture & Allied, Construction and Rest.

Figure 8: Rate of Growth of Avg Rural Male Wage (% yoy)

Source: Authors calculations based on Labour Bureau Rural Male wages data

Comparing the average wage growth in each of these categories to what happened in 2018-19 and Q1 of 2019-29, we find an acceleration of wage growth in each category, relative to the average growth in previous periods. There is therefore no evidence to support the contention that a slowdown of rural wage growth is responsible for the slowdown in private consumption or GDP growth. We also find that rural wages appear to be driven by previous two years of growth of GDP from agriculture, while GDP from agriculture is the biggest driver of Private consumption. We do find however that the Unemployment rate has increased significantly in Q1 of FY2020 (Table 7), so the employment situation & prospects may have played some role in the growth slowdown in H2 of FY2019 & H1 of FY2020.[28]

Man-years of employment supplied under MNREGA increased sharply to 73.4 in 2018-19 from an average of 64.3 during the previous three years (64 in 2017-18, 64.6 in 2016-17 & 64.4 in 2015-16). However, It is unclear what is the effect of MNREGA expenditures.

Table 7: Growth of Rural, Male Wage Rate (real)

Source: Center for Monitoring Indian Economy

The plot of monthly unemployment rate from CMIE, shows a decline in un-employment from its origin in January 2016 to a trough in July 2017, and then a steady rise till around August 2019 (V shape). For this period, it broadly mirrors the inverted U shape of the rate of growth of GDP. The peaking of the unemployment rate in Q3 of FY2020, suggests that GDP growth has bottomed-out (made a trough) in Q3 of FY2020. The flat trend in the UR during the last 6 months, however, suggests that the GDP growth recovery will be slow and prolonged in the absence of any further reform measures

Man-years of employment supplied under MNREGA increased sharply to 73.4 in 2018-19 from an average of 64.3 during the previous three years (64 in 2017-18, 64.6 in 2016-17 & 64.4 in 2015-16). However, It is unclear what is the effect of MNREGA expenditures.

5. Policy and Institutional Reform

The policy reform that will help accelerate the growth recovery to ~ 7.5% potential of the Indian economy, related to the three broad accumulated problems outlined in earlier sections. Fiscal Institution and Policy, Monetary & Credit Policy and Institutions, and Incentive structures for Investment exports and Production.

5.1 Fiscal Policy

The key to effective fiscal reforms, particularly in a period of slow growth is, fiscal changes which are revenue/expenditure neutral in the long term, because they increase the elasticity of revenues or reduce the buoyancy of expenditures by increasing their effectiveness, but provide a fiscal boost in the short term by foregoing some revenues or accelerating some expenditures. In this context the discussion of Fiscal space is only relevant in the context of FRBM constraints arising from the Debt/GDP target and the glide path to achieving the Debt targets.

5.1.1 GST simplification

As noted by many economists, an overly complex GST rate structure has hurt Household industry & trade, and SMEs by raising the cost of compliance. 90% of the countries with VAT have a single rate structure. This must be the conceptual starting point of the simplification, with a minimal amount of changes form uniformity, to make the GST equitable and Revenue neutral in the Indian Context. I would suggest the following approach:

  1. There must be a single uniform rate of GST on all inputs (capital goods, intermediates) into the production of goods & services, of 15% (say). The same rate should apply to electricity, construction and oils & refined products, if & when they are brought into the GST. Petrol & Diesel are however, both intermediate & final consumer good (cars, two wheelers), generating large revenues under the current excise tax and would have a higher rate.

  2. The same rate (15%) should apply to most final consumer goods, with two specific differences: (i) Basic food, Health services & Education-Schooling (incl Pre-school) should be exempt to ensure equity. All other exemptions must be eliminated. (ii) A handful of Goods & services, in which evasion is difficult, raise large revenues & have high income elasticity, will continue to have a higher rate (25% say),to ensure revenue neutrality.

  3. One (5%) or two more rates can be used for final consumer goods, to facilitate transition.

  4. The Value-Added principle must be understood and applied by the tax collection machinery. End-use exemptions are a contradiction of this principle and must be abolished. Compounding also breaks the chain of offsets, particularly if it is done by entities which sell to or buy from GST registered entities.

If GST is simplified as proposed, both tax compliance & enforcement become very easy & cheap for Tiny & Small Industry & Trade (TSIT) & MSMEs. The uniform tax eliminates the need for matching of every invoice by replacing it with matching of total value of sales between each buyer & seller (a simple matrix structure for accumulated sales value - year to date). It will greatly incentivize the shift from Black to White economy. It will also make it possible to refund GST paid by exporters on their inputs on a weekly if not daily basis, imparting a big boost to exports.

