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A strange development seems to be occurring in the Indian economy - it appears to be showing signs of a split personality disorder.

On the one side, is a bright sunny disposition

In September 2021, the Indian stock market graph reached dizzying heights, as it became the world’s sixth-largest, overtaking France for the first time in market capitalization, and behind only the US, China, Japan, Hong Kong and the UK. This is no doubt an astounding achievement, coming as it does at a time of great uncertainty, thereby indicating some confidence in India’s economy and growth prospects. This has also been a year when India has produced a record number of unicorns. India is number three in the world in terms of number of unicorns and second in the number of start-ups. Record FDIs have added to this scenario of economic bloom. Consumer demand is also expected to rise given the approaching festive season and easing of restrictions, albeit an underlying thread of concern on a third wave of the Covid -19 pandemic.

That the stock market does not necessarily represent the real economy, is a now well observed phenomenon. That’s why, perhaps, in spite of this bright side to the economy, there is another side that is not quite as sunny - where stress and fear loom, and which is proving to be a roadblock to progress.

Here, the GDP growth figures tell a different story. Although there was a record GDP growth of 20.1% in the first quarter of the current fiscal year (FY22) compared to the same quarter last year (FY21), it was really a case of making up for low base effects from the sharp contraction earlier. In reality, the GDP was still 9.2% lower than in the first quarter of FY20 - the pre-pandemic period, when the economy was already on a slide.

Further, nearly all segments, except agriculture and related activities, power and allied segments, have contracted compared to pre-Covid levels. Construction jumped by 68.3% in Q1-FY22, but it was still down by close to 15% against the first quarter of FY20. Trade, hotels and the transport sector saw a 34.3% increase this time, against a 48.1% of Q1FY21 contraction, but the segment fell by 30.22% compared to pre pandemic levels.

But perhaps the most worrisome scene is in employment. Even as the economy picked up at the end of the first quarter of FY22, over 1.5 million people from both the formal and informal sectors lost their jobs in August, reversing some of the gains made in July. Unemployment rose in both rural and urban India. As per the Centre for Monitoring Indian Economy (CMIE), the number of the employed fell from 399.38 million in July to 397.78 million in August, with nearly 1.3 million job losses in rural India alone. And this comes on top of an already high unemployment rate of nearly 7%, that has been normalised in the last few years.

Thus, much still needs to be done for growth in the real economy. It is no surprise then, that in spite of clear inflationary pressures, albeit, mostly due to supply side shocks, the government is keeping its sights trained on growth, and calling on the private sector to increase investments, and step-up participation in the economy.

Is India Inc responding?

On the demand side, business investment has still not picked up to pre-Covid levels. Worth noting, is that even before the pandemic, there were deficiencies in both consumption and investment demand - the pandemic merely exacerbated the contraction.

A key indicator is credit growth. In Q1 FY22, due to lacklustre borrowings and credit demand from companies, retail credit overtook business credit for the first time, as banks aggressively pushed retail loans to individuals to make up for the losses, and consumers were only too happy to take advantage of low rates. As per the RBI, outstanding retail loans stood at ₹28.58 lakh crore as of 30 July, while loans to industries stood at ₹28.24 lakh crore. Loans shrank the most among large businesses, at 2.9%.

What are the reasons for this corporate credit reticence?

Some of this reduced demand for credit has come as companies have deleveraged in order to manage their debt stress, after years of low revenues and profits made debt servicing difficult and these challenges were further compounded in the pandemic.

Another key reason is banks’ risk aversion. Banks, especially PSBs, already gripped by a severe NPA crisis, have been reluctant to extend credit. For FY21, banking credit growth was approximately 5.5%, which was close to a seven-decade low.

Risk aversion among banks has been much talked about recently, even though this has been taking hold for several years now, ever since the souring of the infra boom in the early part of the last decade, followed by the NBFC debacle in 2018. So much so, that the RBIs efforts to infuse liquidity into the economy in the pandemic, and its measures to encourage banks to lend to targeted sectors of the economy, did not yield the desired results. Banks, fearing a rise in bad debts on top of their pre-existing NPAs, held onto their cash, or parked it with the RBI through the reverse repo window, instead of lending. Further, in this scenario, as banks struggled to balance their books based on regulatory or govt fiat, they have often agreed to harsher than needed haircuts and caused themselves and other stakeholders, further damage in the process. If the economy has to grow, this needs to be addressed soon, as India’s bond markets and alternative sources of financing are simply not broad and deep enough yet, to make up for the gap in bank lending.

Another factor that has placed a downward pressure on growth in credit and investments may be the unintended consequences of the Insolvency and Bankruptcy Code (IBC) of 2016, which brought in sweeping changes to how corporate bankruptcy was addressed in India. While the law strengthened creditors’ rights, for owners of firms, it created a very real possibility of owners / founders losing control of their firms in bankruptcy. As a result of this new law, businesses became much more cautious about borrowing and leveraging. With the spectre of insolvency and bankruptcy becoming even more real in the last two years as many companies faced unforeseen challenges in the pandemic, a fear of losing out has gripped many businesses.

A more complex but less discussed fallout of banks’ NPA problems and the recent regulatory approaches around defaults has been that, often, banks and regulators have tended to paint all distressed businesses with the same tarnished brush, regardless of whether the defaults were due to genuine distress and external factors, or whether they were wilful, with mala fide intent. This has led to a fearful scenario for many businesses already on rocky ground from the stresses of the last year.

Overcoming fear and gloom is essential

A climate of distrust and fear has come up, with the apprehension that any default or financial problem will be viewed with suspicion, and may lead to prolonged investigations, heavy and harsh punitive measures leading to further losses. There is a growing concern that the prevailing attitude among creditors and regulators is “guilty until proven innocent”. Add to this, some other long-standing problems that have also continued to plague the business sector such as disputes, where businesses find themselves at the receiving end of long arbitration processes, and protracted payments of dues; and we find the climate of uncertainty further compounded.

Taken together, all these factors have created a kind of fear psychosis that is afflicting many businesses, and in turn affecting their entrepreneurial, risk taking and wealth creation spirit -- all of which are essential for reviving business demand and investment.

This fear has become especially pervasive among those who are traditionally dependent on bank lending for their operations. Given that only the highest rated corporates have been able to issue bonds and tap into alternative sources of funding, this is a huge roadblock to reviving the economy.

Thus, while the government has been calling on the private sector to place trust in it and increase investments -- to “release their animal spirits”, to quote the economist John Maynard Keynes, as the FM did recently, it must also understand the impact that certain actions and regulatory thrusts can have on the business psyche. For India Inc to heed its call, the government must show that it is a partner in wealth creation, not a hangman to risk taking entrepreneurs. Only then can the nation’s economic growth and employment graph move upward.