Should India’s potential growth be much higher after

digitalisation and tax reforms?

Is growth pessimism preventing India to achieve its true potential?

Sunny Verma & Alekh Angre

In the 2014-15 Economic Survey, the then Chief Economic Adviser Arvind
Subramanian, wrote that “facts and fortune have aligned in India’s favour” to propel
the country onto a double-digit medium term growth trajectory. Subramanian
argued that India was in a sweet spot, rare in the history of nations, wherein a
historic political mandate coupled with stable external environment leads to
sustained reform push.

It was seen as natural for a large enterprising economy like India to follow China’s
path of multi-decade double-digit growth. Reforms like the Goods and Services Tax
(GST), once stabilised, were estimated to add nearly 2 percentage points extra to
GDP (Gross Domestic Product) growth. Digitalization of the financial sector was an
icing on the cake.

The National Council of Applied Economic Research (NCAER) had in a 2014 report
estimated an increase of 0.9%-1.7% in GDP after GST is fully implemented. A March
2017 paper by researchers at the US Fed had projected the GST implementation to
result in a positive impact on real GDP of up to 4.2 percent. Former bureaucrat Vijay
Kelkar had estimated GST roll out to add 2-2.5 percentage points to GDP.

But the kind of growth expected has not materialised despite several reforms.
Capacity utilisation levels remain stuck below 75% level even as private consumption
growth has been slowest.

Why did that happen?

The basic answer lies in consumption. While everything is aligned for India to grow
the fact remains that Indians are simply not consuming to the extent that the
economy demands. Some say it is the high interest rates, others point out to high
GST and there are some who say that there are just not enough jobs out there for
people to go out and buy things. While private consumption is not happening,
throughout the last 10 years, corporates are not building capacities. They just don’t
see the reason why they should be increasing capacities when demand is not
happening. But on lower capacities they have seen high increase in sales – especially
in areas like high end cars, Acs or even real estate. But this demand is limited to the
top 5 crore people. So with all levers for growth in its best position we are not
growing at our best possible rate. But expectations are high. In fact, large corporates
– after seeing high asset turnover ratios closer to 2.17x for 2023 as compared to
1.69x in 2019. This looks like an improvement in demand for corporartes to add
additional capacities but we will have to wait and see. All the arrows point towards
high interest rate in India which is hampering growth. There are policy experts who
believe that they can be brought down from 6% to 4% and that should kickstart
demand.

India today is the fastest growing large economy with the fresh estimates now
pegging 2023-24 growth at 7.6% and a score of agencies including Moody’s having
bumped up their growth forecasts for India. But the key question remains – is India
punching below its weight? Have we narrowed ourselves into thinking that 7% is the
potential growth for India?

True, the world has seen several disruptions in the post Covid world. The fastest pace
of monetary tightening by the US Fed starting 2022 was projected to topple the
world economy into recession. But recession fears have come undone, as the US
economy continues to cruise at a high-altitude growth and the International
Monetary Fund projects global growth of 3.1% in 2024 and 3.2% in 2025. The UK and
Japan – two of the G-7 countries have slipped into recession recently, but their
combined share in world GDP is below 5%.

Economy Not Overheating

It is in this the above context, one would agree with Professor Jayanth R. Varma that
the kind of “growth pessimism” reflected by the policymakers is not warranted. A
series of reforms have pushed up India’s potential growth rate much higher. The
economy is not overheating, and the interest rates should be lowered by 25 basis
points to send a signal that the MPC takes its dual mandate of inflation and growth
seriously, Varma, a member of the RBI’s Monetary Policy Committee (MPC) said at
the meeting held in early February.

Varma’s comments are worth reiterating:

*Inflation is projected to average 4.5% in 2024-25, and, therefore, the current policy
rate of 6.5% translates into a real rate of 2%. Such a high real rate is not required at
this stage to drive inflation down to the target of 4% as there is no evidence at all
that the economy is overheating.
*Perhaps, the majority of the MPC worry that the output gap has already closed, and
that the projected growth rate of 7% for 2024-25 exceeds the growth potential of the
Indian economy. Such growth pessimism is warranted. A real interest rate of 2%
creates the very real risk of turning growth pessimism into a self-fulfilling prophecy.

*During the last few years, we have seen several policy measures including
digitalization, tax reforms, and a step up in infrastructure investment that should
boost the potential growth rate of the economy.

Headline Inflation Above 4%

In February, India’s retail inflation as measured by the Consumer Price Index stood at
5.09% compared to a three-month low of 5.10% in January. However, it remained
above the central bank’s medium-term target of 4% for the 53rd consecutive month.
CPI inflation has been within the RBI’s tolerance band of 2-6% since last September.

