India needs a counter-cyclical fiscal response to the ongoing slowdown
The advance GDP estimate for FY20 points to the slowest economic growth in nearly 11 years at 5%. This is a disappointing outcome. Without going into the intricacies, there are both cyclical and structural forces at work. The credit market issues that broke out in 2018 have negatively impacted the availability and cost of credit. Consumption growth has moderated, and investment growth is subdued. The fiscal deficit is likely to overshoot but the current account deficit is in the comfort zone. Headline inflation has climbed due to the spike in food prices, but this is likely transient, and inflation should stay moderate as the economy is running well below potential. India’s macro parameters are in reasonably good health even as growth has stalled.
The strategy the economy needs may be analogous to what is required of a pilot when an aeroplane stalls. To recover from a stall, the pilot must push the nose down, not up. Then the pilot must increase the engine power using the throttle. When airspeed increases again, the pilot can level the wings and pull up to return the aircraft to normal flight.
In economics, the response to a slowdown is counter-cyclical policies. The monetary policy committee (MPC) has cut rates by 135 basis points during 2019. Arguably this is yet to transmit to the borrowers. The monetary policy works with a lag and given that the banking system is flush with liquidity, this should gradually transmit through the system. The yield on surplus liquidity for the banks at slightly below 5.15% is below the cost of deposits for the banks and this should gradually push the lenders to move out along the risk spectrum and lend to protect their spreads. However, there is also a trust deficit in credit markets and regulators should consider the equivalent of an asset quality review (AQR) as was done for banks in 2015 to restore confidence. The issue of resolution for financial companies has clarity with the first non-banking finance company (NBFC) being referred under the Insolvency and Bankruptcy Code (IBC). This counter-cyclical policy of rate cuts from the Reserve Bank of India (RBI) combined with measures to address the trust deficit should over time have a healing impact.
The other counter-cyclical response lies in the domain of fiscal policy. With the budget a few weeks away, it is a good time to shine the torch on the government’s fiscal approach. It should be no surprise that tax revenues are running well below the target as growth is weak. Further, nominal GDP growth is well below estimates at under 8%. Under the circumstances, the fiscal deficit is likely to miss the target. Attempts to bring it within control by reducing expenditure will only further dampen growth. The choice of tactics to deliver the fiscal impetus is often drowned in semantics and ideological constructs. Should it be a tax cut—direct or indirect—or should it be social security or income support programs or capital expenditure? The speed at which the chosen tactic is likely to filter through the economy should play the largest role in determining the choice.
In this context, we would also draw attention to a silent disease. The government maintains its accounts on a cash basis and has often resorted to the practice of not paying its dues, thereby avoiding accounting for its expenditure. This merely transfers stress from the government to its creditors. This ill-conceived tactic amounts to “control of payment of expenditure” rather than “control of expenditure”. The finance minister signalled that the government would not resort to this tactic, but anecdotal feedback suggests that this concern persists. The delay in settling dues at year-end to manage the fiscal deficit does more harm than good to the economy.
The policy decision to provide a fiscal stimulus is not easy given that the Indian state has a poor track record of being fiscally restrained. The consolidated fiscal deficit of the government plus its arms and the states is well over 8% by some estimates. To ease the legitimate concerns of the credit rating agencies, MPC and the markets, the government will have to communicate a detailed template of how it would cut the deficit over a three-year period as growth stabilizes.
In this context, MPC’s reference to fiscal deficit is slightly perturbing. Surely if MPC believes it should maintain an accommodative stance to support growth, within its inflation framework, then it should expect that fiscal policy would also adopt an accommodative approach to the same slowdown. Equally perturbing is the government’s lack of enthusiasm to reduce administered rates of interest on small savings and other schemes.
Economic growth is an essential element of India’s macroeconomic stability and growth is arguably the only way to address many of our problems. Economist Paul Samuelson said, “Economics is a choice between alternatives all the time. Those are the trade-offs (that must be considered).” The choice for the government is between staying on its previously announced fiscal glide path and pushing through counter-cyclical fiscal impulse. Both choices have trade-offs. If it chooses the path of a counter-cyclical fiscal impulse, which we think is appropriate, then it needs to execute the same with speed and precision, much like an aircraft pilot, and level off when growth normalizes.
Vetri Subramaniam, group president and head of equity at UTI Asset Management Co. Ltd
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