Notes on the Indian Economic Slowdown

I imagine like many others in India, I have been looking around for some explanation of how the country suddenly finds itself in the midst of an economic crisis. Nothing seems to have changed much over the past couple of years that would explain why or at least why now. There is still a young, growing work force. There is still a lot of catching up to do with the global technology frontier. And, there is a pro business government.

The explanations have also generally been unsatisfactory. Most everyone points to the IL&FS collapse. But this itself then requires an explanation. Others point vaguely to the government’s inability to carry out reforms or more commonly, it’s mismanagement of the economy (eg. demonitization). But that seems insufficient to explain the totality of what’s happening. Demonitization was back in November of 2016, so why are we having this problem at the end of 2019?

This working paper by Subramanian and Feldman offers a convincing explanation of what’s happened and what can be done about it.

How did the Indian economy get in this mess?

The authors argue that India is suffering from a four balance sheet problem. And the story they describe goes something like this:

1. The Good times. In the early 2000s, the world economy was doing well, and so was the Indian economy. Investment activity along with exports were driving the nearly double digit economic growth[1] India was experiencing at the time. Expecting this growth to last a while, banks lent heavily to corporates to invest in infrastructure especially in power and steel.

2. The Global Financial Crisis and the Twin Balance Sheet Problem. The onset of the global financial crisis in 2008 hurt India. Export growth dropped off. Commodity prices collapsed (especially hurting farmers). And, many of those infrastructure projects began to go south dragging down both the corporates and the banks that had financed them. With stressed assets on their books, banks also stopped lending even to deserving companies thus chocking off investment in the economy overall. This is what has been called the twin balance sheet (TBS) problem.

3. The Post Financial Crisis Stimulus. So far, we have the structural part of the story. But the slowing of investment doesn’t explain everything. After all, Indian growth didn’t collapse with the financial crisis. Subramanian and Feldman explain that this is because there were several cyclical factors that kept growth going once investment dropped off. First, the dramatic drop in oil prices boosted demand. Second, the government provided fiscal stimulus via off book entities. And third, the credit boom, deserves special mention below.

4. The Credit Boom and the Housing Bubble. Demonitization in Nov 2016 led to an increase in bank deposits as the population rushed to save their defunct currency notes. And with banks still scared to lend to corporates, they funneled those funds toward non-bank finance companies (NBFCs) which had already been playing a growing role in consumer finance. These modern NBFCs, less mired in bureaucracy, could lend more efficiently for things like cars and motorcycles, but especially for houses. The over-investment in real estate during the good times had left a hangover in housing supply. Cheap credit via the NBFCs helped to move properties but ultimately formed a bubble as credit quality suffered. This consumption spending, the last pillar that had been holding up GDP growth, collapsed with IL&FS and commercial credit generally.

All this has spectacularly brought down growth rates as we have seen in the second half of 2019. The banks and corporates are in trouble again. But, now so are the NBFCs and the real estate sector. The twin balance sheet problem has now become a four balance sheet problem.

What can be done?

The paper also goes on to describe what needs to be done to get the Indian economy back on track. But, to the add to the bad news, they start by explaining why the obvious tools won’t work.

First, monetary policy won’t help because stressed banks are not passing on the central bank rate cuts to their borrowers for fear of adding more bad loans to their books. The transmission mechanism essential for monetary stimulus seems to be broken.

Second, fiscal policy won’t help either for several reasons. First, most of the economy doesn’t pay taxes, so tax cuts won’t help them. Second, the government doesn’t have much extra money to give since debt to gdp is already high. And, finally, banks don’t want to buy government bonds.

Instead, the authors suggest the following steps to free up bank balance sheets and restart credit.

1. Identify what bad assets still remain with banks and NBFCs so we all know how big the problem is.
2. Improve implementation of the bankruptcy code to deal with disposing of those bad assets faster.
3. Create bad banks to hold and dispose of bad assets from power and real estate sectors which require special handling due to government linkages.
4. Regulate NBFC lending to ensure portfolio quality.
5. Recapitalize banks again but tie fresh money to banks taking proactive steps to clean up and reform their balance sheets, and
6. Shrink the public sector banks which seem fundamentally unable to resist making bad loans (due to political influence) or run an efficient operation (due to bad incentives since they expect to be bailed out when they get in trouble).

These steps seem reasonable and are likely to work. But my guess is that they will be hard to do and will be quite slow since they require policy change and/or legislation. Which means that we are likely to be in this mess for a while to come.

The paper goes into much more detail and supports these claims with numbers and analysis. It’s definitely worth a read. I also recommend reading some of the references in the paper especially Raghuram Rajan’s Jindal Lecture at Brown.

Notes

[1] Economic activity, typically measured by expenditure GDP is C + I + G + (X-M) or consumption + investment + government spending + (exports - imports). See here for more from wikipedia