Glitter versus gold in policy-making

Three years of slowing growth hold two important lessons for the Budget

With the economy stuck in the doldrums, attention is fast turning to the Budget on February 1.  The hope is that the government will turn on the spending taps. But if history is any guide, and as counter-intuitive it may sound, a quick fix like that may be the last thing the country needs to get back on its feet.
 
Our study into India’s three-year slowdown reveals some important lessons for policy-makers. Namely, what can look attractive at first glance, for example higher public investment and higher foreign exchange reserves, may have a sting in the tail.
 
Let’s begin by looking at the initial economic slowdown in 2017 and 2018 for clues. The hallmark of this period was a rise in investment following five years of declines. The public sector was behind much of this investment growth with the contribution of public investment to gross domestic product (GDP) growth rising from 0.1 percentage point in 2016 to 0.8 percentage point in 2017.
 
But this spending spree was not without hidden costs. Borrowings by the public sector rose over the period, leading to three undesirable outcomes.
 
One, savings didn’t rise in line with the investment spree. Consequently, the savings minus investment differential fell. This measure is nothing more than the country’s external current account balance, and when domestic savings proved insufficient, the reliance on external funding rose. The current account deficit widened rapidly over these two years.
 
Two, the lackluster rise in savings had implications for economy-wide interest rates. Almost all interest rate spreads in India began to rise around that time.
 
Three, while the idea behind higher public investment was to spur economic growth, it instead fell. GDP is the sum of consumption, investment and net exports (exports minus imports, or broadly speaking the current account deficit). While investments rose, net exports fell.
 
This holds an important lesson for the Budget. It is tempting to assume that the fiscal deficit must widen during slowdowns to help revive growth. However, if this occurs when domestic savings are not enough, it can put upwards pressure on interest rates, and strain external finances, thereby taking away from economic growth.
 

In short, a growth revival policy based on a large fiscal push could backfire by hurting a recovery, more than helping it. A balance here may be to stick to the new fiscal rules enacted by Parliament, which allows for fiscal slippage of 0.5 per cent of GDP, not more. This would help make room for the revenue shortfall led by weak growth.
 
Going back to the growth slowdown, the challenge in 2019 proved a bit different from that in 2018 and 2017. India’s investment rate did not continue to rise, and the mismatch with savings was corrected. This should have meant economy-wide interest rates stabilising or even falling, while, in fact, the opposite happened. The Reserve Bank of India cut rates by 135 basis points, but this barely got transmitted to lending rates. Economy-wide interest rate spreads widened over the year. Something else was going wrong.
 
Following the NBFC, or non-banking financial company (India’s shadow banks), fallout in late-2018, there was concern about the health of their balance sheets. India’s banks had been an important lender to NBFCs, but suddenly they were not sure about the quality of the loans they had made and thus became extremely risk averse.
 
What does this mean for the macro-economy? Three things in particular. One, banks were now much less willing to lend. The pool available for investment had shrunk.
 
Two, with higher interest rates, savers may want to save more. In this situation, saving increases and so does the current account balance. What is the mechanism here? As investment falls, imports fall as well, improving the trade balance. Indeed, the current account deficit has shrunk from 2.1 per cent of GDP in 2018 to 0.9 per cent in September 2019.
 
Three, when banks become reluctant to lend, more savings are placed abroad. What’s the mechanism? As mentioned, imports fall, improving the current account balance, and because the RBI may not want the rupee to appreciate during a downturn, it buys up dollars and adds to its reserves. These are eventually invested in international assets such as US Treasury bills.
 
To cut a long story short, risk aversion at banks can lower domestic investment, placing more of a country’s domestic savings abroad. What are the implications for the Budget? We believe the Budget presents the government with an opportunity to take steps that reduce risk aversion in the banking system and resuscitate credit growth. In fact, we believe this should be a national policy priority as it would help domestic savings stay at home, and help fund investment and a growth revival.
 
Steps to achieve this could include strengthening the bankruptcy regime, untangling stalled investments and reducing government mandates imposed on public sector banks. A regulatory overhaul of shadow banks and increasing the pace of strategic disinvestments by the government would also help.
 
Indeed, some fiscal prudence because savings are stagnant, and steps to remove risk aversion at banks could be a golden opportunity for a growth revival.
 
The writer is chief India economist, HSBC Securities and Capital Markets (India)