5.1.2 Direct Tax Code (DTC)

The proposed DTC is Very important, for easing & encouraging the shift from Black Economy to White economy and for leveling the field between Corporates, Small and medium Enterprises (SME) and Household Enterprises (HHEs). The Corporate law has already been reformed to reduce the after-tax cost of capital to Companies; the reform of taxes on capital and business income, which is the core of Direct Tax Code simplification and rationalization, is vital for SMEs & HHEs.

Tax reductions which are desirable but infeasible given FRBM constraints (ie beyond the flexibility available in the FRBM), can be phased out as per a pre-announced schedule to reduce uncertainty. For instance, the issue of elimination of Cess and Surcharges can be separated from the rest of the DTC reform, which must be done in next budget. Govt can announce a schedule of phasing out of Cesses& Surcharges between 2020-21 and 2024-25, consistent with Fiscal roadmap.

An additional tax simplification measure would be an option to taxpayers to switch to a Flat tax without deductions & exemptions, of the kind proposed by Bhalla & Virmani (2017a b). This would have minor temporary losses followed by increase in voluntary compliance and higher buoyancy over the medium-long term.[29]

5.1.3 Reallocation of Govt Expenditure

On the expenditure side, the focus must be in shifting expenditures, to increase effectiveness and get a bigger bang for the buck in terms of Private consumption demand and impact on GDP growth. For instance, replacement of Fertilizer subsidies by Direct Cash transfers through PMKY or other DCT/DBT schemes for rural areas will put money directly in the hands of farmers, reduce water and land pollution through excess use of fertilizers. Subsidies and expenditures could also be relocated to quicker completion of ongoing construction projects, and MNREGA in stressed States.

5.1.4 Over Dues

As already promised by Finance Minister, Union Govt and CPSEs/PSUs should clear all overdues by March 2020. This is the best way to inject demand into the economy without affecting the real fiscal deficit. While Fiscal Deficit measured on cash basis will show a one-time increase, it will either have no effect on Fiscal Deficit on accrual basis. The payments will help reduce private credit demand and ease flows to others in need of credit. The issue of disputed payments for Infrastructure and other projects, for example in Highways must also be resolved expeditiously. The Govt must not routinely question the awards of Dispute resolution bodies agreed to by itself.

5.1.5 Dis-Investment, FDI, FII

Ensure that as many Strategic sales of CPSE/PSUs as possible occur within 2019-20 i.e. by 31st March 2020. Zero sales in 2019-20, will again dent the credibility of the Govt, whatever the reason given to justify the delay! Govt should lift restrictions on FDI and FII inflows (HLG recommendations) and consider issuing a Sovereign bond as proposed in the budget, to ensure that any increase in the fiscal deficit is financed without an increase in market interest rates.

5.2 Monetary & Credit Policy

5.2.1 Credit System

RBI & Govt must unclog the credit loan channels by dealing with the NPA problem in Banks and NBFCs. Normalization of NBFC credit channels is particularly important for levelling the field for Household and Small enterprises. The grid lock between the alternatives should be broken by adopting a flexible approach fitted to type of borrower & type of Asset (e.g. Bad Bank for industrial assets, take over & auction of marketable assets like land & real estate, ARC for Infrastructure). An expert committee could be appointed to formally define which approach to use for which type of borrower and /or type of asset. Any legal changes required must be made & implemented quickly.

5.2.2 Monetary Loosening

RBI must reduce the Real Repo rate to zero (or even negative if expected 2020 Q3 < 4.5%) and accelerate growth of base money supply and aggregate credit. Some of the monetary-credit action has happened in last 3-6 months, but it must be sustained & credible. Govt should complement it by increasing the flexibility of small saving & other interest rates set by it. A change in the RBI Act to include GDP growth as a subsidiary target for the MPC should be considered, perhaps a Taylor Rule (along the lines of the mandate of the US Federal Reserve Board).

5.3 Competitiveness & Global Value/Supply Chains

There is a once in a generation opportunity to attract Value/Supply Chains, looking to diversify out of China, given the heightened uncertainty about its economy, particularly its External trade.

5.3.1 Labor Policy

Amend Industrial Relations Act to improve flexibility. A start can be made by making the 100-person cut-off for retrenching or dismissing labor, inapplicable in CEZs & SEZ and/or in specific Labor-intensive industries like Garments.

