INDIA'S FALTERING ECONOMIC GROWTH

India’s GDP growth has declined now for four consecutive quarters. Total GDP ( Gross Domestic Product) has dropped almost 3.1% since the 4^th quarter of 2016. Future GDP will likely get worse as the complete effects of demonetization play out.

It is important to read GDP numbers with a grain of salt since they are subject to frequent revisions. In an economy like India, GDP numbers are notoriously hard to estimate because of the size of the informal economy which employs ninety percent of the labor force and produces fifty percent of the nation’s total output. So, estimates and statistical adjustments are necessary for various activities in agriculture, small-scale industry, and services. There is also a deficiency of quality data in India which hinders the accurate estimation of GDP numbers.

Nevertheless, the trend in India’s growth is disturbing.

Leaving out the effect from recent pay hikes to government employees, GDP growth in the fourth quarter of the financial year,2016-2017, slumps to 4.1% on an annual basis. And leaving out the growth in agriculture that resulted largely from the benevolence of rain gods growth plummets further  to just 3.8% for the fourth quarter of 2017.

What is disconcerting are the constant claims of the strength of the Indian economy from the country’s Finance Minister and his mouthpiece the Niti Ayog. Assertions that India is the fastest growing economy in the world, or that India will soon catch up with the USA and China are just pointless chatter. China’s phenomenal growth in the 80’s and 90’s, when its economy was growing at 16% per year, was achieved without much fanfare. Our politicians and bureaucrats would be well advised to cut down on the make-belief euphoria and self-promotion and get on with the urgent business of freeing the economy from red tape and government interference.

Can Indian catch the US or China?

Let’s take the claim that India will overtake the US in terms of gross GDP by the year 2040 and test it with simple Math. USA’s current GDP is about $18 trillion compared to India’s GDP of $ 2 trillion. If the US economy grows at just 1.5 % per year, it’s income will increase by about $ 270 billion. For an equivalent amount of income to be generated the Indian economy would need to grow at 13.5% per year. Furthermore, since India has roughly four times as many people as the US, India’s GDP would have to grow at 54% per year for the average Indian’s income to grow as much as an American’s.

This is clearly impossible. And so the claim that India will catch up with the US by 2040 is just rhetoric. The US is a rich country with strong and long-standing institutions established on the principles of free markets, liberty, limited government, and a fair and equal justice system. India would need to fix its outdated institutional structures before any comparison is even merited.

Equally ridiculous is the claim that India would soon outpace China. Even assuming that going forward India’s growth rate is twice that of China, 8% for India versus 4% for China, it would still be 2040 before India can reach half way of China, and 2060 before India can fully catch up with China. And that is in the extremely unlikely scenario that India’s growth will be double that of China’s for the next forty-three years.

Remember, India was a slightly bigger economy than China’s in the mid-1960’s, but today the Chinese economy is five times larger, and the average Chinese citizen is four times richer than the average Indian.

The sobering reality is we have a long way to go before we can claim we have “arrived.” India is not even in the top 50th percentile of countries on most social, economic, quality of life, health care, liberty, and economic freedom indicators ( read my blog on how India stacks up against other countries here ).

So it is best to temper the euphoria and focus instead on understanding what produces growth and come up with a set of sound economic policies to alter the path of India’s economic growth.

Let’s understand one thing unequivocally. The government does not produce growth. So crediting any government, NDA or UPA, for India’s economic growth or comparing growth rates between two governments is nonsensical.

Economic growth is the result of the production activities of the people of the country. The best a government can do is to adopt policies that support this growth. The worst a government can do is to kill all incentives for private growth by overtaxing business, reducing economic freedom, increasing regulatory burdens, and crowding out capital for private industry through overspending, debt borrowing, and weak financial institutions..

What is GDP?

The simplest way to understand economic growth and GDP is to think of India as a big factory producing widgets. The GDP of this factory is the total value of the widgets produced in a given period. The more widgets this factory produces, the higher the GDP. To ensure that a rise in the price of widgets does not artificially inflate the factory’s GDP, a constant base price is used.

How can this factory increase its GDP?

There are two ways by which this factory can increase its production of widgets. It can increase the size of its production plant, and hire additional workers, or it can increase the productivity ( output per worker ) of its workers by improving their skills, adopting new technology with modern management and production techniques.

(1) Infrastructure

Let’s examine how different variables affect the production of widgets. Let’s take infrastructure. Assume that the factory only gets intermittent power for a few hours a day. That will impact the production of widgets. If the road connecting the factory to the market is in a poor condition and raw materials and finished products can’t be transported efficiently, that too will reduce the production of widgets. So good infrastructure is critical to increasing this factory’s production.

