A large government balance sheet is vital for a financially stable capitalism.
In a world of Lilliputian growth and with China threatening to implode, India’s 7 percent pace of economic growth looks impressive. Yet, the GDP numbers are deceptive. Apart from the problems with the shiny new GDP series, a wide array of indicators—corporate earnings, electricity output, manufacturing production, capacity utilisation, exports, business investment plans, and nonperforming loans—and anecdotal reports show an economy that is still struggling to break out. What can the government do to reaccelerate growth? No doubt you will have heard that the government needs to push for bigger reforms, especially labour reforms. These reforms may well be necessary for the long-term, but they are unlikely to push growth into a higher trajectory at least in the short term. Given the business sector’s high debt load, no amount of reform will restart capex, and banks, struggling with NPLs, are in no position to finance a recovery. Global trade is actually contracting and increasing exports in such an environment is for all practical purposes a nonstarter. The only game in town is a big fiscal push.
Business investment is weak
India’s economy has disappointed expectations largely because business capital spending is still contracting. Earnings in the latest quarter were disappointing. More important, sales growth, excluding oil and gas and finance companies, was the weakest in two years, which is consistent with the low capacity utilisation levels in manufacturing. Businesses expand and hire when they are swamped with demand, not when they are experiencing declining sales. Furthermore, the corporate sector is burdened with excessive debt and is attempting to deleverage, which is holding back capital expenditures.
With the corporate sector unable to drive growth, can the unorganised sector take up the reins? India has a large micro, small, and medium-sized enterprise (MSME) sector. However, small manufacturers have been hurt by cheaper Chinese imports, which are expanding to more and more products. Without cheaper power (China heavily subsidises power for businesses), cheaper credit, and better infrastructure, small manufacturers will continue to lose ground against Chinese competition. These changes are not going to happen immediately, if at all. Meanwhile, global competition, especially from China, is only going to intensify given that most countries are struggling with weak domestic demand and are looking to exports to boost growth. Under the circumstances, forget growth, MSMEs in manufacturing will do very well to maintain current levels of business. They are unlikely to invest and expand. In some of the other sectors—such as, retail—MSMEs are facing challenges. Even if MSMEs were to power robust growth, the credit needed to finance that may not be forthcoming. Unlike larger corporations, MSMEs cannot take recourse to the capital markets and are largely dependent on banks. Banks, dealing with high levels of nonperforming loans and the resulting pressures on capital, are in no position to finance robust business sector expansion plans.
Reforms are not going to spark capex in the short-term
While you will hear reams of commentary on the need for big bang reforms, the fact is that, given the balance sheet constraints, no amount of reform is going to make businesses go on an expansion binge in the present conditions. It may be worthwhile recalling that the 1991 reforms did not spark a recovery in capital spending immediately. For nearly a year, the majority of work was devoted to chasing up delinquent borrowers and evaluating ongoing projects with cost overruns. It was not until 1993-94 that new project lending picked up. Reforms, although vital for fostering long-term productivity and competitiveness, are simply not a panacea, especially in a global economy faced with a general glut.
Why is fiscal push the only game in town?
To understand the crucial role of fiscal policy in the present global economy of extended private sector balance sheets and general glut, we need to go beyond the conventional demand analysis and look at aggregate flow of funds and sector financial balances. The corporate sector is currently trying to run positive financial balances, that is, run positive free cash flows (free cash flow is cash flow less capital expenditures). This is only possible if the other sectors in the economy—households, the government, and the foreign—are together running a financial deficit. This is simply an accounting constraint. India currently runs a current account deficit, that is, the rest of the world is running a financial surplus with India. So, for the corporate sector to run a financial surplus, the government and the household sectors combined must run a financial deficit that more than offsets the surplus of the foreign sector.
India’s national accounts data are available only until fiscal year 2012-2013. For that year, the combined household and public sector financial balance was close to zero. That year, India’s current account deficit—also, the foreign sector’s financial surplus—peaked out at 5.1 percent of GDP. So, the corporate sector ended up with a financial deficit (negative free cash flow) of about 2.3 percent of GDP, which is itself a vast improvement from 8.6 percent of GDP in 2007-2008. Since we do not have full data for the years since fiscal 2012-2013, we have to make some judgments based on the data we have.
The current account deficit has narrowed dramatically, by about four percentage points of GDP. However, general government deficit (the central and state governments together) has also narrowed by about a little over a percentage point. The financial balance of the foreign sector plus the general government sector has improved by about three percentage points. Assuming all this improvement flowed through to the corporate sector, the corporate sector is likely running a small financial surplus. This dramatic improvement is the main reason why Indian stocks have vastly outperformed the rest of the emerging markets and much of the rest of the world since September 2013.
Looking ahead, the corporate sector is still looking to run positive free cash flows and consolidate its balance sheet. To enable the corporate sector achieve its goal, while kick-starting investment, would require that the other sectors combined increase their deficit. India cannot bank on further improvements in the current account deficit. Despite the bonanza from the plunge in petroleum prices, the current account has been largely flat because the weak global economy has caused exports to decline sharply. So far, we have not discussed the household sector—which also includes the large unorganised sector. In fact, household sector financial savings—the equivalent of financial surplus—have come down sharply from12.7 percent of GDP in 2009-2010 to 7.6 percent in 2012-2013. Lacking data, we are left with guessing what has happened since 2012-2013. However, expecting the household sector to bear the burden of corporate deleveraging is unlikely to work in a country like India and not advisable given the worldwide experience of the past decade.
