How to deal with the demand slowdown

Revival of demand is key not just for consumption, but also private investment. Tweaking the tax rates can help in this India’s GDP growth has decelerated to 4.5 per cent in the second quarter of the current fiscal, and the government remains clueless on how to deal with it. Neither consumption nor export nor private investment are supportive. As of now, India’s economic growth is being driven by government expenditure. However, slowing economic growth will lower tax collections and cap the government’s ability to finance any serious stimulus package.

From the expenditure side, the magnitude of India’s deepening slowdown can be observed in three of the four major components of the GDP: consumption, investment and export. Excluding government expenditure, which comprises not more than 13 per cent, the Indian economy grew 3.05 per cent in the July-September quarter. Thus, the current situation is much worse than what the headline growth number shows.

Export prospects

Let’s start with exports. The government has been hinting that global headwinds are behind sluggish exports, and not without reason. The US is increasingly turning protectionist. President Donald Trump has removed India from the US GSP beneficiary list, which had adverse implications on major export items such as chemicals, pharmaceuticals and engineering goods. American tightening of immigration rules has dampened IT export prospects. The EU is struggling to deal with Brexit and slowing growth in its major economies such as Germany. The Middle East, another major export market for Indian merchandise, is troubled by its over-reliance on oil and increasing political tensions between Iran and Saudi Arabia. Supply chains are now sourcing more locally than before. All these developments are bound to affect India’s exports.

However, what the government is not saying is that India’s merchandise exports have been hovering around $300 billion for almost eight years now. It was $305 billion in FY12 and $303 billion in FY18. In FY19, it rose to $330 billion, but export prospects remain bleak in the current financial year. Obviously the problem lies somewhere else. Most of India’s merchandise exports are commodities — undifferentiated products with not much pricing power. Thus, a weaker rupee doesn’t make much difference to such exports.

Countries like Bangladesh and Vietnam are fast replacing India in areas it traditionally dominated, for example ready-made garments. In fact, India’s textile majors such as Arvind and Raymond are silently shifting their production base to Ethiopia to take advantage of cheaper labour and electricity. Vietnam is doing far better in attracting top electronics manufacturers.

Lowered demand

A number of factors are responsible for slowdown in consumption (comprising over 57 per cent of the country’s GDP) that fell to 5.1 per cent in Q2 FY20 compared to 9.8 per cent in Q2 FY19. Continuing rural distress, accentuated first by the note ban and then through domestic and global supply gluts, caps rural demand. The wholesale prices of most pulses crops such as tur (red gram), urad (black gram), channa (Bengal gram) and oilseeds are 15-30 per cent lower now. In contrast, the cost of major farm inputs and equipment such as high-speed diesel, DAP, insecticides and pesticides, tractors, cattle feeds and electricity have gone up by 10 per cent or so, squeezing margins. Lower margins reduce farmers’ income and affect their demand for goods and services.

High taxation and regulatory rent-seeking in sectors such as automobile and real estate are aiding the demand slowdown. For instance, effective taxation is up to 50 per cent for automobiles.

Similarly, high GST on key inputs eg cement, protectionism-induced high-priced steel along with the prohibitive stamp duty and registration charges are keeping home prices artificially high and capping demand. Given their strong backward and forward linkages with many other industries and services, the demand slowdown in these two is bringing down dependent industries.

Rising household debts and credit crunch in the shadow banking space (important for automobiles, consumer durables and homes) are further contributing to the demand slowdown and forcing companies to operate below capacities. No wonder investment, as measured by the gross fixed capital formation (GFCF), grew by a meagre 1.0 per cent in Q2 2019-20, even as its share in the GDP continued to decline. The decline in capacity is reflected by the 5.8 per cent contraction in eight core sector industries, which make up 40 per cent of the total industrial production.

Government investments, which generally bridge the gap during the slowdown started losing steam as State governments’ capex — which makes up the major share of public investments — has shrunk in the last two quarters.

Tax collection

Nevertheless, a 15.6 per cent increase in government expenditure in the second quarter, compared to 10.9 per cent same quarter last fiscal, has contributed one-third of the 4.5 per cent GDP growth rate. However, government demand is primarily dependent upon tax revenue, as it can’t really borrow much without forcing interest rates to rise, crowding out private investment.

Direct tax, including corporate and personal income tax, grew 5 per cent in the April-September period, compared to the same period last year. Thus, to achieve the budgeted target of 17.3 per cent in FY20, it must grow by a whopping 27 per cent — highly unlikely. GST collection remains muted due to slowing growth and a low base — only 1.2 million out of 62 million companies are GST-registered. Given this backdrop, the ill-advised corporate tax cut — estimated to cost ₹1.45 trillion — will further limit the government’s ability to spend and support growth.

In the absence of adequate consumer demand, corporates are using low interest rates to improve margins and indulging in share buybacks to further their stock market prospects. Similarly, halving of corporate tax has not led to any big-bang private investment. Lower return on bank deposits, in a country wherein these remain the primary channel of savings for most Indians, especially the retired and senior citizens, cutting interest rates may dampen consumption demand through their negative wealth effect.

That being said, the government can do two things to revive demand and induce the private sector to invest even in short run. The GST Council should increase the rates on low-GST items with inelastic demand and reduce rates for high-GST items with elastic demand. This will reduce rate differentials and discourage GST evasion and corruption, boosting consumer demand and, in turn, prompting businesses to ramp up their capex plans.

As the revival of demand remains the key to reviving private investment, it would help to consider reducing income tax rates for lower income people, if not for all. Rather than increased import duties, a weaker rupee can provide protection to domestic manufacturers and yet improve export competitiveness.

Singh is the CEO of Indonomics Consulting. Padakandla is a Assistant Professor at IMT, Hyderabad

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