But even in a slowdown, the growth rates in India today exceed the pre-1990s so-called Hindu rate of growth of approximately 3.5 per cent. While the volatility of growth has no doubt increased after the economic reforms in India, post-independence growth cycles still have similarities with the current slowdown. Understanding these is educative.
India’s slowdowns have been triggered mainly by supply shocks. In the early years, these were largely due to monsoon failures, which used to lead to large government spending. Since the Reserve Bank of India was then obliged to automatically finance government deficits, this spending used to be accommodated. But that would usually be followed by a severe tightening, thereby hitting industry just as input prices tended to rise.
A similar pattern occurred as oil price shocks became important from the 1970s onward. Since the increases in global oil prices were not immediately passed through to consumers, government deficits would rise and be monetised. At the same time, private spending would be squeezed, while the period of monetary tightening that followed would also be used for some pass-through of oil prices. So, costs would rise for industry just when demand would fall.
These types of supply shocks raised costs at all levels of production, even though firms continued to have excess capacity. The supply shocks, in other words, would shift up or to the left on an elastic, rather than an inelastic, supply curve.
Economic liberalisation and reforms stopped automatic monetisation, forcing the government to borrow at market rates. Investment, too, was now largely a private sector activity, and the growing share of retail and housing loans increased the sensitivity of consumption to interest rates. As a result, growth and investment became much more sensitive to these rates.
Interest rates were gradually freed but proved to be volatile. In the late 1990s, as capital flowed out of India after the Asian financial crisis, a liquidity squeeze, aggravated by sharp increases in policy rates, resulted in high and sticky loan rates. The investment cycle collapsed and took five years to recover.
At the same time, overcapacities built up during booms make private investment inherently volatile. In the latest boom phase, loan rate volatility was somewhat reduced because of improved articulation of market segments. Maturing of institutions such as the liquidity adjustment facility also allowed more policy fine-tuning in response to shocks.
But volatility in interest rates still came from large corrections in policy rates due to the unprecedented shocks associated with the 2008 global financial crisis. The same crisis was also preceded by a sharp rise in world food and oil prices — canonical supply shocks in the Indian context.
The Indian government responded to the 2008 crisis by reversing fiscal consolidation to create a fiscal stimulus after global export and domestic private demand fell. But government-supported expenditures also raised the demand for food, whose prices were already high, even as restrictions of various types on farm trade prevented an appropriate supply response.
Increased risk aversion by overseas investors as a result of the euro crisis also led to foreign exchange outflows, putting pressure on the rupee and raising the price of imports. The cumulative impact of all this was that demand fell for industry as rates rose, just as input costs rose. This, plus the excess capacity built in the previous boom, inhibited new investments. Problems in land acquisition and in the allocation of other natural resources only compounded the situation, affecting investments in infrastructure and adding to the supply bottlenecks in the economy.
Thus, India has all the components of pre-reform growth slowdowns in its current episode — high food and oil prices, large fiscal deficits and demand squeeze on industry. The difference is that the demand squeeze has now come predominantly through interest rates.
So despite low industrial growth and excess capacity for a year, core inflation remains above 5 per cent. Costs are high and mark-ups on costs are often countercyclical — these being raised to spread fixed costs when capacity utilisation is low.
It is possible to target policy properly to match the structure of the slowdown. The administrative hurdles that restrict investment, especially in areas where there are shortages, must be lifted. The composition of government expenditure must also change from creating demand in sectors where increase in supply is disabled, to releasing supply bottlenecks.
Critical and focused action in these directions is the type of countercyclical policy that is feasible and could be effective. As costs and inflation come down, falling interest rates would help boost recovery. India’s potential rate of growth has risen, but the correct policy combination required for the stabilisation of business cycles has not been implemented.
Ashima Goyal is Professor of Economics at the Indira Gandhi Institute of Development Research, India.
An earlier version of this article was first published here by The Hindu Business Line.