How to get India out of this frustrating and complex recession

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India has more than a sixth of the world’s population. It’s also still a poor country. So what happens there is incredibly important for the welfare of the human race.

For a long time, good things were happening in India. Cautious pro-business reforms in 1980s were followed by the dismantling of much of the country’s overbearing regulatory state in the 1990s and 2000s. At the end of a long boom, India was five times richer per capita than in 1980.

Although the gains tended to go to a small slice of the population, India managed to make great strides against extreme poverty; it’s no longer the country with the largest number of very poor people (that dubious distinction now goes to Nigeria). Development has meant food, shelter and sanitation for hundreds of millions of Indians.

But this good news is now old news. The country has entered a major economic slowdown.

The growth number probably understates the magnitude of the slump. Industrial production has actually shrunk in recent months, as has the production of capital goods. Electricity generation has also slowed by more than gross domestic product growth.

A series of interest-rate cuts has failed to stop the decline. India already has real interest rates of negative 2.2%, lower than other developing Asian countries, suggesting that monetary policy isn’t going to be the answer. The government of Prime Minister Narendra Modi has also been engaging in structural reforms since last summer — cutting taxes, opening up the country to more investment and privatising industries. But although these might help in the long run, they have failed to stem the recessionary tide.

Diagnosing the cause of the crisis has been difficult. In a new paper, economists Arvind Subramanian and Josh Felman argue that the root of the problem isn’t a shortage of aggregate demand, or even Modi policy blunders such as demonetisation, taking currency out of circulation. Instead, imbalances in the country’s growth model have led to a buildup of bad assets in the financial system.

Before the global financial crisis of 2008, Subramanian and Felman note, India’s exports were growing robustly. But then in about 2011-12, when export growth slowed as a result of the crisis, investment fell, corporate profits were squeezed and business loans began to go bad. A rise in troubled loans on bank balance sheets should have caused a recession, but India’s economy was saved by a combination of falling oil prices, a boom in shadow banking and government stimulus. These, the economists argue, gave the economy a lift by causing consumption to rise while also creating a housing bubble. Banks became ever-more exposed to real estate.