Maintaining macroeconomic stability

The Covid-19 crisis has made the Indian economic policy environment extremely tricky. Decisions in the area of monetary policy, financial sector regulation, and fiscal policy over the next few quarters will have an enduring impact on the economy. In the context of monetary policy, headline inflation has been above the upper end of the target band for several months, which has created significant policy uncertainty. If it does not come down quickly, the monetary policy committee (MPC) would have to take remedial action. 

It would not be easy to increase interest rates when the output is contracting. The rate-setting committee would probably have to hold interest rates in the near term, which means that the monetary policy will not be able to extend more support to the real economy. Even if the central bank decides to cut rates, it will not have the desired impact because the markets would factor in its limitation and the possibility of a quick reversal.

Further, aside from the near-term complications in policymaking, the inflation target will come up for review in a few months. Although inflation has been above the target band in recent months, the adoption of the flexible inflation-targeting framework has worked well. Nonetheless, some commentators have suggested that the target should be revised to accommodate higher inflation, or the policy should be anchored to core inflation. All such issues were discussed and settled by the Urjit Patel committee.

Even though the fundamental reasoning has not changed, the government can constitute an expert panel to review the overall framework. However, it would be critical to ensure that changes, if any, are well-reasoned. An impression that the policy establishment is simply willing to accommodate higher inflation would affect policy credibility and increase risks to financial stability. In fact, the idea should be to strengthen the framework. In the recent past, the Reserve Bank of India (RBI) has reduced the reverse repo rate, which is outside the purview of the MPC but is linked to the policy repo rate, and flooded the system with liquidity, practically making the rate-setting committee redundant. Since the reverse repo rate becomes the operating rate when liquidity is in surplus, the central bank can technically reduce rates outside the MPC. Any hint that the MPC can be bypassed should be avoided. If interest rates need to be brought down, it should be done only through the MPC.

The other area which will require special attention is the state of the financial sector. The RBI has decided to allow one-time restructuring of loans as the moratorium on repayment is ending. While the details of the programme are being framed by a panel headed by veteran banker K V Kamath, it would be important to ensure that the mechanism is not used to hide bad loans. The banking regulator will need to be extra vigilant in reviewing the books of banks and non-banking financial companies. A situation where the actual state of the bank balance sheet is hidden for far too long should be avoided.

A build-up of bad loans in the system, which is a real possibility, could pose a threat to both financial stability and economic growth. The RBI will need to ensure that the government also puts adequate capital in public sector banks (PSBs) and it doesn’t end up relaxing regulations to make life easier for state-run banks and, possibly, pushing credit growth. As former deputy governor Viral Acharya has highlighted in his book Quest for Restoring Financial Stability in India, the central bank gets pulled into negotiations with the government regarding regulatory forbearance as timely recognition of losses results in additional capital requirement for PSBs and puts pressure on the Budget. Both the government and the regulator would need to avoid this. The way the banking regulator handles the emerging stress in the coming quarters will be critical for ensuring financial stability and enabling growth. The first test will be the restructuring programme.

Finally, how the government manages its finances in the medium term will be important. The Union government has increased its borrowing target by 50 per cent compared to the Budget estimates. But it crossed the 50 per cent mark of the revised deficit target in the first quarter. Thus, even if the situation improves in the second half, higher borrowings would largely be used to cover the revenue shortfall. The government may not be in a position to increase expenditure and push economic activity as is being suggested by some of its talking heads. The government would need to take a call in this context in the near term.

A substantial increase in government borrowing will further push up the debt stock, which is anyway expected to go up significantly this year. The borrowing limit for states may have to be relaxed further because of the shortfall in tax collection, particularly the goods and services tax. However, the general government deficit would need to be aligned to the possibility that post-pandemic growth could be much lower, which can increase debt sustainability risks. Therefore, policymakers will need to strike a fine balance while addressing the immediate needs of the economy and preserving longer-term economic stability.