Disparate countries from the United States, Spain, Canada, to Korea and Thailand have either paid a heavy price or are still dealing with massive household leverage. To be sure, household debt in India is low and can rise considerably before it causes any problems. While theoretically the household sector can embark on a sustained debt-fueled spending spree and charge economic growth, in practice the prospects are limited. Most Indian households have limited access to formal credit channels and, banks and nonbank finance companies are in need of capital injection and hardly in a position to step up lending. Moreover, given the lack of social insurance, and the potential for abuse/exploitation by debt collectors, increasing the leverage of the household sector is neither feasible not desirable.
Under the circumstance, the government should embark on a significant fiscal expansion, ideally increasing infrastructure investment. Fiscal deficits serve two purposes. The first is increasing the demand for goods and services, directly purchased by the government or indirectly induced through transfers. In addition, running financial surpluses will enable the corporate sector to rapidly deleverage and to strengthen their balance sheets, and eventually position themselves to power the economy.
An increase in fiscal deficits and the consequent acceleration of economic growth will be accompanied by acceleration in imports and a worsening of the current account deficit, draining some of the benefits from the domestic private sector. However, there are reasons to believe that a worsening of the current account deficit will be moderate. First, India’s import intensity in nominal terms is heavily dictated by petroleum prices and, to lesser extent, by other commodity prices. Because oil prices are down and remain under downward pressure, imports will not increase one for one with GDP. Second, India’s other big import, gold, has also lost its sheen for the Indian investor. Gold prices are down significantly in rupee terms from the peak in 2012. Meanwhile, inflation is down and the stock market has rallied. While gold imports surged following the easing of restrictions in November, they have cooled off since then. India’s gold imports are likely to remain subdued.
Will Bulging Fiscal Deficits Stoke Inflation?
There is an understandable concern that large fiscal deficits will stoke inflationary pressures. The big fiscal push in the immediate aftermath of the global financial crisis of 2008-2009 undoubtedly contributed to the high inflation. Older readers will remember the 1980s, when large fiscal deficits spurred inflation and contributed to the eventual balance of payments crisis in 1991. However, there is reason to believe that those episodes are not relevant for the present situation and that large fiscal deficits are unlikely to fuel inflation.
There are three reasons why inflation is likely to remain subdued. First, oil prices, which have an enormous influence on inflation, have plunged and are threatening to fall further. In contrast, in the previous two episodes of rising inflation, oil prices were either rising or historically elevated. In the 1980s, oil prices bottomed in 1986 and increased over the next few years, spiking during the first Gulf War. In the most recent episode of high inflation, oil prices consistently ran above $100/barrel from early 2011 until the second half of last year. Second, food prices, which too have a large influence on overall inflation in India, have been benign. With global food prices having plunged and domestic stocks ample, the threat of soaring food prices is remote. In contrast, both in the late 1980s and earlier in this decade, weak domestic agricultural output, coupled with surging global food prices, caused soaring food inflation. Third, the strength of the feedback from deficits to inflation depends on the context. Running large deficits in the midst of robust private sector activity is likely to result in overheating as supply constraints and bottlenecks become binding. In the 1980s and from 2010-2012, the private sector was expanding rapidly and increased government spending caused the economy to bump up against supply constraints, stoking inflation. Currently, there is a capacity glut. For example, capacity utilisation in the manufacturing sector is running 10 percentage points below the early 2011 peak. In short, the conditions that promote rising inflation are currently absent.
In fact, another episode from the past may be a better parallel to the current situation, and it suggests that fears of fiscal deficits fueling inflation are misplaced. As now, from 1998-2002 the corporate sector underwent balance sheet consolidation. The government ran large fiscal deficits through that period, supporting growth. Government debt as a percentage of GDP rose steadily, peaking in 2004 at 84 percent for general government and about 63 percent for the central government. Yet, inflation remained relatively subdued and stable. Then, as now, oil prices were low and global commodity and food prices were subdued.
Most commentary on India is from the perspective of the so-called Washington consensus. The main elements of the consensus are: deregulation, targeting low and stable inflation, opening the economy to global trade and investment, and reducing government role in the economy, including reducing the fiscal deficit. Some of these appear to be unimpeachable goals, but their actual relationship to short-term or long-term economic growth is questionable. Some, such as low government borrowing and avoidance of large fiscal deficits are purely ideological and, applied at the wrong time, can actually cause enormous damage. Even the IMF, once the bastion of fiscal stringency, has lately been pushing against austerity. India’s central government debt currently stands at about 45 percent of GDP and including the state governments, the debt stands at 67 percent of GDP. Many may consider this high but it is helpful to remember that, at the cusp of the previous boom, in 2003, debt was considerably higher. India has the fiscal capacity to expand stimulus.
History has also shown us that a free market economy left to its own devices has a tendency toward instability. A large government balance sheet—not to be confused with an overbearing role for government or a large central bank balance sheet—is vital for a financially stable capitalism.
Photo: Kaushik Narasimhan