Thirty years ago, the world saw the Indian and Chinese economies as being comparable. Both were considered engines of global growth. Today, the view looks different. China’s GDP and per capita income are nearly five times those of India. Meanwhile, India’s economic engine is sputtering — GDP growth today is the lowest it has been in six years.

In order to prevent the situation from worsening, the Modi government should pay undivided attention to getting growth back on track, says Duvvuri Subbarao, former governor of the Reserve Bank of India, and a research fellow at the Center for Advanced Study of India (CASI) at the University of Pennsylvania. He recently gave a talk at Penn titled, “Will the Indian Elephant Dance Again?”

Knowledge@Wharton: Why is the elephant an apt metaphor for the Indian economy?

Duvvuri Subbarao: In development economics parlance, the East Asian economies — Taiwan, Korea, Singapore, Hong Kong — are referred to as the tigers. The next generation of fast growing Asian economies — Thailand, Philippines, Malaysia, Indonesia — are referred to as the cubs. China is called the dragon. All these countries delivered a growth miracle in the last 40 years. The first off the block were the East Asian tigers which moved from poverty to prosperous societies in just one generation even as they defied the Washington consensus and adopted a model of state-led capitalism. China accomplished an astonishing feat in the history of development economics, growing on an average at double-digit pace for about three decades on a trot.

The next growth miracle, hopefully, will be from India. India is referred to as an elephant because it is a strong animal with enormous potential but it moves at a lumbering pace. The hope is that it will start dancing and deliver the next growth miracle.

Knowledge@Wharton: Why hasn’t it been dancing so far?

Subbarao: Growth in India has slumped to 5%, or in fact less than 5%, on an annualized basis, causing a lot of anxiety both to the government and to all of us Indians. Growth has declined sharply because all growth drivers have petered out. Growth comes from private consumption, government consumption, investment and net exports. The investment driver petered out some years ago. Our net exports are actually deducting from growth. They used to contribute positively to growth, but they’re not doing so anymore. Over the last five years, the single growth driver has been consumption, both government and private. Government is unable to expand spending further because of fiscal constraints. Private consumption has slumped because credit is being choked and households have run down their savings. The net result is that not only is the elephant not dancing, it’s barely able to walk.

Knowledge@Wharton: Could you put India’s growth trajectory during the past 20 years into perspective? What major factors since 2000 have brought the economy to where it stands today?

“Growth has slumped because all growth drivers have petered out.”

Subbarao: That perspective is important. Twenty years ago, a remarkable confluence of circumstances generated and strengthened the view that India had arrived. There was a structural upturn in the economy triggered by an unprecedented investment boom, accompanied by an unprecedented credit boom. Huge investments were made into production and into infrastructure. Investment as a proportion of GDP went as high as 38%. The India growth story started unfolding. In the five years before the global financial crisis, we clocked 8.5% to 9% annual growth on average. We weathered the global financial crisis reasonably well and came out of the crisis sooner than most emerging economies.

Things started unraveling around 2010 when many projects got delayed. Investments soured. Bad loans mounted. The financial sector came under stress. In popular perception, this reversal in prospects is associated with crony capitalism. While there certainly was a bit of that, it will be misleading to attribute the entire downturn to crony capitalism; there were several other factors at play. For example, much of this investment went into infrastructure, which was an uncharted territory both for the corporates investing and for the banks lending to them. The projects were based on demand projections far into the future assuming a high-growth scenario, which was simply unrealistic. Then there were delays in projects because of delays in clearances and permissions. Court orders cancelling some government decisions added to the delays. As a result of all these factors, the investment engine switched off. With investment and net exports not contributing substantially to GDP growth, during Prime Minister Modi’s first term in office, the economy was firing on a single engine, the engine of consumption. But even that consumption engine has now petered out with the result that growth has declined sharply to 5%.

Knowledge@Wharton: People often compare India and China. Why didn’t India follow the path blazed by China, as was widely expected?

Subbarao: If you go back 30 years, India and China were roughly at par, whether you compare by per capita income in terms of PPP [purchasing power parity] or by current market prices. Starting 1990, China zoomed whereas India just lumbered along. Today, China’s GDP is five times that of India. China’s per capita income is nearly five times India’s per capita income. The number of poor people China lifted out of poverty in the last three decades is unprecedented in human history, whereas India still has hundreds of millions of poor people. China is a middle middle-income country. India is a low middle-income country. China’s fear is that it will get locked into a middle-income trap. India’s fear is that it will get locked into a low-income trap. Growth in both India and China was driven by investment. But China’s investment boom continued, whereas India’s investments petered out.

