India’s economy has rebounded quickly as new pandemic cases fall. After contracting by 6.3 per cent in the past year we expect GDP to grow 11.2 per cent in the coming year as pent-up demand boosts consumption. But pent-up demand is released only once. What will drive growth after that?

With lockdowns ending, a mountain of household savings has funded goods purchases, returning demand to pre-pandemic levels. Now, as vaccines are rolled out and herd immunity rises, pent-up demand for services can keep fuelling growth.

But what happens when services demand too is back at pre-virus levels, probably this year? By then, the scars left by the pandemic will also be emerging.

Central government sought to address that in February’s budget by boosting capital expenditure. It raised its own spending, left taxes unchanged hoping that stability will encourage private investment, and announced a ‘bad bank’ plus a Development Finance Institution.

The central bank is offering its support, but it must tread a fine line between normalising liquidity and maintaining orderly bond and currency markets. Inflation already risks exceeding the 4 per cent target next year but we expect the bank to keep interest rates low.

Yet will this partnership between government and central bank provide the new medium-term growth driver India needs?

Take capital spending; the public sector makes up 25 per cent of India’s overall investment but less than a third comes from central government rather than states, and past experience suggests that when revenues are squeezed, capital spending suffers. Other parts of the economy need fixing for state government and private-sector spending to take off.

Meanwhile, the Production Linked Incentive scheme that worked for electronics, medical devices and bulk drugs has been extended to cover about 10 new sectors. But while financial incentives can give an initial push to manufacturing, sustainable growth requires improvements in the ease of doing business, an R&D culture, and a move away from import tariffs.

And the risk-averse banking sector needs to change. Bad debts and insolvencies remain a problem and the structure of the proposed ‘bad bank’ is unclear. Issues such as seed-funding need to be thought through carefully.

Large and listed firms have benefitted through the pandemic and these ‘formal’ businesses can deliver large efficiency gains. But their growth could put small informal firms out of business. Some 85 per cent of India’s economy is informal.

The bottom of the pyramid needs to be protected with social welfare schemes so that the disruption does not lead to a permanent fall in demand. And in the meantime, the government must push on with reforms to help small businesses grow, not least by reducing their regulatory burden.

The government’s medium-term growth proposals are welcome, but what’s on paper must happen in practice. Over the coming months we will be watching to see that disinvestment gets done, if India moves from import substitution to export promotion, and whether social-welfare spending expands. And the sooner the currently suspended Insolvency & Bankruptcy Code is re-instated, the better the chance to overcome banking-sector strains that could potentially pile up.

First published 19 February 2021.

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