Investment in infrastructure is called gross fixed capital formation. In the ten years from 2004 to 2013, gross capital formation in India increased at an average rate of about 19% per year. In the last four years ( 2013-2017), gross fixed capital has grown at a mere 4.2% per year, and this will adversely impact India’s future growth.

(2) Capital

Our widget factory also needs money ( credit ) to expand. If loans are available at reasonable interest rates the factory’s production capacity could be expanded, and production of widgets increased. The availability of credit from banks and financial markets is therefore vital to increasing economic activity.

Are Indian banks able to provide the loans necessary to grow output? Indian banks, especially the public sector banks are in deep trouble because of bad loans, or non-performing assets, as they are euphemistically called.  As a result, bank loan growth has dropped drastically from about 18% in 2011 to 5.1% in 2016-17. And the problem will likely worsen as the magnitude of bad loans increases post- demonetization. The Reserve Bank of India is now contemplating something called Prompt Corrective Action(PCA) against 17 Indian banks, mostly public banks, which will further impede their ability to lend money.

So the ability to borrow money to grow the factory and produce more widgets is in real danger.

(3) Technology and Innovation

Productivity is the key to achieving permanent increases in the standard of living. In fact, the ONLY thing that creates sustainable long-term economic growth is increases in productivity.

Currently, the average worker in India produces $3.40 of GDP per hour which is in the bottom 10th percentile of all countries. In comparison, the average worker in Norway produces $ 75.2 and in the US $67.3 of GDP per hour.

We have a long way to go before we can catch up with the rest of the world. Much of India’s growth so far has come from a growth in the labor force–the number of people in the 18-60 age group. The 1991 liberalization in policy also helped by increasing productivity of both capital and labor. The bottom line is that if India wants to consistently grow at 8%-10% per year, it will have to double its productivity every 7-8 years.

There is NO OTHER WAY.

One of the surest ways to increase the productivity of the workers in our nation-factory is to invest in new and innovative technology. Only changes in technology can bring about permanent increases in productivity.

Unfortunately, India is in the bottom 40th percentile ( ranked 66th out of 128 countries) when it comes to innovation. In 2014, China led the world with 928,177 applications for new patents and the US was second with 578,802. India lagged way behind with 42,854 patent applications. India spends only 0.82% of its GDP on Research & Development while leading countries like S.Korea spend 4.3% of their GDP on R&D.

India, however, does produce the most number of graduates in Science & Engineering of any country in the world and India’s top 3 Universities are ranked 20th ( out of 73 countries) in the QS University average ranking score. So the foundation for success in innovation and technology is there. What is missing is institutional support from the government.

The best thing the government can do to promote economic growth is to target investment towards investments that will increase productivity–technology, new product innovation, R&D, knowledge-intensive employment, high-level skill development, and education.

(4) Taxes and government policy

How does government policy in the form of taxes and regulations affect our widget producing factory? The higher the amount taken away by the government in taxes, the less is available to reinvest back into the business, to increase capacity and hire more people. So high taxes reduce the production of widgets and impede economic growth. Similarly, government regulations affect the production of widgets. If the government regulates when the factory can open and close, how much of its product it can sell and at what price, and imposes huge transactions costs with heavy paperwork, clearances, and burdensome inspections by corrupt officials, then all of that impacts the production of widgets.

It is therefore imperative that for India’s economy to grow, government policy must focus on reducing taxes and eliminating the high regulatory costs on businesses.

In global rankings on economic freedom and ease of doing business India ranks in the bottom 20% in the world. This puts India in the “mostly unfree” economies primarily because the government maintains an extensive presence in many areas through public sector enterprises. A restrictive and burdensome regulatory environment discourages risk-taking, innovation, and entrepreneurship. Corruption, underdeveloped infrastructure, and poor management of public finance also undermine overall development.

How can India increase economic growth?

So how do we get our nation-factory to produce more widgets?

Government’s extensive presence in industry and commerce is the single biggest reason India’s economic growth has never reached its potential. Get the government off the backs of business and watch the Indian economy take off. If the Modi government can somehow understand this very straightforward and intuitive fact it can be the transformational government it promised to be.

Business needs a free, unfettered environment to flourish and regulations reduce economic freedom and make businesses less productive. Free markets have proven to be the most productive economic system by far of all available alternatives. Per capita income in countries with free markets is five times higher on average than in countries in which the government controls the economy ( Heritage Foundation, 2017). To produce more widgets the government needs to reduce the tax burden and the onerous paperwork and regulations and set Indian business free.

