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Good Luck Only Comes With Good Policies

June 19, 2016

Onno Ruhl, Country Director for the World Bank in India and Frederico Gil Sander, Senior Country Economist, World Bank. Business Today

In recent years, it has become uncomfortably common for economic forecasts to be continuously downgraded. In its most recent World Economic Outlook, the IMF has reduced its growth forecast for the global economy by 0.2 percent to a modest 3.2 per cent. What lies behind these repeated downgradings? And what does the current forecast mean for India?

While many factors can lead to slower global growth, we focus on a common source of disappointment in both advanced and emerging economies: financial sustainability.

Credit is a fundamental pillar of the prosperity that the world has achieved today. Families, firms and governments borrow to invest and to cover temporary shortfalls. However, borrowing decisions are often based on optimistic assumptions. For instance, families in the United States hoped they would be able to afford the mortgages on their homes; manufacturing firms borrowed to invest so they could meet demand that was yet to materialise; and today's indebted governments expected that future growth would generate the tax revenues they needed to service their growing debt.

Fifteen years ago, when much of today's debt was incurred, continued growth was not an unreasonable expectation. This was because for the past two centuries, relentless improvements in technology had constantly driven growth. Then, from the beginning of the 21st century, poor countries finally began to catch up with the richer ones in earnest. Growth flourished as new processes and machines were invented, and emerging economies raced to adopt new and existing technologies. Since then, however, escalations in productivity have slowed down. The pace at which the poorer nations are catching up with the richer ones has also decelerated. This has been especially so over the past three years when growth in the large emerging markets such as Brazil and China has cooled.

When expectations do not materialise and revenues are not enough to repay debt, a difficult process known as 'deleveraging' must ensue. Since the time of the global financial crisis we have witnessed the painful deleveraging of households and banks in advanced economies, especially in the United States. Governments in a number of European economies and, more recently, China's provinces have had to undertake reforms to ensure fiscal sustainability. While the slower progress of technological advances and other fundamental drivers of growth may have caused the initial downturn, the need to deleverage has exacerbated the economic slowdown.

Contributing to disappointing growth is the fact that debt can often be 'hidden' in what are called 'contingent liabilities'. These are obligations - sometimes contractual, sometimes implicit - that become debt when certain events happen. For example, just recently, the government of Mozambique found itself with 1.4 billion dollars of new debt when guarantees that it had not previously disclosed were called on. When such hidden debt emerges, or its magnitude becomes apparent, disappointing growth follows, and further deleveraging becomes necessary.

India's growth has not disappointed. The World Bank continues to forecast a modest acceleration of growth in the coming fiscal year despite a number of headwinds from global trade and a dissipating oil dividend.

Yet this 'great deleveraging' across much of the world has at least three implications for India. The first is that prudent macroeconomic and fiscal management is important to reduce the risks of being forced into painful deleveraging. India's FY17 budget sent a strong message that the government values macroeconomic stability and intends to preserve it. With the economy in relatively good shape, gradually bringing down the deficit of the Centre and the States - which at close to 7 per cent is high relative to other countries - is a sensible move. However, the quality of the adjustment is perhaps more important than the adjustment itself. Hence, the focus needs to be on raising tax revenues especially from those who can afford to pay more, and enhancing the efficiency of spending, while protecting expenditure on infrastructure and social sectors. This will help ensure that fiscal sustainability does not come at the expense of growth and poverty reduction.

The second implication is that the soundness of the banking sector needs to be ensured. Globally, this sector is one of the main sources of 'contingent liabilities'. It will therefore be critical to accelerate long-term structural reforms in the sector, specifically to ensure that banks introduce more viable commercial practices, adopt better governance, and sustainably address the issue of rising stress in corporate and bank balance sheets.

The third is the need to focus on productivity-enhancing reforms. The recently approved bankruptcy code is a positive step in this direction. It facilitates the 'creative destruction' that allows economic resources to be better allocated towards more productive firms.

A final, and perhaps most important, lesson is that good luck should not be considered as a permanent phenomenon. When commodity prices were rising, some commodity-exporting countries implicitly assumed that prices would never come down. They failed to save enough of the bounty, or to invest it in difficult structural reforms that would enable them to weather an extended period of low commodity prices, should that occur.

In oil-importing India, the bonanza from oil price declines was wisely perceived as a temporary windfall and prudently used. It directly benefited the government which, for the first time in several years, exceeded its revenue collection targets. The resources were used to lower the fiscal deficit, transfer more funds to states, and spend more on infrastructure.

A normal monsoon in 2016-2017 - which we all hope will materialise - should also be seen as a stroke of good luck, especially at a time of global climate change and rising water stress in many parts of India. A normal monsoon can therefore open a window of opportunity to further invest in boosting agricultural productivity, and improving the management of water resources. It will also provide an opportunity to expand efforts toward inclusive urbanisation by enhancing connectivity between rural and urban areas, investing in urban planning, and improving health and education services in rural areas so that future generations are equipped to work in the more productive jobs that cities generate.

So, good luck and good policies - together they will do the trick.


This opinion piece was originally published in Business Today on 19th June, 2016.