Of course, when you compare India and China, you should not ignore other vital differences between the two giant economies. China is an authoritative regime; India is a democracy. China produced and exported with not much of the benefit ploughed back into domestic consumption, whereas India produced and passed on the benefits to the domestic economy, which boosted consumption, especially of the poorer sections of society. They were different growth models.

Knowledge@Wharton: Do you think India can replicate the Chinese model of export-led growth?

Subbarao: I do hope so, but it’ll be difficult. Prime Minister Modi has talked about engineering a manufacturing revolution in India, because we need to create jobs, hundreds of millions of jobs. We need not just growth, but job-intensive growth. Towards that endeavour, we need to engineer a manufacturing revolution because only the manufacturing sector can generate jobs of the type and in the numbers we want. Sure, we need to maximize exports as well, but whether we can be an export powerhouse like China is a different proposition. There are important differences between 1990, when China started its export drive, and 2019 — when India wants to be an export powerhouse.

“The original sin of not implementing reforms has caught up with us and the economy is down to 5% growth.”

In 1990, globalization was seen as a benign phenomenon, improving welfare in rich countries and in poor countries. Today, there’s a backlash against globalization; it’s viewed as a disruptive force that destroys jobs and erodes welfare. In 1990, world demand was expanding at a scorching pace. Today, world demand is subdued, and is unlikely to revive to the pre-crisis levels because of what is termed ‘secular stagnation.’ In the 1990s, global value chains were becoming the cornerstone of manufacturing. Today, the global value chain model is eroding because of advances in machine learning, artificial intelligence and robotics. Because of all these headwinds today as compared to the 1990s, it will be difficult for India to replicate the China model of export-led growth.

Knowledge@Wharton: When the first Modi administration took office in 2014, it inherited a structural downturn whose roots go back to 2010. Since the Modi government enjoyed widespread business support, hopes were high that the economy would forge ahead. But that didn’t happen. Why did the process of economic reform stall?

Subbarao: I wish I had a credible answer. It is true that there was a lot of business support for Prime Minister Modi when he first came into office nearly six years ago. In fact, in 2014, Modi campaigned mainly on an economic platform — that he would create jobs and revive investment. There were high hopes and expectations that he would plunge headlong into implementing structural reforms to redeem these campaign promises. That required political capital, and he had plenty of that. Arguably he had more political capital than any other recent prime minister. He had a rock solid majority in the Parliament. More than two-third of the states, accounting for over 80% of India’s GDP, were controlled by the BJP, his party.

Regardless, Modi seemed disinclined to invest his enormous political capital to implement the ‘politically’ difficult reforms. Sure, some important reforms got under way during his first term such as the implementation of a nation-wide GST (goods and services tax), the enactment of the bankruptcy code and the inflation targeting framework of the Reserve Bank. But he initiated none of these reforms; these were all initiatives that he inherited. It’s happenstance that they culminated on his watch. On his own, Modi did not initiate any notable fresh economic reform. Early in his first term, he attempted land acquisition reform, but when there was a backlash he quickly gave up.

Modi somehow seemed to have succumbed to the mistaken belief that the economy will run on autopilot without any policy intervention. The original sin of not implementing reforms has now caught up with us and output growth is down to 5%.

Knowledge@Wharton: Since you are a former governor of the Reserve Bank of India, what is your view of the demonetization exercise that the government undertook in 2016? What are the reasons that prompted it? And what impact has it had on the Indian economy?

Subbarao: According to the government, there were several objectives behind demonetization. It was to attack black money. It was to attack counterfeiting of currency and financing of terrorism. It was also to shift the economy from a cash intensive to a cash-light mode. Whether something as draconian as demonetization was necessary to achieve any of these objectives is questionable. Even allowing for the benefit of the doubt, only the first objective, of attacking black money, justifies something as extreme as demonetization. But even there, the justification is weak. The argument is that people who hoarded black money wouldn’t be so stupid as to retain it in the form of cash. They’d have already converted it into gold, jewelry, real estate or moved it into Swiss bank accounts.

Looking back, now that the dust has settled, the economy paid a heavy price.  Hundreds of millions of low-income households who operate in the informal sector, where transactions are almost entirely in cash, suffered enormous losses. Many of them lost jobs; even their livelihood. The economy lost up to 1.5 percentage points of growth.