Introduce Portability & Private competition in provision of ESI, PF etc. to reduce labor costs without reducing benefits.

Amend Apprenticeship Act to facilitate practical, modern, industrial training. The Skill development corporation has not been successful in supplying the skills currently needed by industry, for which they cannot find enough workers. Modify rural school curriculum to promote problem solving & job skills in Agriculture, Processing, and Services.

5.3.2 Land Policy

Even the conversion of Agricultural land to employment generating, low cost housing is a bureaucratic nightmare. Amend land laws to facilitate creation of Industrial Estates/Clusters, Housing and Commercial complexes in rural & semi-rural areas, including through “land pooling” of Rural land. Expand chemicals clusters with environmentally approved pollution control facilities, so that the chemicals industry can expand quickly to meet the doubling of orders, arising from diversification of demand away from China.

5.3.3 Agriculture

The Wheat-Sugar-Rice economy & old policies to support it have reached a dead-end. De-control of internal & external trade in agriculture, rationalize import & export duties is essential for diversifying the agricultural economy into new products for which there is international demand or domestic demand can be developed by private companies (e.g. nutritional vegetable, fruit & coarse cereal snacks).[30] Allow use of low-quality land (fallow or degraded) by Agriculture Companies!

5.3.4 External Trade

Rationalize EXIM policy, Import Tariffs & Export Duties; replace specific duties on Textiles by ad-valorem rates, to eliminate corruption in imports, Improve Ease of Doing Business in External Trade (World Bank Doing Business sub-index).[31]We must grab the once-in-generation opportunity for "Make in India," by partly replacing China in Global Manufacturing Supply chains.

The only certain way to eliminate an inverted customs tariff structure is by moving to a uniform ad-valorem (%) duty on all imports. This objective can be achieved to a great extent by imposing a uniform import duty on oil, minerals, manufactured goods and (to the extent possible) on agricultural raw materials like cotton. The uniform duty would have to be accompanied by a suspension of the ITA (0 duty) agreement for 3-5 years, to ensure elimination of inverted duty structure for electronics items covered in ITA.

The focus of FTA agreements should shift to developed countries as these will be most beneficial for promotion of labor-intensive manufactured exports and Indian entry into Value Chains. The priority should be on FTAs with EU, UK and USA. In the case of the USA, a pragmatic compromise will have to be found between USA’s demands on IPR and of India’s uncompetitive agriculture.[32]

5.3.5 Infrastructure: Electricity Cost

Amend Electricity Act(2003) to limit cross tax-subsidy by, either (a) banning differential pricing for different consumers without demonstrated differential in costs of production and delivery, as this is a monopolistic practice, or (b) Limiting the implicit tax on electricity supplied to manufacturing industry to certain percent of average cost of production (e.g. 10-15%).A Central Electricity Distribution Company should be set up to compete with State Electricity Boards/Companies on a level playing field, and Open access enforced through grants and loans conditional on such access. The PPP framework for infrastructure must be reformed along the lines suggested by Kelkar Committee. Govt must accept the awards given by Dispute resolution bodies, set up by itself as well as by the High courts.

6. Conclusion

Three major sets of policy and institutional changes took place between. Several of these changes were genuine reforms, while some were clearly not. The three sets covered the areas of Monetary Policy and Financial Regulation, Fiscal policy and taxation and Un-accounted Income and Assets. Negative J curve effects were clearly demonstrated in the case of the new Monetary Policy Framework and Tighter norms and stricter enforcement of Financial Regulation such as the new Indian Bankruptcy Code (IBC). In the Fiscal sphere, introduction of the Goods & Services Tax (GST) a major tax reform, also had negative J curve effects, because of over-complex institutional design and rate structure. Other positive reforms such as FRBM and Corporate Income tax simplification was overwhelmed by Ad hoc income tax increases to meet fiscal targets. Institutional changes directed at reducing un-accounted income and Assets (“Black Money”), though partially successful, also had negative J curve effects, because the impact of the changes on GDP growth was neither analyzed nor accounted for in institutional design and implementation. Historical experience in India and abroad suggests that once Corruption is institutionalized, Draconian laws are effective for short periods, but are eventually undermined by even more corruption, given the broader deterioration in enforcement institutions (policing, conviction, legal). Sustained improvement requires an integrated examination of both incentives and disincentives (carrots & sticks) and a policy reforms in both areas. These three sets of J curve effects interacted to set the stage, with a sharp decline in GDP triggered by a set of NBFCs defaults & bankruptcy and effective income tax rates in H2 of 2018-19.

