India’s Great Slowdown

India’s Great Slowdown: What happened? And what’s the way out?

Original Article:

The great slowdown

India’s GDP growth in Q2 of 2019-20 fell to just 4.5%, the worst for a long time. Growth in consumer goods production, exports, imports and government revenues is close to, if not, negative. Many indicators are similar to those of the 1991 slowdown. Electricity generation growth is the slowest in 3 decades.

The slowdown is not on account of the three standard triggers:

  • Food harvests have not failed;
  • Fuel prices have not risen &
  • Fiscal deficit has not spiralled out of control.

The government has introduced various measures to reverse the slowdown – corporate tax cut, plans to privatize 4 PSUs. Meanwhile RBI cut interest rates by 135 points in 2019 in the hopes of reviving lending. But lending is falling, and investments continue to be mired in its slump.

So where is the problem?

India’s economy has been weighed down by both structural and cyclical factors with finance as the dominant factor. India is suffering from a series of Balance Sheet crisisThe first wave was a twin-crises – arising out of banks having lent heavily to infrastructure projects when the Global Financial Crisis struck in 2008. Thus, 2 engines of growth – investments and exports, had suffered.

The economy still managed to exhibit reasonable growth on the back of falling oil prices and the NBFC credit boom. Furthermore, NBFCs over-lent to real estate. India is now facing a Four Balance Sheet Challenge – Investments, Exports, NBFCs and Real Estate. The low growth is further damaging these and other sectors’ balance sheets.

Is the Slowdown Structural or Cyclical?


Structural features such as labour laws, land restrictions and governance or income inequality haven’t changed in decades. Hence, calling the slowdown of the past year structural is flawed. By the same reasoning, calling the boom of mid-2000 structural is flawed too.

Calling the slowdown cyclical seems misguided too. Aggregate demand has fallen but so has supply (production). Pointing just to the demand is inadequate.

GST and demonetization depressed growth in the immediately following quarters but the economy was rebounding strongly after that. Some other elements have triggered the downturn two years after the implementation of these measures. Also, there is merit in the argument that policy

uncertainty might be dampening the economic activity but its link with falling demand is difficult to establish. Some have blamed the slimming of budget deficits but government spending and true deficits have been growing rapidly.

The key components of demand have been weakening for a decade. What we are seeing now is the exhaustion of the last engine of growth, consumption.

Structural Problems Develop in the Growth Engines

From 2002 to 2011, Indian economy witnessed a boom. Three broad factors had been at work – cyclical, global and structural. Initially, all three helped buoy the economy. But more recently, they have been dragging it down.

In the early 2000, world economy was on an upswing and Indian economy began to stir. Firms and consumers started believing that India was now poised to grow at 10% yearly for decades to come. Investments reached a record level of 38% of GDP while capital inflows exceeded 9% of GDP.

Soon, the boom collapsed as global and structural factors that underpinned it fell away. With the Global Financial Crisis of 2008, export growth fell to 5% from 15%. At the same time, global commodity prices also collapsed, hurting farm incomes. Even as output growth remained broadly unchanged, agricultural income growth fell by 1.3% in 2012-2018 as compared to 2002-11. Meanwhile, growth was much slower, interest rates much higher and exchange rate much more depreciated, all of which seriously hurt the corporate financial projections. Soon, many firms were unable to service the interest on their debts. As these problems mounted, NPAs soared. As a result, India was saddled with a serious structural problem, a Twin Balance Sheet (TBS) crisis. Even the corporates in good shape found it difficult to obtain loans from banks. Soon, investment growth decelerated beginning 2010 while exports slowed starting around 2012. Consequently, real imports of goods and services also cratered.

The belief that this TBS problem was addressed by recapitalization of banks and the introduction of Insolvency and Bankruptcy Code (IBC) seems misguided.

Root Cause of the Great Slowdown: Unresolved TBS Stress

Some progress has been made towards resolving the TBS problem. In the last 5 years alone, the government has recapitalized banks to the tune of 2.8 lakh crores apart from the 70000 crores budget for the fiscal year of 2019-20. This has improved their CET1 ratios and by writing off bad loans, reduced net NPAs. Despite that, NPAs, at 9.5 lakh crores, are still at 9.5% of the bank assets, the highest of any major economy in the world. USA’s NPA ratio is below 1%. For PSU banks, NPA is even higher at 12%. Moreover, another 2.5 lakh crores of debt, mainly from the power sector, is being renegotiated, which is really a softer phrase for stressed assets.