“[It] will be difficult for India to replicate the China model of export-led growth.”

It’s not clear that the objectives have been realized. All of the Rs.15 trillion ($211 billion) of cash that was demonetized had come back into the banking system. On the face of it, no black money has been unearthed. Undaunted, the government claims that there will be long term sustainable benefits. How will they materialize? They will materialize through, for example, the tax-GDP ratio going up on a structural basis because of the fear of getting caught. It will materialize through a decline in corruption, which will improve the ease of doing business, drive investment up which, in turn, will boost growth. These are hard to measure benefits, and in any case will take time to materialize.

Knowledge@Wharton: What are the biggest risks the Indian economy faces at present? If you were the RBI governor today, what advice would you give the Modi government about how to turn the economy around?

Subbarao: The biggest risk, I think, is that India will slip into a new Hindu rate of growth; get locked into a low-growth spiral. That’s possible — but not probable and certainly not inevitable. India has the potential to grow faster, indeed significantly faster. To realize that potential, we need to raise investment, and implement policies to improve the productivity of investment. And in order to convert faster growth into poverty reduction, we need to address agricultural distress, create jobs, improve outcomes in education and health, and deepen the skill endowment. As much as the objectives are clear, the agenda too is clear: [We need] structural reforms addressing the real sectors of the economy, and governance reforms to improve the ease of doing business.

What advice would I give the Modi government? I am sure the prime minister is not handicapped by lack of advice. For sure, he is getting a lot of advice, and very competent advice at that. Anyway, since you asked, should I have the opportunity, I will tell the prime minister, “It’s the economy, sir.” What Prime Minister Modi should do, in my view, is to wholeheartedly embrace responsibility for reviving the economy. He should make an unequivocal statement that repairing the economy, putting it on track to a five trillion output as quickly as possible, will be his single-point agenda, and will receive his undivided attention, to the exclusion of all other social and political concerns. To be credible on that, he should back up that statement with an action plan and a roadmap with clear milestones and measurable outcomes.

Knowledge@Wharton: India’s financial sector — both the shadow-banking sector as well as the mainstream banks — is in trouble. What needs to be done to turn that around?

Subbarao: You are right. The financial sector, both the banking sector and the shadow bank sector — what we in India call the non-bank finance company (NBFC) sector — are deeply stressed. The banking sector stress is a result past investments having soured for the reasons that we discussed earlier. The mechanisms for recovery were feeble, and in any case, banks were reluctant to enforce even those feeble mechanisms because a perverse system of incentives was at play. The system of rewards and penalties was such that there was an incentive in not recognizing a bad loan, and instead to camouflage it by evergreening it. As a result, the bad loan problem grew in size, festered and eventually became explosive.

“[We need] structural reforms addressing the real sectors of the economy, and governance reforms to improve the ease of doing business.”

The problem on the NBFC side roughly paralleled that in the banking sector. The loan default by the umbrella infrastructure finance company — IL&FS — last year had a huge knock on impact on the entire nonbank finance sector. Note that with banks in distress, it was the non-bank sector that was lending for consumption, which in turn was fuelling growth. But with the NBFC sector coming under distress too, the credit channel got choked, consumption slowed and growth slumped.

It’s now become common parlance to describe India’s financial sector problem as the “triple balance sheet” problem. The balance sheets of banks, of non-banks and of the corporates are all in distress and need to be repaired.

The task is clear and so is the action plan. Public sector banks need to be capitalized. Given its fiscal constraints, the government simply does not have the resources to capitalize to the full extent necessary. It’s time to stop treating public sector banks as holy cows, and own up to the fact that at least some public sector banks need to be privatized. On the NBFC side, those that are not just illiquid but insolvent should be allowed to die under the bankruptcy process. And, finally, now that the ambiguities in the bankruptcy code have been resolved, the process must be expedited so that confidence revives and new investments come on stream.

Knowledge@Wharton: Has the integrity of institutions like the Reserve Bank of India been compromised because of political and economic pressures? If so, what can be done?

Subbarao: That question defies a binary yes or no answer. Although your question is about institutions in general, let me talk about the Reserve Bank because I’m familiar with the RBI.

