To begin with, it is necessary to get the concept of a ‘recession’ right. It is a state when the economy has two successive quarters of negative growth. This should be accompanied with high levels of unemployment. Growth forecasts by the International Monetary Fund (IMF) and The Economist had shown no negative growth in any developed nation in 2022, though negative rates have since been spoken of for the US and Eurozone by the former. Unemployment rates are very low, however, at 3.5% in the US and UK and even lower at 3% in Germany and 2.5% in Japan. However, for 2023, the IMF is talking of negative growth in Germany and Italy. Therefore, while it may sound impactful to use the word ‘recession’, a slowdown in growth would be a more appropriate term.
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How would India be affected? Here, the two extreme views would hold, with some qualification. It is not doomsday for certain, as the economy is chugging along notwithstanding the travails of high inflation, rising interest rates, selective crop failure, a depreciating currency and limited investment. There is no need to be overly sanguine either, as the numbers are overstated to a large extent by base effects and the mood at the ground level is still cautious. Everyone is worried about inflation being sticky, interest rates going up and not enough jobs being created in the Indian economy.
The impact of a sharp slowdown in the West can be best explained by its effects on the real and monetary sectors, which can also be described as our resilient and vulnerable segments, respectively.
Our real economy is resilient because it is domestic-oriented. Growth emanates from consumption, which is largely domestic, supported more by government and investment expenditure and less by global trade. Our exports-to-GDP ratio at around 12-13% provides a shield, as slowdowns typically mean that export demand declines. The fact that Indian exporters are not significant players in global markets has helped. A negative of being less globalized, thus, has worked to our advantage. This is one reason why GDP growth of about 7% in 2022-23 looks very likely, and this performance may be followed by growth of around 6.5% in 2023-24.
Even if viewed from the production side, sectors such as agriculture, mining, electricity, construction, trade, transport, communication, public administration and real estate are largely driven by domestic factors, which leaves manufacturing as the only vulnerable segment (a sector that accounts for 17-18% of our GDP). This is where the bright story ends, however.
In a globalized world, countries are integrated through prices—of goods, currencies and capital (i.e., interest rates)—which can become major challenges. While growth has slowed down, inflation in the last three months has been very high—in the region of 8-9% in developed countries, 5-7% in emerging Asia and 8-12% in emerging Latin America. This has meant aggressive monetary policy by central banks, with programmes that include sharp monetary tightening.
The immediate impact has been two-fold. First, funds find it better to operate in the West, where returns are higher. Second, there are fewer investable funds that have to be reallocated to different markets. India has been hit hard as foreign portfolio flows have turned negative.
Simultaneously, a slowdown in the West also means that while our GDP growth is resilient, invisible flows are not. Demand for software services would come down, and also the flow of remittances. These two have been major cushions for India’s current account balance for several years. A slowdown in demand will affect both of them, widening our current account deficit, which is expected to be around 3-3.5% this year. Then, even as foreign investment flows become less dependable, there would be pressure on our balance-of-payments and hence on our foreign exchange reserves, which finally gets translated into the rupee weakening based on fundamentals. This is over and above the impact of a strong dollar making other currencies weaker.
The contagion of challenges on the forex front translates to a Reserve Bank of India (RBI) problem: policy must counter not just inflation (which should ideally come down in the course of time as demand ebbs and commodity prices recede), but also currency swings. Selling dollars to steady the Indian currency creates a liquidity problem for the system. Interest rates have to be increased, which RBI has been assiduously doing. But in this process, small and medium enterprises will see their finance costs rise. Larger companies may be immune to this process. Also, under normal conditions, higher interest rates are not a limiting factor for growth. But in the current environment, there will be some impact on smaller firms whose profits will get affected.
This is why policymakers cannot bask in the comfort of 7% GDP growth. A slowdown in the West will seep through, via the monetary route, and this will ultimately have a bearing on India’s growth prospects.
Madan Sabnavis is chief economist, Bank of Baroda, and author of ‘Lockdown or Economic Destruction?’
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