In order to resolve this bad loan problem, RBI introduced the Insolvency and Bankruptcy Code (IBC) in 2016. However, it has proved to be much slower than envisaged – resolved cases took an average of 409 days against the specified 270 days. Only 2 lakh crore of bad loans have been resolved so far with recoveries of just ₹83000 crores. In the meantime, the promoters of stressed companies have been removed but no new owners have assumed responsibility. Their debts are piling up while their repayment capacity has been deteriorating.

Furthermore, as this virus spreads, companies have cut back operations and investments and laid off employees. The stress has now spread beyond the legacy problems of the banks and infrastructure firms, encompassing NBFCs and real estate sectors, thereby making it a Four Balance Sheet Problem.

What has kept the economy going?

The negative shocks of demonetization and GST were offset by a variety of factors with oil price decline as the primary factor from 2014 to 2017. Starting 2017-18, the economy was propped up by three cyclical factors: exports, hidden fiscal stimulus and unexpected credit stimulus.

  • World demand and depreciation of rupee resulted in non-oil exports growing from -8.6% in 2015-16 to 8.9% in 2017-18.
  • A large share of government spends have been shifted off-budget, mainly to Food Corporation of India (FCI) and various PSUs such as NHAI. Accounting for these spends shows that the deficit has really been increasing. Spending has exceeded even the immediate post-GFC years.
  • Demonetization saw heavy cash flows in banks and mutual funds. These funds were lent out as the economy started to recover from the shocks.

Why slowdown now? The bursting of India’s housing Bubble

The trigger for the slowdown was the collapse of ILFS in September 2018. With ₹90000 crores of debt, its failure sent shockwaves throughout the financial system. Also, since the failure was unexpected, markets woke up to reassess the entire NBFC sector. Subsequently, it was uncovered that much of NBFC lending had gone to the ailing real estate sector. The demand for housing has been much smaller and slower than the supply. As of June 2019, the top 8 cities had an unsold inventory of 10 lakh units against annual sales of just over 2 lakh units. Maintenance of this inventory needed incremental financing, much of which came from NBFCs. By 2018-19, NBFCs accounted for about half of the ₹5 lakh crore in real estate outstanding. Demand became evidently sluggish for the foreseeable future. However, the developers could not sell the inventory for lower prices because that would destroy the value of the collateral that was pledged to secure the lending.

Soon, mutual funds started cutting their exposure to NBFCs for the fear that they would not be repaid. As a result, NBFCs were caught in a funding squeeze. Loans to small businesses and consumers for durable goods (cars) were affected, causing the sectors to slow.

The situation was similar to the US housing bubble except that housing prices did neither reach sky high, nor taste the dust. Instead, as supply outpaced demand, there was a rapid unsustainable lending. The bubble finally burst in 2019.

TBS-2 Arrives

Stress on banks began to rise. The issues of slowing exports and ailing power distribution companies had not been resolved and a second wave of problems came from real estate, ILFS and difficulties in NBFCs. Banks’ lending to NBFCs amounts to 10-14% of their loan books. The recapitalization of state banks might not be able to provide an adequate buffer, thus, causing banks to push back lending. From a high of 20 lakh crores in 2018-19 to virtually nothing in the next six months, the brutal crunch in commercial credit clearly shows that the economic activity has collapsed.

The intensifying stress on the corporate sector and thereby on the financial sector has led to an increase in lending rates while the profits of the average corporate are growing similar to the GDP. In Q2 of 2019-20, lending rate was 10.4% while nominal GDP grew at 6.1%. Even the government’s cost of borrowing is above nominal GDP growth. With investments and exports weak since the GFC and consumption no longer propped up by credit, growth is collapsing.


As cyclical supports to growth have fallen, they have exposed severe problems with the structural balance sheet foundation. In the current situation, some of the standard remedies for ordinary cyclical recessions are ineffective and some counterproductive.

Things not to do:

Monetary Policy

As long as rate cuts do not translate into lending rate reductions, policy easing will neither provide support to the economy nor give much boost to the inflation. While banks can now borrow at lower rates, they are charging higher risk premium. Therefore, lending rates have not fallen. Administrative orders can compel banks to reduce lending rates, but that would expose them to real risks without being compensated. The solution is to strengthen the financial and corporate sectors.

Fiscal Policy

Income tax cuts, though politically popular, should not be cut. It would add burden on the already wide fiscal deficit. In fact, it will give more money in the hands of those who have money. In fact, India should think of ways of bringing more taxpayers in the income tax net.

Also, there are constraints on the government’s ability to issue debt because stressed banks have little appetite for government securities. They cannot take more assets with the risk of generating losses. Government securities virtually are very safe, but their prices can fall when interest will rise.