At the end of 2018, there was an acrimonious spat between the government and the Reserve Bank of India that played out in the public domain for several weeks. Differences, or even spats, between governments and central banks are neither unique to India nor are they new. There was a spat here in the in the U.S. with President Trump tweeting that the Fed had gone crazy. There were similar spats between governments and central banks in Turkey, in Europe and in Japan. So what happened in India was not unique. Such spats are not new either. There were differences between the government and the RBI before me, during my time, and after my time. What was different this time around was that the differences played out in the public domain. And they got politicized.

All of that is behind us now and things seem to have settled into a new equilibrium.

“Modi should make an unequivocal statement that repairing the economy … will be his single point agenda and will receive his undivided attention.”

For the long-term, I think it’s important for the government to recognize the significance of the autonomy of the central bank and respect that, and it’s equally important for the central bank to recognize the limits of its autonomy.

After all, why is it that a central bank should be autonomous? Let me spend a minute on that. Around the world, central banks are accorded a certain amount of autonomy because it is believed that an autonomous central bank is necessary for sound macroeconomic management. Preserving macroeconomic stability, which is a necessary condition for sustained growth, requires taking a long-term view of the economy and taking decisions that might run counter to short-term compulsions. Such decisions might inflict pain in the short term, but they deliver long-term gains. You cannot leave such decisions to politicians, who typically have a short-term outlook driven by electoral cycles. Mind you, here I am talking about all countries, not just India. Everywhere, especially in democracies, politicians tend to compromise long-term sustainability for short-term gains. It is to manage these horizon differences that it’s important to have an apolitical central bank, with autonomy and with a mandate to take a long-term view of the economy.

Going forward, in India I think it’s important to institutionalize a code of conduct both for the government and the RBI with regard to autonomy. Government is sovereign and there are obvious limits to the central bank’s autonomy. The government, on its part, should realize that its job is only to set the mandate, but not to tell the RBI how to deliver on that mandate. RBI, on its part, should realize that it is limited by the mandate set by the government. In other words, that it has no goal independence but only instrument independence. And that, I think, will be a Goldilocks relationship.

Knowledge@Wharton: You were the governor of the RBI from 2008 to 2013. It was a very critical period when the global financial crisis ravaged the world economy. You even wrote a book about leading the RBI through five turbulent years. What challenges did you face leading the RBI during that time? How did you deal with those challenges and what lessons can others learn from your experience?

Subbarao: I went in as governor of the RBI on September 5, 2008. On the 7th, Fannie and Freddie went into conservatorship. On the 8th, Countrywide Financial went down. On the 10th, AIG came to the brink of a meltdown. On the 13th, Merrill Lynch vanished. And on the 16th, the big bang — Lehman Brothers collapsed. The global financial sector came to a near-death experience. The global economy plunged into the biggest and deepest downturn since the Great Depression of the 1930s.

Virtually every country in the world was affected by the crisis – and so was India. But in India, there was dismay, disbelief and denial that we could be affected by the crisis. The story going around was that ‘this new governor came and he brought on the crisis.’ I had no option but to go along with that. Wherever I went — within the country or outside — people used to ask me, “Why is India affected by the crisis and when we will get out of it?” My stump answer was, “Since you say I brought on the crisis to India, that the crisis started with me, it will end only when my term is over.” And for good measure, I used to tell them when my term would end. But here’s the thing: The week after I left the Reserve Bank, the crisis ended. Growth started going up. Inflation started going down. The rupee stabilized. If there was one prophecy I wanted to be wrong on, it was this.

It was baptism by fire for me.

Regarding your question about leadership, the crisis threw up lots of leadership lessons, but I will talk about just one, which is how important it is for a leader to have credibility. When I went in as governor, I was an unknown civil servant who suddenly became governor. In other words, I abruptly shifted from being an unknown unknown to a known unknown. But the governor has to be a known quantity. The markets and other stakeholders need to be able to interpret the governor’s style and stance and understand his nuance and body language. This process inevitably takes time, but such time was denied to me. There was a lot of anxiety in the markets about whether I, a greenhorn governor, could manage the crisis. The markets did not have confidence in me. That was bad enough. But what compounded matters was that I had no credibility. There was this view that I was sent into the Reserve Bank by the government to act at the government’s bidding, that I would compromise the Reserve Bank’s autonomy to implement government instructions.

“Credibility is not given to you on a platter. You have to earn it.”

