A balance sheet recession?

Business Standard, 14 December 2015

The debt dynamics of the government and of the private sector, in India, has long been upheld by high nominal GDP growth. In a remarkable turn of events, we are now in an environment where the interest rate exceeds nominal GDP growth rate. This changes the complexion of debt dynamics for the government and for the private sector. It has now become harder, to break free of the recession.

In the field of public finance one key insight is the importance of comparing the interest rate ("I") against the nominal GDP growth rate ("G"). When the growth rate exceeds the interest rate, small primary deficits are compatible with debt stability.

This is the traditional Indian configuration. As an example, in 2012-13, nominal GDP growth was 13.09% and in 2013-14 it was 13.58%. These values were larger than the interest cost paid by the government. Hence, while there were primary deficits of 1.8% and 1.1% in those years, the debt situation degraded only slightly.

In recent quarters, conditions have changed dramatically. As recently as Q3 2014, nominal GDP growth grew by 13.59% on a year-on-year basis. After that, nominal GDP growth has collapsed. The latest four quarters of data (ending with Q3 2015) have shown values of 8.14%, 7.74%, 8.81% and finally 6.04%. We in India have never seen nominal GDP growth, on a year-on-year basis, of just 6.04% before.

Nominal growth of 6.04% has turned into real GDP growth of 7.43% through an inflation adjustment of -1.39%. A lively debate is presently underway about whether this inflation adjustment is appropriate. Whether there are problems with the inflation adjustment or not, generally nominal GDP data is better measured and we should ponder the implications of the 6.04% nominal GDP growth. The picture as shown with nominal Gross Value Added is even more troublesome, with growth of 5.2%.

This has suddenly put us in a different zone in terms of debt dynamics. Earlier, when nominal GDP growth was above 12%, and the interest cost of the government was between 8 and 9 per cent, we were always in the zone where G was greater than I. Now, this has turned around.

Let us suppose this environment persists: of a small primary deficit, coupled with an interest cost of 8 to 9 per cent, and nominal GDP growth of 5 to 6 per cent. What are the implications? The debt/GDP ratio will build up quite rapidly. The interest burden of the government will rise rapidly. Ratings agencies will see Indian public finance as being more vulnerable. The global cost of borrowing for Indian entities will go up.

In and of itself, an increase in the debt/GDP ratio drives up the interest cost in the budget. The present environment, with small primary deficits, has been made possible by the crash in oil prices. If world oil prices go above $40 a barrel, then the primary deficit could worsen. In this case, the debt dynamics become more adverse, with an even more rapid increase of the debt/GDP ratio.

If this environment continues, there are only two choices: We could do nothing, and experience a significant deterioration on public finance, or we could embark on a substantial fiscal correction that gets to a significant primary surplus. Nominal GDP growth of 5 to 6 per cent, coupled with an interest cost of 8 to 9 per cent, can be reconciled with debt stability only if there is a suitably strong primary surplus.

Similar problems are found with the corporate sector also. Let's focus on all non-financial listed companies. These have had nominal top line growth (i.e. nominal net sales growth) of 5 per cent or below for 8 out of 12 most recent quarters. In the latest quarter, Jul-Aug-Sep 2015, nominal year-on-year growth was just 2.51%. The firms are paying perhaps 13% on their debt.

The interest payments of the firms are growing at 9 to 12 per cent while their sales are growing by less than 5 per cent. In this situation, profitability is under a squeeze. A significant subset of the corporations have reached a place where they are not producing enough operating profit to even pay interest.

Operating profit growth is ultimately linked to sales growth or GDP growth. When GDP does not grow by 10% nominal, it is difficult for net sales to grow by 10% nominal, and then it's difficult for operating profit to grow by 10% nominal. In 9 out of the latest 12 quarters, operating profit growth was below 10%. But if operating profit does not grow by 10%, while interest payments are growing by 9 to 12 per cent, profitability worsens.

We in India have limited experience with business cycle fluctuations. We have particularly limited experience with a `balance sheet recession', where adjustments of debt play an important role.

The single dramatic fact about Indian macro in the last decade is that corporate fixed investment has dropped from 16% to 8% of GDP. This focuses our minds of creating an institutional environment that is conducive for firms to invest more. However, when firms are overstretched on their debt, their first priority is survival and their second priority is paying down debt so as to come to a safer place. Economic agents who are keen to pay down debt, in a balance sheet recession, will not spend and will not invest, and will not respond to the normal macroeconomic tools that aim to stimulate spending or investment.

From 2012 onwards, India has had recessionary conditions. The balance sheet of the private sector worsened through this period. We are now in a new phase of difficulty, with low nominal growth exacerbating the debt dynamics for public finance and for private firms. These developments have substantial implications for macro and finance policy.

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