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This article was first published on The India Cable – a premium newsletter from The Wire & Galileo Ideas – and has been republished here. To subscribe to The India Cable, click here.
During the global economic boom after 2002 and a decade of sub-par growth after the 2008 financial meltdown, for policymakers in the developed world, it was as if inflation had been put to rest forever.
Since it was not an imminent threat, there was massive monetary and fiscal expansion to keep growth ticking. This psychology was further entrenched after COVID, when the developed world put their economies on heavy fiscal and monetary steroids without worrying about inflation at all.
But inflation has woken up like a demon after lying dormant for nearly two decades.
Now, the chickens are coming home to roost. For the first time in recent memory, the average inflation rate in the US and Europe is much higher than that of emerging markets like India, Indonesia, Brazil and China. Higher inflation was always associated with developing economies with less sophisticated financial institutions. Not any more.
This inversion presents a huge problem for emerging economies like India. The developed economies are rapidly rolling back monetary and fiscal stimuli to attack inflation, which is getting dangerously entrenched. The result is a severe global slowdown. Last week, the United Nations Conference on Trade and Development (UNCTAD) projected global trade to grow at just 1% in 2023. Its global GDP growth forecast for 2022 is 2.5%, and even lower at 2.2% for 2023.
There is a strong correlation between global trade and the GDP growth of nations. For instance, India’s international trade (exports plus imports) is now nearly 50% of its GDP. For India, UNCTAD projects GDP growth of 5.7% in 2022 and 4.5% in 2023. This is much less than RBI’s projection of 7% and 6.5% for FY23 and FY24.
The bigger challenge for India in the near term will be how to calibrate withdrawal of its monetary and fiscal stimulus over the next six months. India’s problems are different from those of the developed world. The US, UK and EU are not facing such a grave employment problem. They have relatively tight labour markets and therefore, it will be easier for them to withdraw stimuli. India faces its highest unemployment in decades and therefore, may find it much more difficult to rapidly withdraw fiscal and monetary stimuli. This presents a huge problem for the Modi government.
Psychologically, global markets are expecting economies to show greater monetary and fiscal responsibility. Most central banks are increasing interest rates quite rapidly, following in the footsteps of the US Federal Reserve. This has become imperative for emerging economies like India, which has had to defend its currency against the strengthening dollar. India has seen the highest (13%) fall in its reserves this year, spent to defend the rupee. So monetary policy is substantially determined by what the Fed does.
But on the fiscal front, there is less clarity. The UK recently tried to cut its peak tax rate but the markets punished it badly ― sterling lost 5% of its value in a day, before recovering somewhat. In fact, the UK has abandoned its decision to cut the peak income tax rate of 45% for now. Australia is caught in a similar situation: the newly elected Labour government may reconsider a legislated reduction in peak income tax rate from 37% to 30% over the next two years.
The markets are perhaps indicating that a tax cut in the post-Ukraine situation could force nations to borrow more, exacerbating the already difficult national debt situation of most economies. This very sentiment has forced the Liz Truss government in the UK to reconsider its tax cut package. What can India do in such a scenario? The Modi government will present its last full budget in February 2023.
While the RBI has withdrawn much of the post-COVID monetary accommodation, the Union government will also have to chip in by appearing to be fiscally responsible. The present fiscal deficit of nearly 11% of GDP, for the Union and states together, is unsustainable. Global markets will harshly punish India if the Modi government is tempted to increase its borrowings for its large public spending programme on infrastructure and welfare. This realisation has dawned on Modi, who is expressing his concern for fiscal responsibility in a rather skewed manner by blaming only the states for handing out freebies.
Modi will also have to honestly look at his own freebies, specially designed for the 2024 elections. Finally, the Centre may have to increase taxes on corporates, from a low of 15% to 25%, to garner more revenues, instead of increasing borrowings, which would be disastrous. Corporate profits are doing very well after the Finance Ministry cut rates dramatically in 2019. The RBI helped with big interest rate reductions after COVID to strengthen balance sheets.
The Centre would do well to ensure that a large number of businesses whose promoter wealth has multiplied post COVID duly contribute to society in a fair manner.