India's 2021 policy maze

The decline in new Covid-19 cases and developments on the vaccine front have raised hopes. Hopefully, the new strain of coronavirus discovered in the UK will not alter things significantly. While 2021 is likely to be better than 2020, policy management would remain fairly complicated. Policy decisions during the course of the year will determine the strength and durability of recovery in the Indian economy.

The first big policy event of the year, of course, would be the Union Budget, which will set the broad direction. The economy is recovering from Covid-related disruptions, and most forecasters have revised their growth projection to account for a stronger than expected rebound. The Reserve Bank of India (RBI) expects the economy to break out of contraction in the current quarter.  

Although the economy will continue to recover, it might regain the 2019-20 level of output only towards the end of the next fiscal year. This will have implications for the Budget. The Union government has not increased expenditure significantly in the current year, and is unlikely to exceed the Budget estimate by a large margin. But the revenue will fall short significantly. The shortfall is being covered by increased borrowing. While revenues are set to improve next year, it will be on a much lower base. Revenue collections till October were just about 34 per cent of the Budget estimate. A significant increase in expenditure will keep the deficit elevated even in the next fiscal year and push up the public debt. The government would, therefore, be expected to start consolidating its finances from next year and present a medium-term fiscal road map. But a sharp cut in expenditure could affect recovery.

It is also being debated whether the government should give a range for fiscal deficit targets. It would do well to avoid such ideas — at least at this juncture — as it might create confusion. The basic story is that the government has been running a large deficit, which needs to be addressed. Existing higher fiscal deficit and rising public debt prevented the government from increasing expenditure in a crisis year. Thus, redefining the goalpost would not help. It will be critical that the government presents a realistic picture. Impractical assumptions regarding revenue collection would only complicate matters and could potentially affect recovery due to a sudden squeeze in expenditure at a later stage.

While the government will need to do a tough balancing, the RBI's policy path will be even more tricky. The Indian central bank has done most of the heavy lifting over the last few quarters and will need to start rolling back stimulus measures without disrupting the market. So far the RBI has underestimated inflationary pressures. Sustained higher inflation can affect expectations and increase the final cost of containment. But measures to contain inflation could affect economic activity in the short run.

The RBI has also flooded the system with liquidity to the extent that short-term market rates have gone significantly below the policy corridor. While higher liquidity eased financial conditions and helped both the government and businesses raise record sums in the bond market, the present situation is unsustainable. Higher liquidity and easy credit conditions can increase inflation risks. But tightening liquidity would increase the cost of money and potentially affect recovery in the immediate short run. It will not be an easy decision. The RBI also needs to handle government borrowing, which is likely to be reasonably large even in the next fiscal year.

Besides, liquidity is being driven by a large balance of payments surplus and RBI’s intervention in the currency market. A pickup in global commodity prices and a revival in imports with improvement in economic activity will increase the dollar demand, but foreign flows are likely to remain strong. As a result, the RBI will need to continue with currency market interventions to avoid rupee appreciation. This will add to domestic liquidity. So far the RBI has accumulated foreign exchange reserves worth over $120 billion since the beginning of the year. Higher reserves have its own set of complications. But not intervening in the market would result in a sharp rupee appreciation, which will not only affect India’s external competitiveness but can also create longer-term imbalances in the economy.

Thus, as things stand today, the RBI will need to contain inflation while minimising risks to growth in the short run. It will need to bring down liquidity without disrupting the bond market and manage government borrowings. Further, it has to make sure foreign flows don’t push up the rupee, which is anyway overvalued in real terms, and manage the resultant liquidity. The Indian central bank will not only have to make complex decisions but also get the timing right. Delays in decision-making will have consequences.

Furthermore, RBI’s inflation target will come up for review in 2021. The government is reportedly considering loosening the target. This will, presumably, allow the central bank to focus more on growth. The government would be well-advised to take a considered view and look beyond short-term requirements. Loosening the target will affect the standing of both the RBI and its monetary policy committee. This could be seen as a reflection of their inability to contain inflation and affect the credibility of the Indian policy establishment with longer-term costs.

Although the fiscal and monetary policy will significantly affect economic outcomes, there are several other aspects that will determine India’s growth trajectory. How the government handles the ongoing farm protests, for instance, can have a lasting impact on the future economic reforms.