The growth path India must take

'The need of the hour is the building up of macro-financial, fiscal, and external buffers', said the authors

The beginning of a global recovery that should be music to us during difficult times could actually turn out to be a threat. Not only are commodity prices, such as that of oil, rising, but there is also escalating price growth in the US and other major economies that is causing rising expectations amongst investors that rates will rise. This will, in turn, push up bond yields and make public debt more expensive. Since the inflation in these economies is accompanied by better growth prospects, there is the correlated risk of a capital outflow from emerging markets, such as India, and associated currency weakness. Any attempt to contain this through the build-up of foreign exchange reserves as the central bank has done just adds to inflationary pressure. It is not unrelated that CPI inflation has averaged over 6 per cent over the past year. 

Some would maintain that India relies more on domestic lenders, which makes it less vulnerable to capital outflows. However, it needs to be kept in mind that borrowing has taken place at shorter maturities during the course of the pandemic. Much of that debt has been picked up by the banking system. An increase in public debt held by domestic banks accentuates the link between the health of the fisc and that of the banking system. When banks expand their exposure to the sovereign, they help overcome temporary fiscal stress. But as rates rise and the value of bonds decline, their exposure affects the bank balance sheet adversely. The suspension of insolvency proceedings against new defaults and temporary freeze on loan repayments have added to the risk on bank balance sheets. Corporate and small and medium enterprises distress has the potential to affect financial stability if banks continue to have unrecognised loan losses on their books. At this stage, an important policy that should be encouraged is to provide greater transparency in the conduct of bank asset quality reviews and to tighten macroprudential policies on financial institutions.  

Apart from restoring financial regulatory standards, it is also important to set out a time path over which fiscal rules will be followed and the steps that will be taken to reduce debt and debt accumulation. The medium-term priorities need to be laid out on tax capacity and spending on public services as there will be continued efforts to secure adequate vaccines and to mitigate the spread of the virus, which must be traded off with normalising policies so as to build economic resilience and not upset expectations of the take-off growth that are slowly taking root. The need of the hour is the building up of macro-financial, fiscal, and external buffers.
 

Indian growth has been consumption-led and whenever this has been impacted the government has stepped in with larger fiscal expenditures to support the economy. As the large deficits and debt make further public borrowing difficult, the tap of private consumption expenditure is unavailable to provide multiplier effects on aggregate income. The pandemic with the associated loss of jobs and increase in health-related expenditures has pushed more people into poverty (approximately 75 million additional people have fallen below the poverty line post-Covid, taking the total number of poor in the country to 134 million, according to a Pew Research Centre study using data from the World Bank) and dragged many households into further indebtedness. The increase in rates as the rest of the world recovers and inflation remains high domestically, causes penny-pinching by those households that are leveraged. Discretionary spending is not available to these households who have a higher marginal propensity to consume and who in times of stress have little capacity to change consumption when they are living from one pay cheque to the next. By contrast, high-income households may have the discretionary income but with an economy that has restricted mobility, the preference is for higher savings and in deploying those to make gains on the movements of asset prices. Stock markets can thereby show gains even as large sections of the population are in distress. The price-to-earnings ratio of many firms are inexplicably high and the Reserve Bank of India has warned investors of a likely bubble reflected in asset price inflation. The economy needs transfers to those in distress and credit guarantees to reduce risk and facilitate start-ups and small business. 

The road ahead may well be more turbulent. It is not just new strains of the virus that could derail growth. It is the management of the normalisation of the fiscal, macroprudential-financial, and external sector issues that could very well be our undoing if we do not give it the right focus that these issues deserve. The signposts are there as to how to travel on the road to sustainable growth.

D'Souza is IIM Ahmedabad director, and Agarwalla is associate professor at Adani Institute of Infrastructure Management