Expansion of fiscal deficit will push up government interest rates. Thus, corporate bond rates will shoot up as well. Consequently corporates will seek bank lending, thereby pushing bank rates higher.

Things to do:


Despite its solid AAA rating, ILFS defaulted. That is why, investors are worried that corporates and NBFCs might still have unseen solvency issues. A comprehensive review, therefore, of the NBFCs and mutual funds and even banks is needed because a second wave of stress has arrived – good assets are turning into bad ones. Once the worst problems are unearthed, the government and RBI will be able to focus on clean up (resolution).


IBC needs overhauling by improving the incentives of bankers, promoters and judiciary.

Bankers find little incentives in resolving bad loans as it runs the risk of being investigated by anti-corruption agencies. They need to feel safe that a witch-hunt against them will not be launched.

Courts should not be involved in assessing the different resolution plans. It should be the creditors’ responsibility to make a plan towards realizing maximum value while the courts must only ensure that proper procedures have been followed in arriving at a decision.

Most delays are caused by endless appeals by the promoters of bankrupt enterprises. Since they cannot be prohibited from exercising their legal rights, their incentives need to be changed. Only wilful defaulters should be barred from bidding for assets. That way, promoters would have an incentive to cooperate with creditors and not hinder the resolution process by appealing at every step of the process. This would create a fairer system where IBC would no longer penalize the promoters whose firms went bankrupt for no wilful action of their own.

Also, Debt Recovery Tribunals (DRT) should be opened up for non-banks so that they do not clog the IBC system by inappropriately filing bankruptcy claims.

IBC may not be suitable for certain sectors, power and real estate for example, where social considerations are as important as commercial criteria.

When real estate developers go bankrupt without completing projects, retail buyers who had booked their houses in advance are left with neither money nor the house. The IBC’s resolution might give them only a fraction of their money back. It would seem far better to provide them with a speedy settlement, with a guaranteed minimum fraction of their purchase amount. This can be done only by government intervention by way of a bad bank for ailing real estate projects.

Many ailing power distribution companies, though technologically sound, are unable to find buyers owing to their debt and operational costs. A bad bank would have to create a holding company to hold on to such assets and manage them until they can be sold back to the private sector.


Troubles in private sector banks such as ICICI and Yes, the Nirav Modi scandal, and the shenanigans of ILFS and other NBFCs have all exposed the shortcomings of RBI and government. A major re-haul of the regulatory framework is necessary. To start with, risk weights of lending to NBFCs should be increased. Even the banks under PCA in 2017-18 were increasing their exposure to NBFCs because lending to NBFCs is categorized as low risk avenue.


Apart from meeting the minimum capital requirements, additional funds beyond minimum should be linked to each bank’s progress in cleaning up its balance sheet. This will give banks an incentive to resolve their bad loans.


PSU banks continue to have legacy issues and suffer from political interference and decision making inertia, all leading to imprudent lending. A simple but politically difficult way would be to allow majority private sector participation in the PSU banks by amending the Bank Nationalization Act.

Better Data for Policy Navigation

The government must reboot the data systems in three sectors: real, fiscal and financial. Reliable data on GDP, employment, budget and bad loans is needed. This can be done by setting up the relevant committees and mechanisms with their respective authorities. When these numbers are dependable, they can do both instil confidence and provide a reliable basis for policy making.


Rural livelihoods need to be reinvigorated for the sake of the farmers and the overall economy at large. Certain reforms in the sector have been recommended by Professors Ashok Gulati, Bharat Ramaswami and Harish Damodaran:

  • Replace power and fertilizer subsidies with direct transfers
  • Create a single market for agricultural products
  • Do not impose export restrictions when domestic prices are high and import restrictions when domestic prices are low
  • Incentivise water conservation
  • Grant permission to new GMO technologies

The Centre and the states will have to cooperate to bring about these reforms in agriculture. Direct cash transfers to farmers are better alternatives to income tax cuts. In practice, implementing it would involve extending the size and scope of the PM-Kisan scheme.


The government currently has a tremendous amount of political capital. It now has the opportunity, need and the ability to take politically difficult decisions and not settle for easier alternatives with a short term fix. A short term fix could bring euphoria, lulling us back into policy inertia. Such a reaction would be dangerous.

The near term growth expectations need to be more realistic and moderate on account of the external environment. India has not even reached the upper-middle income status and trading opportunities are seeing a decline.

However, if we got into the great slowdown in part because of what we did in the past, surely we can also emerge out of it by what we do next.

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