There is good news and bad news. The good news is that the recent behaviour of the Indian economy tells us that it is no longer a developing economy. India is behaving like a middle-income economy. The behaviour of the economy over the last twenty years has been much like a capitalist economy, which is the subject of economics textbooks in developed economies. No doubt the government plays a part, both positive and negative, but the economy is moved by private sector behaviour.
The Indian economy has gone through a growth cycle. In a business cycle of the normal sort, we say there is a recession when income growth is negative for two successive quarters, i.e., total income has gone down for six months at least. This was what happened during the post-2008 crash in many developed economies. India has not had an output loss in any two successive quarters in living memory.
What India has experienced is a cycle in growth rates. In his recent Jindal Lecture, Raghuram Rajan has charted the course of the economy over the last twenty years. What we see between 1999 and 2019 is a sharp upward movement in investment until around 2007, and then a drop in investment till 2019. At the peak in 2007, investment was as high as 50%+ of the GDP. There was a brief upsurge again in 2014-16, but then decline resumed.
GDP growth averages 8% (new series) for 2005-11, and then 6.8% for 2012-19. But, each phase is characterised by see-saw movements. Growth is not constant from quarter to quarter. The short upsurge in investment in the 2013-2019 period leads to an upsurge in growth from 2012 to 2016, but, then, both investment, and growth fall away. The Indian economy has moved to a higher plateau of sustainable growth. But, having said that, we still do not understand the nature of the growth cycle.
What India is going through is a cycle of the type which was first studied by the great Swedish economist Knut Wicksell. In the second half of the nineteenth century, there had been a rapid growth of banks, and bank credit. While in earlier years an entrepreneur was restricted by how much money he had or could borrow from friends, now banks were willing to lend. The amount of cash needed to sustain a large inverted pyramid of bank lending was quite small.
When there was optimism, investors expected high returns. If banks were willing to lend at rates below the expected profit rate, there would be an expansion of credit, and an investment boom. But, if investment was not matched by real savings sooner or later, there would be inflation. Banks would have to hack up interest rates, and the boom would collapse. Several borrowers would go bankrupt as they would have invested in long-run projects that were not as yet complete or begun to earn income. Banks may also find themselves over-stretched, and fail if their borrowers could not repay.
This picture painted by Wicksell is exactly what has happened in India. Various PSU banks were lending money to long-term investment projects for mining, infrastructure, and real estate. As the boom continued, more lending was done to consumers, whose incomes were going up. Not just banks, but even non-banking lending companies proliferated. Investment led to growth, and the higher incomes reinforced the growth through consumer spending.
India also had the problem of inconsistency in different parts of the government. Thus, under UPA, while loans were given to various infrastructure projects, the government introduced an environmental policy that stopped licensing such projects. Investors had borrowed money-even invested it-but, were banned from finishing their projects. This led to non-performing assets.
Wicksell foresaw that such booms collapse when banks find they need to recall loans, and put up interest rates to avid losses. Once the boom ends, the downward cycle continues inexorably. Wicksell wrote at a time when there was no tradition of state action. But, even the state may be caught in a financial constraint, and may not be able to revive the economy.
So, India is behaving like a capitalist economy acquiring maturity. In early phases, economists believe, the state can drive the economy. But, in mature phases, the state is also part of the economy. It is also a borrower, and an investor. This way of thinking about policy has not yet become common in India. There is a temptation to think that the state can, or should be able to solve any slowdown. That is no longer so. The breakdown in the credit market, both in banking and non-banking sectors with bankruptcies, are part of the collapse in a growth cycle of this kind. The cure is not a Keynesian one of spending more public money. Partly, it is to wait till expectations improve. But, more important is a drastic reconstruction of the credit markets. India needs a serious regulatory institution for credit markets. RBI is no longer enough. Other countries, such as the UK, have a separate Financial Regulatory Authority besides the central bank. India needs serious examination of the regulation of its financial markets.
The author is prominent economist and Labour peer. (Views are personal)