India’s economic growth slowed to 5.7 percent this quarter, alarming many economists and investors. The sharp decline in GDP growth, from 6.1 percent last quarter, follows a series of ambitious yet disruptive policies from the Modi administration, including the rollout of the standardized Goods and Services Tax (GST) and demonetization. However, pinning the recent slowdown on the transitory effect of the central government’s reform packages would be a mistake. Far from being blips caused by the haphazard rollout of well-intentioned policies, India’s economic slowdown is symptomatic of broader macroeconomic problems. Trends in investment, manufacturing, and consumption form a troubling picture of slowing growth, which threatens to harm India’s bid to modernize industry and lift standards of living.
Demonetization is a natural scapegoat for India’s slow growth. The program was highly criticized by Indian Nobel Laureate and Economist Amartya Sen who said “I find no reasoning behind this decision. It will have adverse effects.” By eliminating 86 percent of the usable cash in India, economists believe that demonetization hurts consumption and spending. This in turn hurts manufacturing and industry by lowering the demand for goods and depressing growth.
But demonetization alone is unlikely to be the cause of India’s economic woes. Demonetization occurred in the middle of last year, but declining rates of growth were seen well in advance of its implementation. India’s growth was dropping a full three quarters before demonetization took place, which would suggest that other factors were responsible. It also seems unlikely that demonetization would be the only factor in declining growth three quarters after its implementation last year. Abheek Barua, chief economist at HDFC Bank Ltd said, “I don’t see it as a transitory slowdown even though growth may pick up from its current level in coming quarters.” Despite demonetization fading into the past, the trends in competitiveness and industry which underpin India’s slow growth are likely to continue.
Another factor that is contributing to slower growth is the rollout of India’s new Goods and Services Tax. The GST is said to have contributed to the economic slump by causing sellers to empty their inventories prior to the rollout of the tax, depressing sales which occurred post-tax. Economists expected the rollout of the GST to have a downward pressure on growth, but few expected the effects to be this significant, with polls of economists predicting growth to stabilize at 6.6 percent.
While demonetization and the GST are two easy places to pin the blame for slower growth, it would be wrong to stop there. Instead, structural problems with the economy as well as the natural decline in growth associated with development play an important part in India’s economic prospects. Coping with declining growth therefore requires addressing more fundamental aspects of the economy, and not simply pointing the finger and expecting things to improve in the future.
Declining competitiveness for Indian exports has been a major long-term factor in India’s slow growth. In 2015-2016 Indian exports dropped by 262 billion dollars, or 15.6 percent. Additionally, manufacturing expansion slowed 9 percent from last year’s high, and the finance and service sectors also saw sluggish growth. Conversely, under the period of rapid growth between 2003 and 2011 Indian exports grew by 20 percent.
Struggling export, manufacturing, and finance sectors are symptomatic of broader problems in the Indian economy. Swaminathan Aiyar, a frequent consultant to the world bank, attributes much of the lackluster growth to “low productivity, the cost of doing business, export logistics and red tape, and the cost of credit.” In the same vein, capacity utilization, which measures the extent that production capacity is being used, has fallen almost ten points since 2012. Low capacity utilization leads to low investment by signaling a lack of confidence and momentum in India’s economy.
Allowing demonetization and the GST to mask the need for more comprehensive economic reforms would be a mistake. Education, skill development, labor regulations, and the business permit environment all require substantial development by the government. In the long run, these factors are the most important parts of driving economic growth, and far outweigh the impact of any one or two isolated policies. For example, India’s ranking in the global Doing Business report was 134th out of 190 nations, highlighting the struggle that manufacturers face when attempting to grow.
Instead of simply blaming GST and demonetization, serious economic reforms are needed to accelerate growth. Prioritizing education, reducing the share of industry controlled by state owned enterprises, and lifting caps on foreign direct investment are all important steps that the Modi government should take to begin to make Indian industry more competitive. Even with the impact of the GST and demonetization beginning to fade, without structural reforms to make Indian enterprise more competitive, the Modi administration cannot expect to see growth return to previous highs.