Calibrating the policy mix

The right fiscal-monetary-external balance must be achieved to nurture and harness a nascent recovery

After a challenging few months, first light is emerging at the end of the growth tunnel. The recent high frequency data — whether power demand, cargo and railway traffic, industrial production, or the Purchasing Manager Index surveys — are either showing signs of stabilisation or some lift on a sequential (month-on-month) basis. But this will not show up any time soon in the year-on-year data, which is far more sluggish and doesn’t capture turning points well. 

Year-on-year growth in the October-December quarter is tracking 4.5 per cent — the same as last quarter — and may even print a tad lower. Prima facie, this will suggest no respite from the slowdown. In fact, however, a year-on-year print of 4.5 per cent would be signalling a sequential growth (quarter-on-quarter, seasonally adjusted and annualised) pick-up to 5.5 per cent in the October-December quarter from 3.5 per cent the previous two quarters.

Yet, it’s too early to believe the corner has been turned just yet. Some of the lift is likely because of a series of one-offs (a postponement of consumption on goods and services tax, or GST, uncertainty in September and unseasonal rains that hurt mining and electricity production) have corrected. Only when growth stabilises at the 5-6 per cent level sequentially for a couple of quarters will there be conviction a corner has been turned. Furthermore, any lift is likely to be bounded given different balance sheets in the economy. Consumption has been the prime mover in recent years, but with individual debt rising, households have become risk-averse in the wake of the slowdown, manifested in falling consumer confidence in recent surveys. Meanwhile, financial sector balance sheets have thwarted the Reserve Bank of India’s (RBI’s) monetary easing cycle in 2019 from permeating to the broader economy. Lending rates have only come down a fraction of policy rates and inflation, such that real lending rates have actually increased over the last year. This helps neither household consumption nor corporate deleveraging.

Given these cross-currents, policy will have to perform a delicate balancing act in 2020. Fiscal policy, in particular, will have to walk a tightrope between avoiding pro-cyclicality yet simultaneously pursuing prudence. Government spending has grown twice as fast as other components of demand in recent quarters, and, therefore, played an important counter-cyclical role in propping up growth. But with real and nominal growth slowing precipitously, tax buoyancy is understandably under pressure. With the Centre’s tax collections (net of the state share) estimated to undershoot budget targets by about 1.5 per cent of gross domestic product (GDP), sticking to this year’s deficit target of 3.3 per cent of GDP, will likely entail a sharp cut in government spending in the last quarter of the fiscal year — which would constitute a formidable headwind to a fledgling growth recovery. Against this backdrop, it’s understandable if authorities were to use the 0.5 per cent of GDP space accorded under the FRBM Act, and let the deficit widen towards 3.8 per cent of GDP. This should be seen more as the Budget’s “automatic stabilisers” being allowed to work on the revenue side, rather than a fiscal stimulus in the form of the underlying structural deficit widening.

Illustration: Ajay Mohanty

If, however, the deficit does widen to these levels, it’s important to show credible, if gradual, consolidation next year. India’s yield curve remains steep—despite the growth slowdown, a sustained monetary easing cycle, and a gush of inter-bank liquidity —  more confirmation it’s an equilibrium response to the difference between public sector borrowing requirements and household savings, with foreign interest in India’s bond market remaining muted in recent years. Against this backdrop, it will be important to show a credible consolidation to anchor bond market expectations, and avoid an inadvertent  tightening of financial conditions.

But if fiscal policy is tightening next year, wouldn’t that hurt growth in 2020-21? Not if that consolidation is achieved through asset sales. If asset sales were to rise from, say, 0.3 per cent of GDP to, say, 0.8 per cent of GDP next year, and the deficit is consolidated by, say, 0.3 per cent of GDP next year, the underlying fiscal impulse will actually be expansionary, even as the headline deficit is narrowing. From the perspective of macro management, one cannot think of a more appropriate time to step on the asset-sale pedal.

Finally, fiscal space created should ideally be spent to generate the highest possible fiscal multipliers. This would include spending that directly impacts the bottom of the pyramid (NREGA, PM Kisan) where the marginal propensity to consume is the highest, or temporary indirect tax-cuts to sectors with large multiplier effects (e.g. real estate sector) to stoke and bring-forward demand. New infrastructure spending has large positive spill-over effects, but its gestation often makes it impractical to serve as an urgent counter-cyclical response. All told, fiscal policy will have to perform a delicate balancing act, striving to remain counter-cyclical without inadvertently turning counter-productive. 

But if fiscal policy must face trade-offs, monetary policy is not far behind. The sharp growth and inflation slowdown in 2019 allowed the RBI to slash policy rates to support growth. But the recent food price surge is creating policy trade-offs. While the focus is on vegetable prices, the real story is food inflation (ex-vegetables) has firmed from less than 1 per cent in 2017 and 2018 to almost a 7 per cent annualised momentum in recent months. Is this because of a temporary supply disruption from the unseasonal deluge last year? Or is it a more organic supply response to muted prices in recent years (Cobweb Cycle)? Or is some of it from firming global food inflation, which is in double digits? The answer to these questions will likely shape the inflation  and monetary policy — trajectory for 2020.

There are other considerations. While firming food prices could harden urban inflation expectations, they will help correct the agrarian terms of trade that have been declining for a decade. To the extent that the resulting food inflation is not completely offset by the quantum of any supply shock, agrarian purchasing power and consumption should lift. Think of this as a transfer of purchasing power back from urban to rural.

But the trade-offs don’t end there. With growth slowing, India’s current account deficit is tracking just 1 per cent of GDP. Simultaneously, capital inflows have increased as global financial conditions have eased and Indian firms seek to raise capital overseas. This is resulting in a large balance of payments surplus. The RBI has correctly intervened to prevent rupee appreciation so that tradable sector competitiveness is not impinged. But this intervention creates a large liquidity surplus which can complicate monetary management if inflation firms. The RBI could intervene in a liquidity-neutral manner in the forward market, but that could disincentivise economic agents from hedging their dollar exposures, creating financial stability concerns down the line. There are no easy answers and this is the classical “trilemma” that emerging markets must contend with. Ultimately, more instruments (like macro prudential measures) may be needed to address multiple objectives.

Policy-makers must be commended for a slew of pronouncements in recent months to arrest the slowdown. There are first signs that growth is inflecting. Now, policy must calibrate the fiscal-monetary-external mix appropriately to nurture and harness a fledgling recovery.        

The writer is chief India economist at J P Morgan. Views are personal