The remedial actions taken during 2019-20 by the Union Govt and the RBI have ensured that GDP growth has likely bottomed out in Q3 of 2019-20, though larger than average revisions in data have made predictions a little riskier than usual. However, the recovery is likely to be U shaped, in contrast to V shaped recoveries seen from the smaller shocks since the Global Financial Crisis. The issue before us today is therefore the speed of recovery of GDP growth. The speed of recovery to the previously demonstrated growth potential of about 7.5%, will depend critically on the correct macro-economic policy mix and economic policy reforms to remove bottlenecks, reduce bad policies and institute incentives for efficient growth and productive employment generation. Based on an analysis of the causes of the Growth slowdown, and the opportunities available domestically and Globally, this note outlines some of the policies needed to accelerate the recovery. The speed of the recovery depends critically on the speed of implementation of these reforms.

The paper also shows that the effectiveness of reforms depends on better policy design and timing & phasing of reform, a lesson which reinforces authors personal experience of two decades of Economic Policy reforms.[34] Consultation and preparation is essential for maximizing the positive and minimizing the negative effects, of major economic policy and institutional reforms. One way to ensure this is to appoint professional committees, with diverse expertise to consider all aspects, and headed by bureaucratically-politically savvy professionals. Further, efficient and effective macro management requires a lot of information, particularly in crisis situations. Openness to information and knowledge and a holistic macro perspective is needed to account for the interactive effects of different policies and new developments in the economic environment, to keep the economy on a sustained & sustainable GDP and welfare growth path. Mechanisms are needed to ensure this. Finally, its essential to have a trusted professional with a macro-economic/ macro-institutional perspective inside the Government, to drive the reform.[35] There are powerful vested interests inside and outside the government with access to a great deal of expertise, which is directed at narrow ends, but can mislead decision makers. Such a respected professional is essential for bringing in a macro perspective, to separating out the chaff from the gems of advice that is proffered. Such professionals can also help grab opportunities when they arrive, by bringing these to the attention of decision makers and preparing the grounds for quick decisions.

I would like to thank Roberto Zagha, Dr Charan Singh, Dr Vishandas and Karan Bhasin for comments on an earlier version of this paper.

[1] The latest data revision shows that FY19 growth was approximately 0.5% point lower than the initial data indicated.


[3] We use Institutions as defined by Alfred North, as the formal laws and informal rules under which economic individuals, including economic agents, operate. Detailed definition below.

[4] FRBM = Fiscal Responsibility and Budget Management Act. GST = Goods and Services Tax. The complex design of GST also nullified the predicted 1-2% acceleration in GDP growth from the simplified GST considered earlier [ Virmani (2002) & ].

[4] Average growth till 2011-12 is calculated from GDP base 2004-05.

[5] The collapse of Construction activity, indicative of severe problems in real estate and PPP infrastructure was much more severe, with growth rate collapsing by 50% to 90% after the Global Financial crisis. The restoration of the growth rate was a little slower but almost as strong as for total GDP, it collapsed much more than overall GDP (to an average 1.4% per annum in FY12-13), given the grinding down of real estate and infrastructure investment due to the effect of NPAs (hidden to the public, but known to insiders).

[6] One of the drivers of this growth was an unsustainable spike in Agricultural growth to an 6.5% per annum average during FY2011+FY2012 from 3.8% average during FY2004 to FY2010. This spike in agricultural growth, also temporarily raised the rate of growth of real rural wages. The rural wage growth reverted to normal, along with the reversion of agricultural growth to 3.1% average in FY13+FY14. This contrasts with the growth of GDP from manufacturing, which in the same three periods, was 10.6% (FY04-10), 9.0%(FY11-12) and 0.2% (FY13-14), with the collapse driven by retroactive taxation, increase in complexity of land acquisition, increase in bureaucratic controls on education and botched Spectrum allocations, leading to a nose-dive of confidence among private investors, Domestic and Foreign.

[7] Growth numbers are based on quarterly averages, to capture the time patters of shocks, policy actions and consequences/results.

[8] .

[9] Among the measures taken during 1991-96 was to replace political appointees on boards of Government Financial Institutions (e.g. LIC, UTI) and Public Sector Banks (SBI, Nationalized banks).

[10] As analyzed by and shown in Economic Survey 2018-19

[11] Note that by 2009-10 Q3, all fiscal & monetary measures were in operation and the GDP growth was on the recovery path. IMF’s post-GFC research has shown that IIP is the best predicter for Country Financial Crisis.

