The recent news that India’s economic growth rates over the last four consecutive quarters have been declining is disturbing for policymakers. The economy is seeing a swelling of foreign exchange reserves, which is raising the value of the rupee and hurting exports. As exports fall, India’s trade deficit is widening which comes with rising inflationary potential. These are challenges to the Reserve Bank of India, which is committed to keep the annual inflation below 4%. Furthermore, all these developments are against the background of falling consumption demand and investment by the private sector.
GDP grew at 5.7% on a year-on-year basis during the second quarter (April- June) of the year, as compared to 6.1% in the previous quarter (January –March). It is also the weakest growth since the first quarter of 2014. The falling growth rate for each quarter is attributed to a decrease in domestic consumption as well as external spending on Indian goods and services. As regards manufacturing and agriculture, the growth figures reveal a further slowdown too, with a third consecutive quarter of decline.
It is now agreed that demonetisation resulted in the large-scale disruption of economic activities in urban and rural India for a while.
Though the introduction of the goods and services tax (GST) in July was smooth and acknowledged as “good and simple tax,” it contributed its own mite to the prevailing uncertainties. Till date there have been many revisions (about 32 notifications, modifications and corrigenda) with resultant changes in tax rates on 98 goods and more to come.
All of this took a toll on investor confidence.
Further, rapidly increasing excess capacity (with Indian manufacturing plants running at about 74% of capacity October-December) and resultant job losses, and poor credit growth reflecting the worsening climate of confidence during April-June, were by no means considered favourable.
Table 1: GDP growth rates
|Month, Year||GDP growth % (year on year)|
Table 2: Inflation
Inflation is now raising its ugly head after being benevolently low thanks to world oil prices. Consumer price index rose by 3.36% year-on-year basis in August. That was above market expectations of 3.2%. The trend is indisputable. It was a 2.36% rise in July. That is also the highest inflation rate since March 2017, which was due to rapid rise in food prices.
The latest RBI estimate of inflation is 2-3.5% in the first half of this fiscal year (April to September) and at 3.5-4.5% in the second half (October to March 2018). Indications are, the RBI, which is more concerned with mandated inflation target of 4%, may not consider any cuts in its policy rate.
In the midst of all this troubling news we have good tidings: plentiful foreign reserves. India is one of the three Asian countries to have benefited from the rapid inflow of capital, comprising foreign direct investment and institutional capital on a 12-month basis. Now the reserves stand at a record level of $400 billion. The country can, therefore, withstand the impact of any headwinds. It can pay for its rising imports, and it can face any outflow of funds at ease, in case the US Federal Reserve raises its interest rate reversing the capital flows to Asia.
The rising reserves have been causing its own headaches for the RBI. Cries by exporters to stabilise nominal exchange rate have already been responded to by the RBI purchasing foreign exchange from the business houses. These purchases are now adding to money supply in the economy, which is already experiencing excess liquidity with banks unable to step up lending.
Controlling money supply in the presence of growing capital inflows can be simultaneously dealt with massive sterilised interventions; but they are not always successful in economies which have accepted a floating exchange rate regime along with perfect capital mobility.
The problem of trilemma faced by such economies would not spare India either. One cannot simultaneously achieve all the three objectives: (i) perfect capital mobility, (ii) full control over monetary policy and (iii) a stable exchange rate. A country can achieve only two of them.
And policymakers in the government know this.
The latest indications are that the government is considering a more aggressive fiscal push in its 2018 Budget. The government is keen to use this to meet the vacuum “created by subdued private sector investment and to overcome the problems created by a banking sector which is now grappling with rising non-performing assets”.
Implications of expansionary fiscal policy
Fiscal policy is a blunt tool, with its attendant delays right from inviting tenders, processing and approval to implementation. The gestation period of each project depends on all these delays, besides their uncertain returns. No project has ever been quick yielding.
Further, the current commitments including agriculture loan waivers have already overburdened state treasuries. New, fresh initiatives would add to overall fiscal deficit to a new high level. Former chief economic adviser Shankar Acharya has issued a warning: with uncertainty over the revenue outcome post-GST, net revenue collection would be being lower both for the Centre and states in fiscal year 2018, and hence “the combined fiscal deficit of the Centre and the states would be around 7% of GDP”.
The government may feel confident that the excess liquidity would help to finance public sector deficits by issuing special bonds and would not raise interest rate. Further it may feel confident, it would not crowd-out but only crowd-in private investment.
Table 3: Indian’s twin deficits and impact on debt and foreign reserves
|Year||Budget balance (%of GDP)||Trade balance (% of GDP)||Current A/C (% of GDP)||Govt debt (% of GDP)||Foreign reserves (US$ billion)||Overall BoP balance|
Source: ADB key indicators (Sept 2017)
But past experiences here indicate contrary things.
Budget deficits (government expenditures over revenue) raise aggregate demand and disturb the equilibrium. Irrespective of whether funded by borrowing or printing money, budget deficits would raise the price level, given aggregate supply. Further, budget deficits lead to government bidding resources away from the private sector. Furthermore, they make borrowings by private sector more costly. All these give rise to fanning inflationary potential given the short run supply.
Every budget deficit also brings its own twin, whether formally invited or not. The twin brother is trade deficit, which accompanies budget deficit. Excess domestic demand created by public expenditure spills over into external sector, resulting in excess imports over exports. The balance of trade worsens. If net receipts from services such as tourism and unrequited transfers including grants and remittances are not sufficient to cover, it would deteriorate into current account deficits.
One can take comfort from the fact that the present record level of foreign reserves can cover the current account deficits and overall balance of payment deficit, provided the present trend in capital transfers would continue.
According to the RBI, the indications for expansionary monetary or aggressive fiscal policies are not supportive by any means.
The N.K. Singh Committee on Fiscal Discipline has recommended reducing the fiscal deficit and domestic debt-to-GDP ratio to 2.5% and 38.7% by fiscal year 2022-23 from 3.5% and 49.4% in 2016-17.
The central bank can always be relied upon expert policy advice on the efficacy of fiscal policy and its limits in each circumstance. So, we return to the eternal problem of effective fiscal and monetary policy coordination. Would government sit down and listen to RBI?
Presently, what is needed is not any additional fiscal push but simply better governance. It will restore confidence. The present display of earnestness to implement reforms, structural and labour, which have been initiated, should be carried through to logical conclusion.
With due apologies to James Carville, a campaign strategist during Bill Clinton’s successful 1992 campaign days, we borrow his oft-quoted words and adapt to our purpose to say: “it is governance, stupid.”
T.K. Jayaraman is a research professor under International Collaborative Partner programme at University of Tunku Abdul Rahman, Kampar, Perak, Malaysia.