India's No. 2 Again, And PM Modi Should Be Worried

For quite awhile now, it's been rare to hear the name "India" without the giddy qualifier, "the world's fastest-growing large economy." Those seeking to promote India as a destination for investment -- including, perhaps especially, its government -- have driven home the message that India is the "bright spot" in the global economy.

The latest data on economic growth have, however, punctured that narrative reasonably effectively. While full-year growth for 2016-17 came in at a respectable 7.1 percent, the numbers have benefited from a change in how inflation is measured. The real news is that fourth-quarter GDP growth fell to 6.1 percent -- lower, in other words, than China's. India's no longer the fastest-growing large economy in the world, and government ministers are going to need a new first line for their speeches.

It would be easy to blame this on Prime Minister Narendra Modi's disastrous decision, last November, to withdraw 86 percent of India's currency from circulation. His predecessor, Manmohan Singh, said in Parliament at the time that the move might dent growth by two percentage points or more, and that estimate might well be borne out by these numbers.

But what's more worrying is that it's now clear that India's economy was slowing well before Modi delivered a coup de grace last November. Growth in gross value added -- output as measured from the economy's supply side -- has slowed every quarter since last spring: It's down from 8.7 percent to 5.6 percent in these latest figures. The problem isn't just demonetization: Something is very wrong with India's engine of growth, which looks to be spluttering.

The biggest problem is, of course, that nobody is investing. Those speeches about how India was the world economy's sole bright spot might have won enthusiastic applause, but too few investors and companies followed up with actual money. As a proportion of GDP, investment has trended downwards for some time, and is now well below 30 percent. Investment actually shrank in absolute terms in 2016-17.

Partly, that's because the government has simply not moved swiftly or decisively enough to address India's mountain of bad loans beyond passing a bankruptcy law and, more recently, giving the central bank additional power to force resolutions in the most pressing cases. Much of Indian investment, even for large-scale, growth-enhancing infrastructure projects, is routed through banks. And public-sector banks, struggling with their balance sheets, are reluctant to lend. Bank credit growth has recently hit multi-decade lows.

But that's hardly the only problem. As and when banks are willing to lend, they find too few takers for funds. Companies complain, of course, that the Reserve Bank of India -- now officially targeting inflation -- is keeping real interest rates too high. What's more relevant, however, is that the government hasn't worked hard enough to reduce the sort of risk that worries investors who've been burned multiple times in the past when they reposed faith in the "India story." India desperately needs a more efficient and less intrusive state, as well as deeper and more flexible markets. But structural reform of that sort has been taken off the government's agenda. 

The finance minister, in a press conference after the GDP data was released, defended the government's record by highlighting the troubles it inherited, and the poor monsoons with which it's had to deal. He wasn't wrong, but that's not the whole story. While the government inherited an underperforming economy in 2014, the data show it was tracking upwards. The business cycle was turning, commodity prices were easing and growth was increasing steadily as Modi took office.

And while there have indeed been bad monsoons, the last one was excellent -- a fact that's visible in the strong performance of the agricultural sector in the latest data. In other words, if the economy started slowing two years into the government's tenure, and that loss of momentum has continued and intensified, then it can blame nobody but itself.

What has India's government done wrong? Its greatest faults have been a lack of focus, a shortage of ambition and misplaced priorities. Since he took over three years ago, Modi has focused on being simply a competent manager and an investment-oriented marketing man for the India story. He seemed to believe that would be enough to propel India to double-digit growth.

But it's now clear that this simply isn't enough. Deeper reform can't be avoided any longer: defanging India's obstructive state, cleaning up its judicial processes and dispute resolution, reforming and privatizing state-owned banks, easing restrictive land and labor laws. Investors were willing, early in Modi's tenure, to buy into the idea that he would start on some of these long-pressing problems; that enthusiasm has clearly dissipated now.

Given that the political opposition is in disarray, Modi might imagine that he will coast to reelection easily in 2019. But these numbers should be a wake-up call. Unless he starts working on real structural reforms immediately, the damage to India's growth story -- and to his own image -- could be permanent.

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