On November 8, India marked the third anniversary of demonetization, the single biggest monetary experiment in human history to curb black money. Prime Minister Narendra Modi surprised India and the rest of the world with the announcement that 500- and 1,000-rupee banknotes would no longer be legal tender. Overnight, more than 86% (US$206 billion) of the total currency in circulation at that time was affected. The prime reason given by the government for such a bold move was to root out corruption. But cash only accounts for about 6% of all illegal holdings in the country.
The suddenness of the announcement and printing-press constraints prevented the immediate replacement of the demonetized currency with new notes. The total amount of currency used as legal tender declined by 75% overnight. This acted as a shock to the economy and created a liquidity crisis. It also hit consumption badly, which directly impacted production, and following the domino effect, employment, growth as well as tax revenue went down. The GDP growth rate of 8.01% in the 2015-16 fiscal year fell to 7.11% in 2016-17 after demonetization. With this monetary exercise, India took its biggest ever risk with its domestic consumption driven economy.
Before Indians had a chance to recover from this shock, the government implemented the most complex tax reforms in its history, the GST (goods and services tax), on July 1, 2017. The old license regime (an elaborate system of licensing, regulations and red tape for setting up a business) was back with a new name, in the form of a complex tax rate mechanism.
There were several issues with the GST, such as multiple tax rates, surcharges, and the requirement to file monthly returns. It imposed criminal penalties for a sale without an invoice, misuse of tax refunds, and manipulation of tax credits. In a country as big as India with a large informal sector, the high GST rates and complex compliance needs make doing business quite difficult.
According to a survey by AITUC (the All India Trade Union Congress), as of September 2018, a fifth of India’s 63 million small businesses contributing 32% to the economy and employing 111 million people has faced a 20% fall in profits since the GST rollout and had to fire hundreds of thousands of workers. According to the Laffer curve, raising tax rates always results in lower tax revenues. That’s mainly due to confiscatory tax rates slowing the velocity of money.
After these two major disastrous reforms, India’s economy has seen a lot of turbulence in relation to GDP growth going down each successive quarter, the fiscal deficit growing significantly, and various sectors facing crises.
The fundamental reason behind such dismal performance on the economic front is government policy itself. In order to eliminate corruption, the government has waged a war against the informal economy. But a large portion of the economy, especially in rural regions, is informal, so this becomes a war on the economy itself. Hence the government has ended up killing the economy. India lost its crown as the world’s fastest-growing economy in May this year.
Is the slowdown cyclical or structural?
The current debate among economists is whether the current slowdown is cyclical or structural. The government probably thinks it is more cyclical in nature. But that ignores the fact that cyclical slowdowns are recessionary. A recession is two consecutive quarters of slow growth, but the Indian economy has been slowing down for quite some time and despite having successive interest rate cuts this year and the fiscal deficit reaching 102% of the 2019 annual budget, the economy has yet to show any positive signs.
According to Fitch Ratings, the Indian economy grew by 4.7% in the July-to-September quarter, the lowest in six years. It’s quite evident that the current slowdown is depressionary rather than recessionary in nature. A depression is a sustained period of below-trend growth with no signs of collapse or getting back on trend. For example, if a country’s trend growth is 5-6% and it is currently growing at 3-4%, then the 2-percentage-point gap is a depressed growth. Depressions are persistent and structural in nature, which take decades to resolve. Structural problems cannot be solved with cyclical solutions.
An economy based on creating value
India needs urgently to start the second wave of reforms (since 1990) in order to address structural challenges faced by the economy, such as slowing demand, low saving rates, complex labor laws and land reforms. Relaxation of capital controls is one of the best ways to attract foreign investment. Apart from that, India needs to take bold steps in the capital market with more focus on connecting rural India, which accounts for 80% of consumption demand.
It should focus more on research and product development rather than the more traditional focus on manufacturing and assembly. India needs to move up the value chain and progress from being primarily a service provider for many different industries, to becoming an innovator across industries, and indeed, many parts of the local and global economy.
India needs to focus on three key factors: competition, deregulation, and market access. A long-term strategy for sustainable growth in the next few decades should be built to counter the threats posed by artificial intelligence (AI) and automation. For that, an economy based upon on innovation and creation of intellectual property will be vital for sustainable growth. In the future, countries high in IP activity and a strong culture to boost innovation will have a large share of world GDP.
We Indians have already missed the opportunity to reap the benefits of the demographic dividend, but we need to capitalize on human resources efficiently. It’s a race against time, and if the current administration keeps prioritizing settling the political agenda (as it appears from five years’ experience) and ignoring the economic woes, then there is a greater chance of the Indian economy heading for structural breakdown within a few years.