Saving the Indian Economy
Act decisively now or prepare for a bad decade.
How Financial Machine Works
Indian GDP data published last week was shocking, but it shouldn’t have been. We all know we are in a slowdown, but why, and what we can do, is what I want to discuss. I learned how our financial machine works from Mr.Dalio’s research and books. I will rely heavily on research published by him.
Ray beautifully explains ( watch video) how our happiness and misery are a factor of money supply, a sum of cash and credit in the economy. Over centuries, the dominant component of the money supply shifted from gold to cash and, in the recent few decades, to credit. By cheaper borrowing, low-Interest rates increase the money supply, which is then spent or invested. By spending to purchase goods and services, we add to the incomes of others. Sellers are incentivized to produce efficiently, for a profit. With time buying and selling go higher and higher, fulled by money supply (credit), leading to economic growth.
But overspending in luxuries or wars heats the economy. We, as individuals and nations, borrow more than we produce. More money ends up chasing the same no of goods, which causes inflation. Inflation hurts the poor more. Extra money is also invested in financial assets such as real estate and stocks, making bubbles.
Every decade or so, central banks deflate these bubbles by increasing interest rates, which decreases money ( credit). Otherwise, like in 2008, these bubbles burst on their own, leading to economic crashes. Low credit is the cause of modern crashes in contrast to centuries back when kingdoms collapsed from low availability of cash (gold).
Governments and central banks keep this equation balanced. If one part is down, they stimulate the others.
What happens in Crash
In a crash, spending and incomes are down in a self-enforcing spiral. People immediately cut spending and become austere. One’s spending is another’s income, causing a domino of falling incomes for everyone. Incentives to produce also decrease simultaneously, leading to layoffs and industry shutdowns.
Governments respond to crashes by austerity or by increasing the money supply and their expenditure. In the great depression, we learned the government cant become austere; they have to make up for the falling consumption by people. Otherwise, consumption will decline further, and unemployment and bankruptcies will increase to painful levels causing social unrest. With some exceptions, the prices of goods also fall (deflation).
Before modern banking, the only way to pump money in economies was to spend on big infrastructural projects. That’s why in famines, Indian rulers built their palaces and forts to create employment and jump-start economies. After modern banking, the main lever was to decrease interest rates, if possible, in a time of the crash. Ironically low-interest rates are the cause and solution of economic crashes.
To summarise, the path of deflation and austerity is detrimental to any economy. Not even a single country recently took the approach of austerity; I mean, except India.
COVID
COVID caused a unique economic crash. With extremely low-interest rates across the globe, the money supply peaked before the crash. But COVID causes a massive fall in demand for goods and services. People sitting at home were neither producing nor spending, starting a domino of falling incomes and spendings.
To balance the equation, governments across the world lowered interest rates to support incomes by increased credit. But it didn’t work. No one was borrowing to produce and spend, and all this money went into assets, leading to stock price bubbles. The world started a recession (deflationary cycle) in March.
USA and EU increased government spending by giving money directly to people ( cash transfer or wage programs) to support incomes and spending. These governments have a rather unlimited amount of money in the short term because of strong currencies(reserve status). But the developing world doesn’t have that luxury.
Let’s summarise how western countries responded. Pump money in the economy directly ( cash transfer) and indirectly ( interest rates) until consumer spending picks up. Once a vaccine comes out, all this money will bring economies back on track with some inflation. It’s like sowing the seeds and waiting for rain. But India hasn’t sown anything.
Indian Slowdown in the 2010s
The Indian economy was slowing down even before the crisis, thanks to our jammed banking system ( link). Modern banks function as pipelines for the money supply. After a spree of un-responsible lending and defaults, Indian banks became hyper-cautious, limiting money supply to consumers and producers. That’s why just by lowering interest rates, the Reserve bank of India can’t increase the money supply. Besides, this strategy didn’t work anywhere else in the world during COVID. No one is borrowing to produce and spend; however, low-interest rates.
So India entered COVID lockdowns with a slowing economy and a twin balance sheet problem ( jammed banks and indebted corporates). But it’s not our past but our response to COVID that will destroy the economy.
Vulnerability and response
Our indebted businesses couldn’t make any revenue for months. Globally only the tech sector did well in COVID, which we don’t have in India. Heavy reliance on services and domestic consumptions became our Achilles heel.
You can see from the figures Indian corporate revenues are expected to fall highest globally — 48%.
To make the situation worse, we have also adopted a view that once lockdown is lifted, all will be hunky-dory. No, it won’t be. Who will make up for bankrupt businesses, or people who got fired? Even without a vaccine, the hole left in six months will slow the economy by 1–2% for a decade. That’s over the 4–5% growth before COVID.
This attitude lead came out in our stimulus (increased expenditure by the government to support incomes). Our stimulus was too small, only 8.6% of GDP, leaving a big hole of -17% in GDP.
Frankly, I will be surprised if the stimulus can give even 3.3% support to GDP. From my past professional experience, I know how little of this 8.6% will be delivered to people this year ( most items have a long gestation period or will be limited by rules and regulations). We can’t try direct cash transfer because of political and logistic reasons. Furthermore, any stimulus must increase government spending to make up for the contraction in people’s spending. The stimulus must be extra to the current government budget and must come from printing( borrowing), and it must put money in the hands of people ASAP.
To make things worse, our small stimulus shifted money from one department to another. An escalation with China is forcing the country to buy military equipment from abroad, decreasing domestic spending further. Finally, any further expenditure from the government will weaken the rupee in the international market leading to political uproar.
To summarise, the west increased money in the hands of people, and we are not doing a good job of it. Indian markets will open, the vaccine will come out, but a long term economic slowdown will come because we are leaving a hole.
Opportunity in crises
But this crisis is also giving us a big opportunity like the Kings of ancient India. If there is famine, make the best use of it by getting a new palace for yourself.
There is an opportunity for India to take up big infrastructure projects that start within months or complete those stalled because of budget. This will put money in the hands of people directly. These can be funded by domestic borrowing. After all, why should Indian banks lead to only philanderers? Or the government can print ( borrow from RBI), which will make the rupee a little weak, but also give our exports a boost. Anyhow our import bill has fallen thanks to low oil prices. This increased government spending will increase tax revenue boost and will start a positive economic cycle for everyone.
I know all these measures will be a little inflationary, and that holds the government back, given the political sensitivity to inflation. But there are easier ways to protect people from inflation than deflation.
Indian public and the political class are yet to face deflation. Since independence, inflation has been our only problem. Read world history; we will be begging for inflation when we will see deflation. The entire world is working on avoiding deflation; if we won’t, we must plan for a decade of economic hardship and social unrest.