Pivoting from a cyclical response to the structural reform agenda

But, in contrast to expansive lists, state capacity and political capital are typically much more limited. The challenge, therefore, is to identify which reforms to spend political capital on, and, equally, how to sequence them. To do this, however, one must first identify what the binding macroeconomic constraint to higher growth currently is.

Back in 2011-12, it was clear what the constraints were. The economy was overheating, reflected in an unsustainable current account deficit (CAD) and stubbornly elevated core inflation. The need of the hour was to temporarily tame demand—through tighter fiscal and monetary policy—and buy time to fix the supply side more durably. 

Since then, policymakers have doggedly pursued the latter, cleaning up the banking system, introducing a bankruptcy law, ensuring the housing sector is better regulated and making infrastructure an urgent priority. Simultaneously, macroeconomic stability has been institutionalized. 

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An inflation-targeting regime has ensured monetary policy is more rule-based, a goods and services tax (GST) has begun to pay dividends on the fiscal front, and a war chest of accumulated forex reserves has provided buffers to withstand global shocks.

Many of these actions have already borne fruit. Bank balance sheets are the healthiest in a decade and credit is flowing again. The housing sector has begun to flourish, albeit driven by the upper end. Combined tax as a proportion of GDP likely touched an all-time high of 18% last fiscal year, inflation has remained relatively well tethered, and forex buffers have bought the central bank some monetary policy independence from the US Fed.

But such is the nature of the development process that once one set of constraints is alleviated, new ones emerge. What then is the binding macroeconomic constraint to higher growth at the moment? Arguably, it is private sector demand not being broad or strong enough. 

This perhaps best explains why the much-awaited private sector investment cycle has not taken off more fully, despite corporate balance sheets being strong, profits healthy and cash levels high. With capacity utilization unable to decisively break out of the mid-70s, core inflation at multi-year lows—suggesting firms don’t have much pricing power—and nominal sales growth in single digits, firms are likely perceiving a demand constraint. 

Add to this the China Shock 2.0—the excess capacity that China is again flooding the world with, including India, whose imports from it are still elevated—and it is clear why corporates remain cautious for now.

To be sure, policymakers have undertaken a determined public investment push since the pandemic to combat softer private demand. Looking forward, however, stabilizing post-pandemic public debt will require fiscal policy to progressively retrench, as policymakers have correctly identified. 

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That said, it’s important for the fiscal consolidation to be gradual, so that the fiscal impulse is not withdrawn too rapidly, even as fiscal end-points may need to be tighter than envisaged to bring down public debt and create space for the next shock. All this will make it challenging to keep increasing public capex, year after year. 

On its part, monetary policy will have some space, though potentially limited by global headwinds and the growing vagaries of food inflation underpinned by weather shocks of increasing frequency and amplitude.

The implication: Cyclical policy space is largely exhausted after doing the heavy lifting for the last four years. For private investment to flourish, demand visibility will need to emerge more structurally, by boosting consumption and exports through reforms.

So what will this take? Consumption growth has been more tepid, averaging 4.3% over the last five years. Over any length of time, consumption dynamics are inextricably tied to household income dynamics. The fact that credit is flowing freely to households suggests that consumption is not constrained by liquidity—as was the case when the financial sector retrenched in 2019 —but by balance sheets instead. 

Sustainably boosting consumption will therefore come down to boosting incomes by raising quality employment further. India’s employment imperatives are not new. For much of the last two decades, labour’s contribution to GDP growth— vis-à-vis that of capital and total factor productivity—has discernibly undershot the growth rate of the working-age population.

This is also reflected in the rising capital intensity of India’s manufacturing and export baskets over the last two decades. In effect, therefore, boosting consumption necessitates making labour (vis-à-vis capital) a more attractive factor of production. What will it take to redress the balance between capital and labour? 

Why has Indian capital shied away from labour in recent decades? What is the role of education, health and skilling? Of labour laws and hiring frictions? Of the incentive structure directed at capital vis-à-vis labour? And of regulatory and managerial constraints? 

Answers to these questions is the key to making growth more labour-intensive and thereby supporting consumption. While these challenges are not new, they take on a renewed urgency because, by impeding consumption, they have bubbled up to become a binding macroeconomic constraint.

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But consumption cannot do it alone. Since World War II, only 13 ‘miracle economies’ have grown at above 7% for 25 years. They all had one thing in common: strong exports and global engagement. Prima facie, the current global backdrop appears more adverse, characterized by economic balkanization and industrial policy adventurism by advanced economies. 

But through the clouds, light emerges. India is quickly establishing a dominance in higher value-added service exports, which it must consolidate and expand. And China is vacating crucial space in labour-intensive, lower-skilled manufacturing exports, which India must seek to occupy. 

This will entail developing a relentless export mindset and engagement with the world, with all the policy pre-requisites that are so needed, including the recognition that import tariffs are often equivalent to export taxes.

All this will also require crucial investments in education, health, skilling, physical infrastructure and logistics, apart from those needed to enable the green transition. How will all this be funded, given the need to bring deficits down? By focusing on further boosting the tax-to-GDP ratio, which has already made encouraging progress. 

Revenue mobilization, however, should not accrue through higher tax rates, but by broadening the base and eliminating distortionary exemptions on direct taxes, rationalizing, simplifying and broadening GST, and shedding diffidence on asset sales. 

Next week’s budget offers a unique opportunity to lay out both the broader economic strategy and the enabling role that fiscal policy can play on the revenue, expenditure and regulatory fronts.

The good news: With corporate and bank balance sheets healthy, a benign CAD and a war chest of foreign currency reserves, the next growth cycle could be a long one. Therefore, if reforms can structurally boost demand—by making growth more labour-intensive and improving export competitiveness—the payoff could be very large. We must seize the moment.

These are the author’s personal views.

Sajjid Z. Chinoy is chief India economist at J.P. Morgan.