Since the summer of 2009 the world economy has begun to climb out of the Great Recession of 2008-09, much sooner than most people believed possible in the grim months of autumn 2008. Even the US turned the corner in the quarter ending September, registering annualised growth of over 3 per cent. The Asian behemoths of China and India suffered “only” a growth recession and an upswing is now clearly under way, rapidly in China and more sedately in India. Huge questions remain about the durability and strength of the recovery, especially in the highly leveraged economies of the industrial West and Japan. But throughout the world the focus of macroeconomic policy is shifting decisively to the issues of “exit”: its timing, sequencing and phasing. For those holidaying in Mars over the past six months, “exit” refers to the rollback of massive fiscal deficits, very low policy interest rates and unprecedented quantitative easing of liquidity, which were the primary tools deployed by nearly all countries to combat the Great Recession. In India too, this is becoming the central focus of macroeconomic policy. What should we do and when in regard to fiscal, monetary and exchange rate policies?
FISCAL POLICY
The successful fiscal consolidation of 2003-08 saw the combined (centre plus states) fiscal deficit drop to 5 per cent of GDP in 2007-08. Then along came the huge fiscal profligacy of 2008-09 (Pay Commission decisions, farm loan waiver and massive subsidies for oil, fertiliser and food) and the modest “fiscal stimuli” of the final four months, which took the combined deficit close to 11 per cent of GDP in 2008-09. This record deficit level was almost matched in the July Budget (for 2009-10) of the new UPA (II) government, which planned for a deficit of 6.8 per cent of GDP in the Centre and allowed for another 4 per cent in the states.
Every senior policy-maker, including the prime minister and the finance minister, has repeatedly stated that such exceptional deficits are unsustainable beyond the present financial year. The global crisis, which (arguably) justified these record deficits, is now ending. While presenting the Budget in July, the finance minister had outlined to Parliament a central government deficit reduction target of 5.5 per cent of GDP for 2010-11 and 4.0 per cent of GDP in 2011-12. Quite clearly, the Budget for 2010-11 will need to show deficit reduction of this order. It will not be easy (see my article in BS, 23 July, 2009). But it may be possible. As economic growth recovers, so should tax revenues. On income tax rates, the potentially dangerous adventurism of the draft Direct Taxes Code seems to have been postponed for at least a year. The important recent announcements on disinvestment policy are heartening and clearly pave the way for a substantial disinvestment effort in the months ahead, especially in 2010-11. The 3G telecom auction revenues could perhaps be phased to assist the deficit reduction for 2010-11.
An important policy issue will be how to deal with the excise/CENVAT tax rates, which were sharply reduced from 16 to 8 per cent during 2008-09. One temptation will be to postpone any change in this hugely reduced modal excise rate until the transition to the GST, which now seems likely to be postponed by some months beyond the announced target of April 2010. My recommendation would be to revise the modal excise rate upwards to 12 per cent in the February 2010 Budget and unify the general services tax rate at this same level until such time that the GST can be implemented.
MONETARY POLICY
The RBI’s recent, “second quarter monetary policy review” provides a balanced and well-nuanced statement of the central bank’s current policy stance and hints at its likely evolution. In a nutshell, RBI left the key policy rates and the CRR unchanged, phased out the special liquidity facilities which had been launched during the post-Lehman crisis months (including reverting the SLR to 25 per cent), raised provisioning norms for bank lending for commercial real estate and tightened provisioning requirements against non-performing loans. The language of the policy statement was more hawkish, given the continued high rates of consumer inflation and an anticipated rebound in wholesale price inflation. Quite clearly, RBI signalled the possibility of some increases in policy rates and the CRR in the months ahead.
It is reasonable to conclude that RBI has laid the groundwork for exiting from its exceptionally accommodative monetary and credit policies of the past year. Indeed, one could go further and interpret the language and announcements of the recent policy review as beginning the process of exit. Whether the actual increases in policy rates and/or the CRR occurs in three or six months will obviously depend on the pace of economic activity (at home and abroad), trends in prices of goods, services and assets and the level and volatility of external capital flows.
EXCHANGE RATE POLICY
Ever since the government and RBI moved to a market-responsive exchange rate system in March 1993, the exchange rate policy of the authorities has been pretty straightforward and largely successful in promoting trade and economic growth. The key elements of the policy include: no particular nominal rate is targeted or defended; “excessive volatility” is contained through intervention; and there is a revealed preference for maintaining a “competitive” or “realistic” exchange rate level. In operational terms, this seems to mean that the authorities are comfortable when the real effective exchange rate (REER) is close to the level prevailing in 1993-94. After the aberration of 2007-08 (when the six-country REER index shot up to 114, with 1993-94=100) it has reverted close to 100 throughout the year running from October 2008 to September 2009. The considerations that appear to influence this preference include India’s continuing current account deficit in the balance of payments, the structural constraints handicapping the tradable sector, especially manufacturing (poor infrastructure, bad labour laws, etc) and the systematic currency undervaluation in major competitors, notably China.
Against this background, the major threat to sensible exchange rate policy comes from a possible repetition of the kind of foreign capital inflow surge that India experienced in 2005-07. Given the exceptionally high liquidity, low interest rates and slow growth prevailing in industrial countries, juxtaposed with the Indian economy’s resilience, such a surge seems quite likely and may well be under way. The tools for dealing with it are tried and tested and include: sterilised intervention, increases in the CRR, caps on external commercial borrowing by both companies and government and allowing limited nominal appreciation. If these are not enough, the government should seriously consider taking a leaf out of Brazil’s policy book and imposing a small, temporary tax on portfolio and debt inflows. But the details, where the devil resides, will have to be carefully thought through. Judging by the recent discussion in G-20 gatherings and the western financial press, adding this instrument to the armoury may not be very heterodox.
The author is Honorary Professor at ICRIER and former Chief Economic Adviser to the Government of India. Views expressed are personal
