Gravity will pull Indian economic growth back down to Earth

Ritesh Kumar Singh is the founder and chief executive of the policy research and advisory company Indonomics Consulting in New Delhi.

India and China are running neck and neck for the title of the world’s largest country by population. But in terms of economic growth, India is racing far ahead.

Last week, the Indian government released figures showing that growth for the fiscal year that ended in March reached 7.2%. In China by contrast, due to tight COVID controls, gross domestic product rose just 3% last year.

Amid growing gloom over the global macroeconomic outlook, India’s growth pace is quite a feat. With the country’s stock market booming, and the government’s budget deficit and consumer inflation both tamed, the Indian economy appears to be in a sweet spot.

But its momentum is weaker than it appears, even though economic output for the January-March quarter was up 6.1% from a year before, above expectations.

Both the government and the Reserve Bank of India expect growth in the current fiscal year to reach 6.5%. This is probably not realistic. Sluggish exports, worsening youth unemployment, and weak consumption are likely to cap growth at closer to 6%. Without effective action to ignite new growth engines, New Delhi is likely to have to settle for less.

Around three-quarters of last year’s output growth can be traced to the robust performance of the labor-intensive construction sector and services more broadly.

Despite the government’s effort to boost manufacturing with the Production-Linked Incentives subsidy program and high import tariffs, that sector continues to struggle. Indeed, the agricultural sector, which remains dominated by small farmers who have limited access to bank credit or quality inputs and depend greatly on unpredictable weather, is growing faster than manufacturing.

India’s manufacturing sector continues to struggle while its agricultural sector, dominated by financially vulnerable small farmers, grows at a faster pace.    © Reuters

The government of Prime Minister Narendra Modi has also been striving to stimulate private-sector investment but with little success. While financial markets were enthused by the reported 8.9% increase in gross fixed capital formation — a proxy for growth in investment — included in the GDP figures, this exuberance was misplaced. Most of the increase can be attributed to higher capital spending by state-owned companies and by the government itself to support infrastructure development.

Foreign companies are not proving any more eager to invest than Indian private companies. Net foreign direct investment inflows fell 27% in the last fiscal year, reflecting India’s inability to better capitalize on the push by multinational companies to diversify their supply chains away from China.

Consumer demand has been persistently weak, too. Moreover, demand is increasingly showing a K-shaped pattern, reflected in sales growth for expensive cars and SUVs outrunning the pace of sales of inexpensive motorbikes.

This divergence stems from deepening income and wealth inequality, an ominous trend for demand as the marginal propensity to consume tends to be higher for poorer households.

Foreigners cannot be counted on to take up the slack in demand for Indian goods. Goods exports are falling, and the year-on-year drop reached 12.7% in April. With protectionism on the rise as global growth slows, India’s export outlook is dim.

Weak demand in turn gives private companies less incentive to invest, even with banks more willing to lend. Consumer demand is unlikely to revive without a significant improvement to the employment outlook. According to World Bank data, only 23% of Indians aged between 15 and 24 are employed, less than half the proportion seen in North America.

Small and midsized enterprises (SMEs) and first-time entrepreneurs could play a significant role in job creation. By cutting back on red tape, the government could help all kinds of smaller business entities without the need to tap additional fiscal resources.

But the government has instead been increasing compliance burdens for SMEs. With a single-minded focus on maximizing tax revenues, the government has been steadily adding to filing and reporting requirements, which in turn compels small companies to spend more on consultants, accountants, and often, bribes for inspectors.

Rationalizing regulations will free up small businesses to focus on their actual operations. As their operations are usually more labor-intensive than those of large corporations, this could provide a significant boost to job creation without the need for additional subsidies or tax breaks.

Reduced red tape and regulation would also help rein in the kind of unproductive spending that now takes up more than four-fifths of the government budget. The savings could be used for growth-promoting capital investment.

The Modi government has done a good job bringing the budget deficit under control and ensuring macroeconomic stability. But it has failed to cut the regulatory cholesterol that is discouraging entrepreneurship and job creation, and in turn GDP growth.

In the absence of a broader recovery in private-sector investment or demand for Indian goods, the government will have to continue doing the heavy lifting. This will get more challenging if slowing GDP growth leads to lower tax collection. The silver lining remains the services sector, which can be expected to do relatively well and provide much-needed resilience for the economy.