Consumption slowdown should be a cause of concern as it was the last engine driving GDP growth.
Avinash M Tripathi
The National Democratic Alliance (NDA), led by Prime Minister Narendra Modi, scripted a new chapter in our polity by getting re-elected with a huge majority. Though consistent with the post-election exit polls, the scale of victory belied most conservative assessments before the election. The NDA now has a nearly two-thirds majority in the house of the people (Lok Sabha). It is also on its way of securing a majority in the Rajya Sabha by next year, according to some estimates.
Thus, this government has sufficient numbers to enact laws and lay the legislative framework for the coming decades. This is good news because, given the enormity of challenges, the stroke of pen reforms may not be sufficient.
The big challenges facing the finance minister are the crisis in the non- banking financial companies (NBFCs) and housing finance companies (HFC), and the GDP growth slowdown, especially the slowdown in private consumption expenditure.
Turmoil in the NBFC sector is threatening financial stability. The two prominent examples where asset-liability mismatch (ALM) and/or insolvency problems have manifested so far are Infrastructure Leasing and Financial Services (IL&FS) and Dewan Housing and Finance Limited (DHFL).
At first sight, there are strong reasons for the government to adopt a non-interventionist stance. The arguments are as follows: First, given smaller balance sheets, NBFCs are not systemically critical. For example, the balance sheet of DHFL is less than Rs 1 trillion, which is quite small compared to the public sector banks such as the State Bank of India.
Second, every act of rescue accentuates what economists call ‘moral hazard’. Privatisation of gains and socialisation of losses creates perverse incentives. Further, it erodes the legitimacy of the political system and leads to expectations of and demands for future bailouts.
Third, a Central Bank (CB) rescue is based on a compact between the CB and the financial institutions in which CB enjoys considerable supervisory powers during normal times, and takes responsibility for the downsides. Because NBFCs have enjoyed a light touch regulation by the Reserve Bank of India (RBI), the argument goes, the central bank should not be acting as a lender of last resort.
Fourth, the liabilities of the banking sector are monetary in nature. Demand deposits are used as a means of payment. By contrast, as the liabilities of the NBFCs are non-monetary, their failure would not undermine faith in the payment system. Consequently, NBFCs are less systemically critical than deposit-taking banks.
These arguments are correct up to a point. But we should also keep in mind the problems associated with negative sentiments and the crisis of confidence. What creates a financial crisis is not so much the financial loss but the uncertainty. Protracted resolution of the default makes the liabilities issued by the distressed financial institutions illiquid, freezing markets and creating an overall climate of doubt and suspicion. The sentiment is the key and the government should weigh its options carefully. RBI governor Shaktikanta Das’ assurance that the central bank will not hesitate to take whatever steps required to ensure financial stability is welcome in this context.
The second challenge facing the government is more structural in nature. According to the newly released data, the GDP growth fell to 5.8 percent in the March quarter, the lowest in the past five financial years. But more worrying is the composition of the slowdown. In theory, there are four major sources of aggregate demand: investment, private final consumption expenditure (PFCE), net exports and government expenditure. Exports and investment have been lukewarm for quite some time.
Recent data shows a sharp slowdown in PFCE growth. These figures are further corroborated by the forward-looking measures such as the recently released RBI consumer confidence survey. The survey shows that the share of consumers who are contemplating to increase non-essential discretionary spending in the near future has plummeted to the lowest level since September 2015.
Consumption slowdown should be a cause of concern as it was the last engine driving GDP growth. A consumption slowdown is protracted and hard to reverse. Moreover, worsening consumption sentiment implies that investment is unlikely to be revived soon. Businessmen make investments when their existing production units are working at full capacity, inventories are running low and projected estimates of consumption in the immediate future are high. Conversely, when there is excess capacity, inventories are building up and future consumption is estimated to be low, firms are unlikely to invest.
As Milton Friedman has said: “Only a crisis—actual or perceived—produces real change.” The challenge before the finance minister is to utilize the legislative mandate in crafting permanent and enduring solutions to these problems. The crisis is here. Will we see real change? Only time will tell.(Avinash M Tripathi is an associate research fellow (economics) at Takshashila Institution. Views are personal)Subscribe to Moneycontrol Pro and gain access to curated markets data, exclusive trading recommendations, independent equity analysis, actionable investment ideas, nuanced takes on macro, corporate and policy actions, practical insights from market gurus and much more.