[11] .

[12] .


[14] .

[15] Historically, real estate sale and purchase is estimated to use 70% black cash and 30% white cheque payments; Thus, the decline in generation and/or domestic circulation of black money would be reflected in the demand for tradable Real estate. The decline in demand could also be due to individuals with Black Money/assets (or family members) moving their unaccounted funds abroad.

[16] .

[17] Virmani and Hashim (2011), Virmani, Hashim and Kumar (2011, 2009).

[18] The author was a member of the Informal Advisory Committee on Monetary Policy, appointed by Governor Raghu Ram Rajan.

[19] .


[21] .

[22] .

[23] , .

[24] The attempt to simplify the system after its introduction, was beneficial to large and medium firms, but created further confusion for Small trade and industry, with limited resources, to keep track of all the changes.

[25] Anecdotal evidence suggests that “Telephone Banking” initiated a dilution of standards and led to increasing numbers of bank officials compromising on commercial lending standards.

[26] India VIX Index* Volatility Index is a measure of market's expectation of volatility over the near term. ... From the best bid-ask prices of NIFTY Options contracts, a volatility figure (%) is calculated which indicates the expected market volatility over the next 30 calendar days. To the extent stock market reflects economic volatility, the index can also be seen as an indicator of economic volatility.

[27] An important reason for the negative growth of Motor vehicles in H1 FY2020, are the increase in regulatory costs arising from higher insurance and registration charges and the switch from BS IV to BS VI pollution standards. Industry leaders have estimated the cost increase to be of the order of 30% over 12-18 month period. This would explain the >20% decline in demand during H1 of FY2020.

[27] A Technical committee on Buffer stocking norms used to be set up periodically to update norms. The actual stocks have been so large (2x to 3x of old norms), that no new Technical committee was set up in the last decade or two.

[28] Highest correlation of 0.58 as against correlation of 0.36 & 0.34 with MNREGA & rural wages and 0.22 with Food stock accumulation. Please note that these are in turn driven by Agricultural growth so additional effect is unclear.

[29] ,

[30] Essential Commodity Act, Agricultural Produce Marketing Act, Agricultural procurement and stocking by FCI, Import-Export controls and Quantity restrictions.

[31]Among other negative effects high and complex specific duties on Synthetic fibers, yarns and fabrics are responsible for making non-cotton textiles & garment exports uncompetitive.

[32] The time has also come to accept the invitation of OECD to join the organization, as it is now involved in designing the architecture of digital taxation, and other issues which will affect us in future.

[33] 1985-2010

[34] See Mehra (2019)

[35] Either in the PMO or the MOF or both


Surjit Bhalla and Arvind Virmani, Income Tax Reform: A Benchmark Flat Tax cum Transfer System, January 2017. .

Surjit Bhalla and Arvind Virmani, Income Tax Reform II: A Feasible Negative Income Tax/ Net Income Transfer (NIT), January 2017. .

Puja Mehra, “How India’s Growth Story Devolved into Growth Without a Story, Ebury Press, April 2019

Arvind Virmani, “A New Development Paradigm: Employment, Entitlement and Empowerment’, Global Business Review, International Management Institute, SAGE Publications, Vol. 3, No. 2, July-December, 2002, pp. 222-45. [ NewParadigm4nf ].

Arvind Virmani, “A New Development Paradigm: Employment, Entitlement and Empowerment”, Economic and Political Weekly, Vol. XXXVII No. 22, June 1-7, 2002, pp. 2145-2154. [ NewParadigm4nf ].

Arvind Virmani and With Danish Hashim, “The J curve of Productivity and Growth: Indian Manufacturing Post-Liberalization,” IMF Working Paper, No WP/11/263. July, 2011.

Arvind Virmani, Danish Hashim and Ajay Kumar, “Impact of Major Liberalisation on Indian Manufacturing: The J Curve Hypothesis,” Indian Economic Review, Volume 46, Issue Number 1, 2011.

Arvind Virmani, Danish Hashim and Ajay Kumar, “Impact of Major Liberalisation on Indian Manufacturing: The J Curve Hypothesis,” Working paper No. 5/2009-DEA, Ministry of Finance, September 2009. ,

Arvind Virmani, "Deceleration, De-Monetization and GST: Growth Prospects and Policy Solutions," Working Paper No 2/2017, September 2017. GrowthDeceleration2017sep.docx.