The coming Union Budget is a huge challenge for the government. The world economy is facing the severest stresses since the financial crisis of 2008. In 2015-16, the Indian economy will grow at 7-7.5 per cent, less than the 8.1-8.5 per cent projected earlier. On present trends, growth in 2016-17 will not be any higher than in 2015-16. India’s public sector banks (PSBs) are in their worst shapein over a decade. The stock market has declined to the level seen before the Narendra Modi government assumed power in 2014. Against this background, the promise of an early return to the growth path of 8 per cent has faded. The Budget must do what it takes to ensure an early return. As the animal spirits of businessmen are weak, government spending must take the lead.
The change since 2008
Following the financial crisis of 2008, the government knew what to do. It opted to provide both fiscal and monetary stimuli — as governments the world over did. This was the obvious thing to do then because there was space for both types of stimuli. Growth revived strongly in India after the crisis (although we had to reckon with higher inflation down the road).
The situation today is different. The space for fiscal stimulus is limited by the commitment on a fiscal consolidation path given by the government. The space for monetary stimuli is limited by the monetary policy framework agreed to by the government and the Reserve Bank of India, which commits the RBI to a time table for meeting specified targets for inflation.
As a result, the government today faces critical choices. Should it opt to accelerate growth in the present situation? If so, should it do so through fiscal stimulus or by creating conditions for a monetary stimulus? And how should it go about restoring the health of PSBs so that credit growth is not undermined?
The answers must be determined by the conditions on the ground. India’s growth is estimated to be below its growth potential. Two sources of aggregate demand, exports and private investment, are weak at the moment. Greater public investment is clearly the answer.
In the coming year, the government is not in a position to reduce costs significantly enough (by pruning subsidies drastically, for instance) or to raise revenues sufficiently (by disinvestment or a buoyancy in tax revenues). Something must give. This has to be the fiscal deficit target of 3.5 per cent for 2016-17.
Many economists oppose any departure from the stipulated path of fiscal consolidation. They say it will undermine investor confidence in the Indian economy. They warn that FIIs will flee the Indian market, and this will devastate the markets and the rupee.
One doubts that the situation is as grim as that. Foreign investors will see the case for boosting growth in the present international environment. They know that India’s macro-economic indicators are in better shape than those of most emerging markets. Rational investors will focus on the quality of spending, not the size of the fiscal deficit itself. As long as the departure from the fiscal deficit target is on account of higher investment spending (which is growth-inducing), they are unlikely to take a harsh view of matters.
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The Brazil comparison
In his recent C.D. Deshmukh memorial lecture, RBI Governor Raghuram Rajan makes a stronger argument against any relaxation in fiscal consolidation. He believes attempts to boost growth can end up delivering even slower growth in future. He cites the example of Brazil that went down the path of fiscal stimulus only to end up with a shrinking economy last year. India’s consolidated fiscal deficit of the Centre and the States, he points out, is rivalled only by that of Brazil.
In his recent C.D. Deshmukh memorial lecture, RBI Governor Raghuram Rajan makes a stronger argument against any relaxation in fiscal consolidation. He believes attempts to boost growth can end up delivering even slower growth in future. He cites the example of Brazil that went down the path of fiscal stimulus only to end up with a shrinking economy last year. India’s consolidated fiscal deficit of the Centre and the States, he points out, is rivalled only by that of Brazil.
It is possible to exaggerate the comparison, and hence the dangers to macro-economic stability, of a limited fiscal stimulus at this point. Brazil is a commodity exporter and is a loser in a context in which commodities prices have been hammered down. India is a net importer of oil and hence a potential gainer. India’s public debt to GDP ratio has declined over the years and is today below 70 per cent, which looks a lot better than that of many advanced economies, including the U.K. and the U.S.
Not least, as the Mid-Year Review of the Finance Ministry points out, the fiscal multiplier — the increase in GDP per unit of government spending (or borrowing) — tends to be high in times of economic contraction. Any increase in the fiscal deficit will tend to be offset by an even greater increase in the GDP. This should cause the ratio of fiscal deficit to GDP to decline.
There’s a third argument against a fiscal stimulus at this point, that sticking to the 3.5 per cent target will make it easier for the RBI to drop its policy rate by, say, 25 basis points. We can thus facilitate growth through a monetary stimulus rather than a fiscal stimulus.
One wishes matters were as simple. First, it’s not clear that with retail inflation climbing to 5.7 per cent in January, the RBI will oblige with a rate cut soon. Second, we have seen that RBI rate cuts over the past year have not translated into commensurate reductions in lending rates. Of the 125 basis points in rate reduction since January 2015, banks have passed on only about 50-60 basis points.
There are many reasons for this. Banks face high deposit rates because of high regulated rates on government savings instruments. They have to contend with huge pressure on profits because of high non-performing assets, hence they need to maintain high margins (the difference between lending and borrowing rates).
Moreover, banks have traditionally priced their loans using the average cost of funds. When the rate of incremental borrowing falls (following a policy rate cut), it does not much impact the average cost of funds and hence the lending rate. The RBI has recently asked that banks link their lending rates for new loans to the marginal cost of funds. It will be a while before the impact of this change kicks in.
It is not the cost of loans alone that is the problem today. The volume of loans is also an issue. PSBs have seen their net worth being battered in recent days. This follows the RBI’s determination to get banks to recognise and provide for non-performing assets in full here and now. It has made clear its objective of cleaning up banks’ balance sheets by 2017.
This is a laudable objective. However, for banks to be able to lend freely, they need an adequate buffer of capital over and above the regulatory minimum. This can happen only if there is a substantial infusion of capital into PSBs by the government. The infusion of capital will have to be higher than the Rs.70,000 promised over four years under the Indradhanush plan. There is a case for relaxing the fiscal deficit target on this count too. Only then can credit revive strongly and private investment pick up.
The Modi government came to power on a promise of delivering faster growth and more jobs. We have seen two years of growth below 8 per cent. It’s hard to see the political authority reconciling itself to another year or two of the same growth rate — that would wash out most of the tenure of the present government. A departure from the fiscal consolidation path is the best answer to flagging growth. The risk to macro-economic stability can be managed.
(T.T. Ram Mohan is a professor at the Indian Institute of Management, Ahmedabad.)
