Five major challenges that shook India’s economy in 2018

The bronze bull statue at the Bombay Stock Exchange | Dhiraj Singh/Bloomberg

From GST to RBI to NPAs, both institutions and governance had a turbulent ride.

The year 2018 saw significant challenges for the Indian economy. Implementation of the GST, a new bankruptcy process, recognition of non-performing loans by banks, changes in Reserve Bank of India (RBI) governance and global trade wars were among the most serious concerns.

1. GST in focus:

The goods and services tax (GST) was one of the most important reforms introduced in the Indian economy. The GST Act came into effect from July 2017 but the implementation is still a work in progress. Implementing the GST would have been challenging enough if it was a simple, low rate tax. But India’s GST was complicated by multiple and high rates. The new tax filings required for compliance posed additional costs. Compliance by service sector firms, who now had to file returns across all states, implied new costs for them.

Rules, rates, exemption levels for turnover and GST forms were changed during the year to make it easier to comply. While this was positive in the long run, it meant adjustment would become a continuous process. Delays in getting input credits plagued exporters and small businesses. Tax revenue from GST did not seem to match up to targets.

The year will be remembered by many businesses, particularly small ones, as one in which they struggled with the new tax regime. GST was a big audacious reform, much needed to harmonise tax rates across the country. For the first time, a product in India had the same tax rate anywhere in the country. But a better design could have made the adoption less painful. The simplification of the process, uniform rates and the extension of GST to products and sectors that have been excluded like petroleum will remain a challenge for the coming year.

2. Bankruptcy bogey:

For many years, the financial sector in India had lamented about the lack of debtor rights. First, debtor rights are a necessary condition for a bond market to function. Second, India’s banking system was caught in nearly a decade of various attempts to solve the problem of stressed assets. However, there was no timely way to sell off defaulting companies. The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (SARFAESI) which allowed the collateral to be sold when a default occurred, not the firm as a whole, was inadequate. The Insolvency and Bankruptcy Code, 2016 (IBC)  provided a mechanism for dealing with defaulting firms. Since then the institutions and ecosystem needed for implementing the bankruptcy process have been put in place.

The resolution mechanism still faces many challenges. The functioning of the institutions, the capacity of the tribunal, resolution professionals and the committee of creditors is far from smooth. An amendment to prevent promoters from getting their companies back was made in August 2018. The objective of the IBC is to rapidly sell off a firm and save its value from eroding. The speed of resolution, built into the law as a critical element, remains a challenge.

Yet, despite all the quibbles, putting in place a bankruptcy process was a path breaking reform for the Indian economy. Capitalism survives only because factors of production—land, labour and capital—can be efficiently allocated. Bankruptcy processes allow this to happen by changing management and ownership of the firm, and where that is not possible, by liquidating the firm so that resources can be used for new purposes.

Creative destruction, so necessary for growth, cannot happen unless firms are allowed to die. The process of bankruptcy is not just important for debtor rights, but also for releasing factors of production from inefficient enterprises for more productive uses.

3. Recognising bad bank assets:

On February 12, 2018, the RBI issued a circular shutting down existing bank loan restructuring schemes (CDR, SDR, S4A, JLF, 5:25) and requiring that all large bank loans be referred to the bankruptcy process when a default occurred. The rules for what was a default and how soon the bad loan had to be recognised were stringent.

This circular triggered off a process of banks having to recognise bad assets. The banking sector saw a rise in non-performing assets. Large loans in power, steel and infrastructure sectors were referred to the National Company Law Tribunal (NCLT). Credit growth slowed down.

For some time Non-Bank Financial Intermediaries (NBFIs) stepped in to provide credit in the place of banks. But soon this mechanism was in trouble. A default by IL&FS created a crisis in the NBFI sector as well. A large number of Public Sector Banks (PSB) faced difficulties and were put into the Prompt Corrective Action framework (PCA) by RBI under which their lending slowed down.

The government put money into PSBs to “recapitalise” them but with bad assets of banks rising, more is required.

4. The RBI-government standoff:

If a bank has to continue lending when some of its borrowers have defaulted, it needs more capital. In 2018, many loss-making PSBs required money from the central government budget if they had to continue lending. Already hitting its fiscal deficit targets, the government turned to the RBI for easing norms for capital requirements for PSBs as well as additional money for the budget. This led to much publicised differences between the RBI and the central government, including stormy board meetings. Incidentally, it was followed by the resignation of RBI governor Urjit Patel.

5. Return of the trade wars:

On the global front, US President Donald Trump, who stood for protectionist policies against China, kept his election promise of raising tariff barriers on Chinese imports. While a decline in world trade is always bad for global economic prosperity, in principle, India could have gained if US companies in India had chosen to relocate manufacturing plants in India and made India a part of the global supply chain.

However, so far, more business seems to have gone to Vietnam and there is little evidence of relocation to India.

The return of global trade wars, the undermining of the World Trade Organization and decades of trade liberalisation will mark 2018 as the year when trade wars were squarely back on the table.