All these doubts and suspicions swirled in a time of crisis when governments and central banks had to work together. Everywhere around the world, governments and central banks were working together and in close coordination – here in the U.S., in the U.K., and in Europe, Japan and China. But in India, when the government and the Reserve Bank were working together, it was interpreted as my taking instructions from the government and in the process compromising the Reserve Bank’s autonomy. The sum and substance of all this was that circumstances conspired against me to deny me the credibility required of a leader. And that in turn threatened to erode my effectiveness. The lesson from my ‘crisis’ experience is that to be effective, a leader needs to have credibility. And credibility is not given to you on a platter. You have to earn it.

Knowledge@Wharton: How did you earn it?

Subbarao: Well, you must go through the slog. In a situation like mine, I couldn’t have earned credibility simply by declaring that that I am independent, that I will preserve and protect the autonomy of the Reserve Bank of India and that I will not succumb to pressures. Credibility has to be earned, not through words, but through actions and behaviour. And that inevitably takes time. I can say with some satisfaction that when I look back on my record, I believe I have earned a reasonable reputation for standing for the autonomy of the Reserve Bank of India. And that I believe came through an evaluation of my actions.

Knowledge@Wharton: There has been a lot of discussion these days about central banks launching their own digital currencies. Do you think this is a good idea?

Subbarao: I’m not sure there is a clear-cut answer. As of now, opinion is divided.

Money, as we know, has three functions. It’s a unit of account, a medium of exchange and a store of value. Money issued by central banks, which is the norm around the world, performs all these three functions. Such money is uncontested legal tender.

Technological advances over the last 10 to 15 years have made possible crypto currencies. Bitcoin was the first into the market, but now there are possibly 50 to 60 crypto currencies. What is common to all of them is the underlying block chain technology and a decentralized management. None of them is obviously legal tender; in other words, one can refuse to transact in them.

A central bank digital currency (CBDC) is a different proposition, different from these commercial crypto currencies, because a CBDC will be able to perform like money. It will be able to perform all the three functions of money that I listed above. It will be like traditional money except that it will be in a digital form. The main advantage will be that a CBDC will make payment systems more efficient. For example, at present if I have to transfer money to you, we need the intermediation of a commercial bank; but if there was a CBDC, you and I could transact directly through our central bank accounts. It is also argued that a CBDC will make monetary policy transmission more efficient, especially in a situation of negative interest rates, which is now the case in some rich countries.

On the other hand, a CBDC is not costless. For example, if there was a CBDC, it’s possible that commercial banks might be undermined. Commercial banks, after all, perform an important function of financial intermediation. That might be undermined. Also, the central bank might expose itself to credit risk, and should that risk materialize, the cost will be borne by taxpayers. So, it’s not as if a central bank digital currency is unambiguously good. Let me also add that it’s not as if central banks currently don’t issue digital currencies. They do, but they issue them only to commercial banks. So, the question is, how do they expand the realm of CBDCs? Open up CBDCs first to nonbank financial companies, then to nonbank nonfinancial companies, and eventually to ordinary people like you and me? Can that be managed? Is it necessary at all? What implications will it have?

These are all important questions without clear answers as yet. I think central banks are now in a wait and watch mode. They want to understand the full implications and have a better understanding of the costs and benefits before moving forward. But some central banks, like in Sweden and China, are going forward at a rapid pace.

Knowledge@Wharton: If India were to try and launch a digital currency, how would it be done there? And how might that process differ from the way it could be done in, say, a developed economy like the U.S.?

Subbarao: I heard the governor of the Reserve Bank of India recently comment on whether the Reserve Bank will issue a digital currency. He said that they’re watching the situation. He didn’t close the option, but he did not also say that the RBI is going to adopt a CBDC soon. India’s main motivation for launching a CBDC would be to promote financial inclusion. Technology has been the main force behind the deepening of financial inclusion in India over the last 10 years and a CBDC can potentially help accelerate and deepen the financial inclusion.

To your second question, about how it might differ from a digital currency issued by the Federal Reserve — I’m thinking on my feet now — you’ve got to recognize that the dollar is the dominant reserve currency today. If the Federal Reserve were to issue a digital currency, it will very soon become the currency for the international payment system whereas a digital currency issued by the Reserve Bank of India will not enjoy that status.

Knowledge@Wharton: To end with the question with which we began, when will the Indian elephant start dancing again?

Subbarao: I hope it will start dancing soon. The elephant, you must recognize, is a strong animal and has great potential. Once it starts dancing, it can go on and on for a long time.

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