The government needs to invest and not consume, build roads, storage facilities, and power grids and not statues, invest in skill development and education and not in loan waivers and populist subsidies. The Indian government consumes about 23% of the total annual budget and invests less than 5%. Those proportions need to flip for the economy to grow.

I have written extensively about the bloated Indian bureaucracy and government and how it sucks up resources for its existence.

The nation-factory also needs capital to grow. Companies can keep more capital to reinvest if the government would reduce taxes on business. I have called for a radically new tax policy that replaces all existing taxes, including income, corporate and capital gains taxes, by a simple consumption tax of 10% on the gross value of ALL goods and services consumed in the country. This single government policy has the potential to rocket India’s growth into double figures ( 12%-15% per year).

The Reserve Bank also needs to find market-based solutions to the bad loan problem. It needs to force the government’s hand into privatizing all banking in India. It is important to understand that the only reason we have government-owned banks in India is to allow politicians and their crony capitalist friends to loot the system. These public banks are inefficient, poorly managed, corrupt institutions and must be privatized immediately so that a strong institutional base of credible, risk-based banking can be developed in this country.

A well capitalized privately owned banking system, complemented by strong equity and bond markets, is vital to support India’s economic growth. The government should eliminate all unnecessary regulations ( and there are hundreds of such mindless regulations currently in place), and create an environment for the efficient allocation of capital.

Lastly, the average Indian needs to up his skill set to compete in today’s rapidly changing global economy. India spends only about 3% of its GDP on education compared to 5% for the average country, and 9% for the top twenty richest countries in the world. There is direct causality between education and skill levels, productivity and economic growth.

India needs to triple its expenditure on skill development and education for the nation-factory to produce more widgets.

The government also needs to privatize the widget producing factory. Individual entrepreneurs who risk their own capital will run the factory more efficiently compared to a factory run by bureaucrats who have absolutely no skin in the game. The Indian government still manages many of the large resource and raw material companies –energy, steel, cement, chemicals, coal, fertilizers. These behemoths are monuments of inefficiency and increase input costs for the widget factory, as a result of which Indian widgets cannot compete in the global market.

Finally, for the nation-factory to produce more widgets demand has to increase. Otherwise, it would just be building inventory. This demand could also come from other countries but only if Indian widgets are competitive in price and quality. India’s merchandise exports shrank for the 11th month in a row in November 2016. Over the last three years exports of Indian products has dropped 4.7% ( see chart below), and the government’s target of exporting goods and services worth $900 billion by 2020, now looks ridiculously abstract.

Conclusions:

India’s economic growth is facing headwinds. Demonetization was a reckless gamble, and it cost the nation almost 2% points of GDP–in other words a loss of about Rs. 2.5 lakh crores–with nothing to show for in return. India’s public banking system is running on life support starving the nation’s businesses of much-needed capital. And the deep underlying structural problems of overregulation, high tax burdens, inefficient and corrupt bureaucracy, and the authoritative reach of the government machinery, have not been addressed by a government that promised transformational change. The only thing that has gone up is the putrid back-slapping rhetoric of politicians and bureaucrats most of whom wouldn’t have a clue of how to grow an economy.

The government cannot grow the economy. The best it can do is get out of the way and let private enterprise and free markets produce wealth. If Mr. Modi thinks that he can somehow ‘fix’ the economy he needs a rethink. The economy is too complex an ecosystem for anyone to be able to manipulate or fix. Hopefully, Mr. Modi has learned that lesson after his failed demonetization experiment the currency.

If Mr. Modi wants to be the transformational leader he so desperately craves then he must understand the government’s limited role role in promoting economic growth. He must realize that there are only two ways to increase India’s GDP: by either increasing the number of people working to produce widgets and by increasing the number of widgets each worker produces ( productivity).

Much of India’s growth so far has come from growth in the number of people in the 18-60 age group–the working age group–and the 1991 liberalization policy which helped to increase capital and labor productivity.

The demographic dividend may go on for a few more years. But, if India wants sustainable growth of  8%-10% per year going forward it has to double its productivity every 7-8 years. This will only happen if we reduce the size of the government and invest that money in improving the infrastructure, upgrading human capital by spending heavily on skill development and education, creating a government-free environment for creative innovation and R&D, lowering taxes on capital and wealth creation, and reducing the regulatory burden.

The Modi government has done very little to impact the economy in any meaningful manner. It has applied failed Keynesian-style policies and tried to grow the economy by increasing consumption through stimulus packages. These policies have failed everywhere else and are unlikely to work in India. What is required is an investment-led growth built upon cutting-edge technologies that have the potential to raise productivity,

If Mr. Modi wants to transform India, he needs to transform his thinking and get some right-minded advisors.