The interesting character of the present growth slump is that we did not see it coming. In theory, there are a lot of low-hanging fruits in the Indian economy to sustain demand for a few decades. Even after the financial crisis of 2008, India was growing fast. That fast growth had caused high inflation.
Between 2012 and 2014, India's consumer price inflation (CPI), hovered around 10%. We wanted to bring it under control. The rapid policy action brought it down to 5% by 2015, i.e. within nearly one year. The CPI stayed around this mark till second half of 2017 and, thereafter, dipped even lower. Today it is below 3%. This should have been a cause for celebration. Yet, quite suddenly, growth was just gone. Why?
There were, of course, many reasons. In this article, we will try to understand one that is the least understood—growth-inflation dynamics.
Human Psychology Determines How Inflation and Growth Interact
Take the hypothetical case of a company that is doing reasonably well; its revenues growing at 11%. Out of this, around, say, 8% is contributed by inflation. So, the real growth of the company is about 3%. Now imagine suddenly the inflation turns to 3%. So, the company grow by about 6% instead of 11%. In reality, the real earnings of that company were the same.
When a business that is growing at 11% suddenly grows only at 6%, it will feel like a slowdown. It means that the company defers the purchase of a Rs10-crore machine. These ripple effects temper the economy.
The Knock-on Effects of Low Inflation
First, the profits of many companies fall because of lower inflation. Most companies have a credit period of 180 days or more. That means, their costs represent last year’s cost and revenues represent this year's revenue. If inflation falls drastically in that time, the margin between cost and revenue reduces rapidly.
If instead of Rs22 crore revenue, a company gets Rs21 crore, it may eliminate all its profits.
Second, these companies find it difficult to service debt. High inflation helps the repayment of debt. This is because debt repayment is always fixed in nominal terms.
When you take a loan, say in 2015, the loan instalments are fixed based on the outlook of inflation and interest rates. Ideally, as inflation falls, instalments should also fall, but does it ever happen? Companies that have wafer-thin margins, default.
This increases risks to banks. So, banks hold on to the instalments. Naturally, they make other borrowers more vulnerable.
Third, when companies see profits decline, they tend to scale back expenses. The scaling is not linear. For example, if your profits reduce by 50%, you cannot buy half a CNC machine; you buy none. Thus, corporate spending reduces. Such companies also cannot give a generous bonus to workmen. To keep afloat, they may have to fire some workers. Or, companies may stop hiring. Thus, this creates an investment slowdown.
Similarly, household spending also reduces. Imagine a family whose income is already committed to house rent, food, school fees, etc. When salaries rise 10%-15%, the burden of expenditure becomes easier year after year.
But when salaries do not rise or rise merely 5% and they don’t even get any bonus, they must defer their spending. They cannot go for luxurious holidays and have less discretionary spending, etc. All these cutbacks, cause a consumption slowdown.
Fourth, as both investments and consumptions slow, economic growth suffers. This causes revenues to decline even more, and economy is pushed into a negative spiral. Tax revenues fall. There are more bad loans. It strains bank balance-sheets even more. India has experienced all of these symptoms since late-2014, when inflation hit 4% level.
Low Growth Caused by Lowering Inflation Rapidly
The groundwork for inflation targeting was laid in 2008 Financial Sector Reform Committee chaired by Raghuram Rajan. Since Raghuram Rajan took over as the governor of the Reserve Bank of India (RBI) in 2013, RBI focus shifted to inflation targeting.
Bringing inflation down is not a bad idea. The Indian mind is acclimatised to 7% inflation. In 2012, inflation went beyond 10%. If it was brought down to 7%, we would have been fine.
But the lowering inflation beyond 7% rapidly, affects public psychology. The general public was not prepared for lower salary growth. Companies were not prepared to slow revenue growth. Banks were not prepared with strong balance sheets. These preparations should have been done BEFORE setting in motion the inflation constriction of the economy.
Without these preparations, the economy faltered. While revenues were being constricted, banks were being forced to recognise bad loans under prudential norms. This is akin to performing heart surgery and brain surgery at the same time.
To allow the public perception to adjust, we needed both, a mass education campaign to move to lower inflation paradigm AND a gradual reduction in inflation. Absent both, the impact of sharp constriction in demand and supply, to tame inflation, resulted in a slowdown, which superficially seems to be without any reason.
What Can We Do Now?
The first step is a explain this to the people. Ministers, experts, economists should explain the new paradigm of low inflation. There are many examples of low inflation economies in the developed world. Using their examples, we can explain how the low-inflation economy implies lower salary growth even when real growth is high. It means the interest rate on savings will SEEM low.
A concurrent effort is required to bring the large and small corporates to this new low-inflation paradigm. Corporates should expect lower revenue growth. It implies we cannot set sales targets at 20% revenue growth. The margin transmission across the supply chain may happen smoother if everyone is aware of the paradigm shift in inflation.
The education efforts must be targeted to banks too. As inflation expectations change, the strategies for managing bank balance sheets also change. The way interest rate transmission is done. None of this was done. It should start immediately because it seems lo inflation is here to stay.