According to rating agency CRISIL, core inflation core inflation fell to a 52-month low
of 3.4% but could not entirely offset the pressure from food prices.

Core inflation excludes volatile components of food and fuel and where monetary
policy has most influence. Economists believe the fall is on the back of monetary
tightening-led compression in demand. But the concern is headline inflation
remaining above 4% target mainly due to food inflation.

Reforms Should Boost Potential Growth

The reforms that Varma referred to have all been done and dusted. Several studies
had argued that a well designed and implemented GST regime could add around 2%
to the domestic GDP by removing administrative barriers and improving supply
chains. As the GST system has stabilized alongside other reforms, the target growth
ought to be much higher than 7%.

That would require a key component of GDP to start performing. Private final
consumption expenditure, an indicator of consumption demand comprising 55% of
GDP, rose by a mere 3.5% year-on-year in October-December 2023, as per latest
data.

For the full year, it is projected to grow at 3.02%. This is far lower than the 7.5%
growth in private spending seen in 2022-23. For 2023-24, expansion in private
consumption will be slowest non-pandemic year growth in over 20 years.

This shows that aggregate demand is weak.

Higher consumption typically leads to expansion of capacities, setting up of new
factories to cater to increased demand. This creates a virtuous cycle needed for
growth to reach its potential and to operate there over the medium term. But the
official data shows that capacity utilization in the manufacturing sector is around or
below the pre-pandemic trend level. (See Chart)

As per the latest RBI data, at the aggregate level, the capacity utilisation (CU) in the
manufacturing sector increased to 74.0 per cent in Q2 FY24 from 73.6 per cent in Q1
FY24. But seasonally adjusted capacity utilisation fell to 74.5 per cent from 75.4 per
cent during the same period.

India’s industrial output growth moderated to 3.8% YoY in January from 4.2% in
December (revised upwards).

Two Camps on Rate Cuts

Economists at Nomura believe that the overall, the macro data continue to point
towards a Goldilocks economy and are pencilling a 100 basis point cut in rates in
FY25 starting August.

“The RBI remains on a hold for now, but dissents within the MPC and a more
proactive stance on liquidity (vs previous stealth tightening) are typically the first
steps in the choreography of an eventual easing cycle. Our analysis of past policies
also shows that the stance has historically been changed belatedly and hence it does
not provide a reliable forward guidance”

The current ongoing debate between economist and market experts is pertaining to
rate cuts. The pro-rate cut camp is of the view that food inflation, which has 46%
weightage in CPI basket, cannot be directly controlled by monetary tightening. Here,
mainly supply-side measures work. On the contrary, some people may ask if elevated
interest rate is restricting growth and had there been a lower rate, would growth had
been much higher?

The question will lower interest rate propel investment growth?

“I am not too sure,” says Soumyajit Niyogi, director core analytical group at India
Ratings.

“Capex is mainly led by big corporates and lending rate for them has not gone up by
250 bps but just 100-150 bps. Banks are offering fine rates to best rated companies
by pegging it to the repo rate instead of MCLR. The private sector is not doing capex
even when the interest is benign,” he said.

Stagnant Wages Suppress Consumption

Similarly, what is stopping aggregate consumption?

“The growth in wages in both the urban economy and urban economy is only
modest. Nominal growth is single digit. If you adjust it for headline picture, then
growth is not very encouraging. Lower Interest rate will alleviate consumption trend
but that depends on whether lower rate is propelling private capex or not,” Niyogi
said.

According to Nuvama Institutional Equities, wage bill for BSE 500 private sector
companies moderated to 9% YoY in December quarter. This closed to decadal lows
(ex-covid) and has moderated from 20% growth in Q4FY23. “Such a sharp slowdown,
if it persists, could weigh on consumption, particularly the premium segment. By
sector, wage bill growth is strong only in BFSI (20–25% YoY growth). The moderation
is most pronounced in IT with wage bill growth now at just 3% YoY,” it said in a
reporting reviewing latest quarterly earnings.

CARE Ratings said that it remain optimistic about the prospects of the
infrastructure/construction related segments given the government’s strong capex
push. On the consumption front, a durable and broad-based improvement remains
also crucial for industrial activity. “With retail inflation moderating, it remains to be
seen if this gets reflected in an improvement in consumption.”

At the same time, experts are of view that domestic demand is expected to
moderate as lenders full transmit MPC’s past rate hikes and also due to regulatory
measures on credit growth.

The Final Cut

For turning dovish, the RBI could be waiting for a cue from the US Fed, which is
expected to cut rates starting June. But with core inflation staying below 4% and
consumption growth remaining weak, it may be time to stay ahead of the curve.
Fastest growing economy tag notwithstanding, it’s time for India to punch above its
weight.

END