A cycle of low growth, higher inflation

Source: The Hindu

Synopsis: Unless policy action ensures higher demand and growth, India will continue on the path of a K-shaped recovery

Background

• Some economists are of the opinion that the Government should not intervene with the economy and that it will revive by itself.
• These economists’ reason that, like after the Great Depression, the economy rebounded worldwide, and so will it with us.
• However, such arguments are fallacious on four accounts

Why government intervention is needed for Economic recovery?

The first factor, demand.

• In the case of the Great Depression, demand was created by the Second World War effort.
• In the current scenario, there is no war to create demand.
• Further, the COVID-19 pandemic has resulted in demand destruction as confirmed in the Centre for Monitoring Indian Economy and other surveys.
• To counter demand destruction the western world has spent a lot of money stimulating the economy.
• Rising freight costs, non-availability of containers and a strong rupee relative to major competitors is hampering India’s growth exports to Western countries where demand has been generated.

Second factor is the rising inflation accompanied by stagnant growth.

• India is suffering from stagnant growth to low growth in the last two quarters along with rise in inflation
• Causes of Rising Inflation
  • One, high asset price inflation caused by ultra-loose monetary policy followed across the globe.
    • Foreign portfolio investors have directed a portion of the liquidity towards our markets.
    • Compared to a developed capital market such as that of the U.S., India has a relatively low market capitalisation.
    • It, therefore, cannot absorb the enormous capital inflow without asset prices inflating.
  • Two, supply chain bottlenecks have contributed to the inflation. Essential goods have increased in cost due to scarce supply because of these bottlenecks caused by COVID-19 and its reactionary measures enforced.
  • Three, India’s taxation policy on fuel has made things worse. Rising fuel prices percolate into the economy by increasing costs for transport.
    • Furthermore, the increase in fuel prices will also lead to a rise in wages demanded as the monthly expense of the general public increases.
  • Four, RBI is infusing massive liquidity into the system by following an expansionary monetary policy through the G-SAP, or Government Securities Acquisition Programme.
  • Five, an added threat of rising rates is the crowding out of the private sector, which corporates are threatening to do by deleveraging their balance sheets and not investing.

The third is interest rates.

• The only solution for any central banker to limit rising inflation is through tightening liquidity and further pushing the cost of money.
• However, rising interest rates lead to a decrease in aggregate demand in a country, which affects the GDP.
• There is less spending by consumers and investments by corporates.

Finally, rising non-performing assets, or NPAs.

• Our small and medium scale sector is facing a Minsky moment.
• The Minsky moment marks the decline of asset prices, causing mass panic and the inability of debtors to pay their interest and principal.
• India has reached its Minsky moment. Several banks and financial institutions have collapsed in the last 18 months in India.
• As a result of the above causes, credit growth is at a multi-year low of 5.6%. Banks do not want to risk any more loans on their books.
• This will further dampen demand for real estate and automobiles once the pent-up demand is over.

The Indian economy is in a vicious cycle of low growth and higher inflation. In the absence of policy interventions, India will continue on the path of a K-shaped recovery where large corporates with low debt will prosper at the cost of small and medium sectors.