The consolidated fiscal deficit of the state and the Centre in India is by far the largest among countries we like to compare ourselves with; at present only Brazil, a country in difficulty, rivals us on this measure. According to IMF (International Monetary Fund estimates - which is what the global investor sees - our consolidated fiscal deficit went up from seven per cent in 2014 to 7.2 per cent in 2015. So we actually expanded the aggregate deficit in the last calendar year. With UDAY, the scheme to revive state power distribution companies, coming into operation in the next fiscal, it is unlikely that states will be shrinking their deficits, which puts pressure on the Centre to adjust more.
Some say that fiscal expansion is necessary to generate the growth needed to put our debt-to-GDP ratio back on a sustainable path. This is a novel argument. Ordinarily one would think that a government should borrow less, that is, run lower fiscal deficits in order to reduce its debt. But there is indeed a theoretical possibility that the growth generated by the fiscal expansion is so great as to outweigh the additional debt that is taken on. Unfortunately, the growth multipliers on government spending at this juncture are likely to be much smaller, so more spending will probably hurt debt dynamics. Put differently, it is worth asking if there really are very high return investments that we are foregoing by staying on the consolidation path?
Of course, the common man does not really care whether we stay on the consolidation path or not. But the bond markets, where we have to finance over Rs 10 lakh crore of deficits plus UDAY state bonds, do care. Deviating from the fiscal consolidation path could push up government bond yields, both because of the greater volume of bonds to be financed and the potential loss of government credibility on future consolidation. It was James Carville who said, "I used to think if there was reincarnation, I wanted to come back as the president or the Pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody." The government understands the importance of bond market confidence, but I wonder if the economists debating in public put adequate weight on it.
The fall in inflation has been a major contributor to lower bond yields, and is the joint work of the government and the RBI, aided to some extent by the fall in international commodity prices. This is no mean achievement given two successive droughts that would have, in the past, pushed inflation into double digits. Despite this success, we hear voices suggesting weakening the fight against inflation. Let me reiterate that macroeconomic stability relies immensely on policy credibility, which is the public belief that policy will depart from the charted course only in extreme necessity, and not because of convenience. If every time there is any minor difficulty, we change the goalposts, we signal to the markets that we have no staying power. Let me therefore reiterate that we have absolutely no intent of departing from the inflation framework that has been agreed with the government. We look forward to the government amending the RBI Act to usher in the monetary policy committee, further strengthening the framework.
Macroeconomic stability will be the platform on which we will build the growth that will sustain our country for many years to come, no matter what the world does. Indeed, I am reminded today of the period 1997-2002 when India laboured and reformed with only moderate growth, only to see a decade of high growth after that.
Before I turn to the main body of this talk, a word on interest rates. Industrialists grumble about high rates while retirees complain about the low rates they get today on deposits. Both overstate their case, though as I have said repeatedly, the way to resolve their differences is to bring CPI (Consumer Price Index) inflation steadily down.
Let me explain, starting with the retiree. The typical letter I get goes, "I used to get 10 per cent earlier on a one year fixed deposit, now I barely get eight per cent, please tell banks to pay me more else I won't be able to make ends meet". The truth is that the retiree is getting more today but he does not realise it, because he is focusing only on the nominal interest he gets and not on the underlying inflation which has come down even more sharply, from about 10 per cent to 5.5 per cent.
To see this, let us indulge in dosa economics. Say, the pensioner wants to buy dosas and at the beginning of the period; they cost Rs 50 per dosa. Let us say he has savings of Rs 1 lakh. He could buy 2,000 dosas with the money today, but he wants more by investing.
At 10 per cent interest, he gets Rs 10,000 after one year, plus his principal. With dosa prices having gone up by 10 per cent to Rs 55, he can buy 182 dosas approximately with the Rs 10,000 interest.
At eight per cent interest, he gets Rs 8,000. With dosas having gone up by 5.5 per cent, each dosa costs Rs 52.75, so he can now buy only 152 dosas approximately. So the pensioner seems vindicated: with lower interest payments, he can now buy less.
But wait a minute. Remember, he gets his principal back also and that too has to be adjusted for inflation. In the high inflation period, it was worth 1,818 dosas, in the low inflation period, it is worth 1,896 dosas. So in the high inflation period, principal plus interest are worth 2,000 dosas together, while in the low inflation period it is worth 2,048 dosas. He is about 2.5 per cent better off in the low inflation period in terms of dosas.
This is a long-winded way of saying that inflation is the silent killer because it eats into pensioners' principal, even while they are deluded by high nominal interest rates into thinking they are getting an adequate return. Indeed, with 10 per cent return and 10 per cent inflation, the deposit is not giving you any real return net of inflation, which is why you can buy only 2,000 dosas after a year of investing, the same as you could buy before you invested. In contrast, when inflation is 5.5 per cent but the interest rate you are getting is eight per cent, you are earning a real rate of 2.5 per cent, which means 2.5 per cent more dosas. So while I sympathise with pensioners, they certainly are better off today than in the past.
Edited excerpt from the CD Deshmukh Memorial Lecture by Reserve Bank of India Governor Raghuram Rajan, in New Delhi, on January 29
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