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17 Sep 2019


Statistically speaking, it is difficult to assess optimal growth for an emerging market such as India. By the virtue of being a highly unorganized economy, India’s market sentiment cannot be ascertained solely on macro numbers. Also, this is not the first time the Indian economy has recorded such a disappointing performance as there are instances in recent history when the number has been much lower than the current threshold. Nevertheless, the slowdown is evident, and all is not well with the world’s fastest growing major economy. At 5%, the Q1 FY20 number has indeed come as a surprise and is even lower than the estimate of most economists. Predicting whether growth has bottomed out though is difficult, as things stand.

The Transition: Too much stimulus may stoke inflation fears despite demand side slowdown

Giving due cognizance to the persistently low inflation as well as high unemployment metric, we believe that India is showing classic signs of what the short run phillips curve represents. The assumption states that in the short term, the relation between inflation and unemployment remains inverse. In other words, in a country’s economic environment - high unemployment and low inflation can co-exist. Worryingly however, this negative correlation ceases in the longer term as repeated monetary and fiscal efforts lead to a rise in inflation while keeping high unemployment conditions intact. This happens because of two reasons.

Firstly, as the Government tries to spend its way out of a slowdown, it raises more debt. Consequently, the RBI must print more money – increasing the currency in circulation in the process. Following closely, interest rates go up to control the resultant inflation and stifle the very capex fiscal expansion intended to start by making both capital and labor expensive. Unemployment therefore no longer influences inflation and resultantly rises simultaneously along with inflation. If this condition holds true than in the longer term, India may be heading towards stagflation, which is a socio-economic cleft stick.

Demand Side Constraints: The efforts centered around supply side may not yield desired results

Taking cues from the ongoing slowdown, we believe that the poor manufacturing GVA of 0.6% and a headline inflation of below 4% are signs of severe demand side constraints – pushing India into a vicious cycle of high unemployment and low inflation. Evidently, if the slowdown persists than corporations will be forced to lay off employees, which further increase the rate of unemployment. At the same time, panic will ensue, followed by monetary easing and rapid fiscal expansion, which will in turn spawn inflationary tendencies. RBI’s accommodative monetary stance along with the Union Government’s massive expenditure plan are a case in point here. Undoubtedly, this is a response to the ongoing production cuts, job losses and inventory buildups being reported from across the system.

While the Government has taken steps to control this malady and arrest the apparent shift, most of its efforts are concentrated towards the supply side. On the other side, the revelation of the Q1 FY20 GDP numbers are however confirming our concerns regarding the ongoing consumption slowdown in India. It is therefore the demand side, which needs immediate attention. In terms of constant prices, we note that the Private Final Consumption Expenditure (PFCE) or household consumption has further gone down by 100 bps as a percent of GDP this quarter. Even though an unfavorable base effect is also a contributory factor, the impact of the slowdown on the manufacturing value add is very much apparent.

The remedy therefore lies within the mandate of stoking household consumption. In order to achieve this objective, the Government must therefore influence consumer sentiment by way of tax sops, GST rationalizations and cheaper credit. While this may negatively impact the Government’s financial fire power, we are with the view that a fillip to consumption will more than compensate for any tax revenue losses. If the demand side remains constricted, there is a very high probability of a sticky stagflation

spawning in the medium to long term. Buildup of systemic inventories, holding up of fresh capex along with a slowing credit demand will compel the supply side to take drastic measures – a situation that will exacerbate the slowdown and hasten the advent of ill-effects associated with high unemployment and high inflation conditions. By the virtue of India being a domestic demand driven economy, it is therefore clear that household consumption remains the country’s best bet out of this slowdown.