The Reserve Bank of India has an impossible task. It must contain inflation without compromising growth, using four arrows in its quiver- setting domestic interest rates; managing liquidity; using its foreign exchange war chest to fight exchange rate volatility and the mandate to regulate banking operations-the last being an atypical central bank function. It can only hope for supportive fiscal policy.
Dampening inflation via interest rate increase
Synchronous interest rate action is a signal for international investors that a national monetary authority, like the RBI is determined to preserve stability. “Central banks are charting new territory with aggressive rate hikes, even if it entails sacrificing growth in the near term” said Governor, RBI on September 30, 2022, highlighting thereby, the compulsion to tag the domestic interest rate to rate increases in the advanced economies, even though, unlike them, our economy never enjoyed the rush of stimulus financing which is the precursor for high inflation- a price paid for safeguarding household income and supporting business through the pandemic downturn.
Stimulus in India was at a lower level. The combined fiscal deficit (FD) of the Union and state governments increased sharply from 7.2 percent of GDP in 2019-20 to 13.9 percent in 2020-21 and 10.4 percent in the succeeding year (2021-22). But our economy had been heating on a slow fire ever since the Western Financial Crisis. An FD of 8.3 in 2008-09 was followed by an FD of 9.3 in the following year 2009-10. Thereafter, instead of tapering to the notional FD target of 3 percent per the Fiscal Responsibility and Budgetary Management Act 2004 (FRBM), FD hovered around 7 percent for nine of the intervening ten years (2010-11 to 2019-20).
Fiscal policy perpetually above sustainable limits
Inflation expectations were therefore baked into the loose fiscal policy even prior to the twin supply shocks from the pandemic and the Ukraine crisis. This sapped the fiscal capacity for incremental stimulus, unlike in advanced economies, and permitted only a highly controlled and targeted fiscal policy during the pandemic.
Some supply price shocks might have become embedded into core inflation via permanent supply line reorientation because of reshoring or onshoring supply with a preference for domestic value addition and job creation. Additionally, loose fiscal policy dilutes the inflation dampening impact of interest rate increases. The Union government’s FD will remain above 4.5 percent of GDP till 2025-26. Allowing another 2 percent FD for state governments, this takes the combined FD to around 6 percent of GDP level – a far cry from the 3 percent envisaged under the FRBM Act.
Protecting the domestic currency
The Monetary Policy Committee of the RBI (September 30, 2022) increased the Repo rate – the rate at which commercial banks can borrow from the RBI- by 0.5 percent point from 5.40 to 5.90 percent partly to keep domestic interest rates competitive for international investors who could otherwise decide to pull out and invest elsewhere- triggering a run on the currency. Such preemptive action by the RBI show that it walks the talk on maintaining macroeconomic stability building credibility and positive investor perceptions.
The Repo Rate is now more than 2 percentage points higher than the United States Federal Funds rate of 3.75 percent. This is neither unusual nor capricious. During the Western Financial Crisis (2008-10) the difference in interest rates varied between 4.75 to 6.25 percent. A lower differential than earlier is justified by inflation in India being 7 percent, unusually, 1 percent (or more) lower than in the United States and other advanced European economies. US Federal Reserve is expected to target an FF rate (upper bound) of between 4.5 to 5 percent by mid-2023. This means, just to retain the current differential, the Repo Rate could increase to between 6.5 to 7 percent before the fiscal year end in March 2023.
The reversal of an easy money policy by the Federal Reserve has appreciated the US$ significantly against all currencies. The INR has depreciated less than most other international currencies – 9 percent over the year to September 28, 2022, versus 23 percent for the Chinese yuan. This protects us from imported inflation but also harms export competitiveness and uses up foreign exchange reserves to withstand INR selling pressure.
Changes in the Repo Rate target maintain a deft balance between managing the currency, containing inflation, and safeguarding growth. The Repo Rate was at 8 percent in May 2014 when the Modi government came to office. It reduced to 6 percent over the next three years, by August 2017. From April 2019 it gradually reduced to 4 percent in May 2020 where it stayed till April 2022. Between the five-month period, May 2022, and September 2022, it increased by 1.9 percent points to 5.9 percent in response to tightening international benchmark rates and domestic inflation at 7 percent in August 2022 versus the outside norm of 6 percent.
Complementary fiscal policy is better suited to kindle growth and dilute fuel and food price shocks through transfers. The Performance Linked Incentive (PLI) scheme of the Union government stimulates new private investments in an environment of rising interest rates and global uncertainty. Corporate taxes were reduced to competitive levels of 25 percent in 2019.Liquidity constraints were eased by the RBI during the run up to the pandemic and remain easy even today.
Missing growth impetus
Growth has been low from even before the pandemic. The RBI has decreased the forecasted growth rate for the current fiscal from 7.2 percent to 7 percent. More downward revisions could follow. Q1 2022-23 growth data of 14 percent enjoys the optical benefit of a low, pandemic induced GDP base in Q1 2021-22 of Rs 32.5 trillion. Using as an alternative base, GDP of Q1 2019-20 of Rs 35.7 trillion – the last normal quarter before the pandemic- growth rate slips from 14 percent to 3.3 percent.
The growth rate even in the last pre-pandemic quarter (Q1 2019-20) was just 5.4 percent. The economy, whilst recovering from the pandemic slowdown, is reverting to the same low level output equilibrium it had before the pandemic. This is reflected in the RBI assessment of growth rates progressively reducing from 6 to 4 percent for the three remaining quarters of this fiscal. Considering adverse external circumstances and domestic rate increases the projected growth of 7.2 percent for fiscal 2023-24 appears optimistic.
Selectively defanging interest rate hikes
The extent to which increase in the base rate will constrain growth remains unclear. The downstream impact of an increase in the base rate can be minimized for bank lending to productive sectors, by nudging banks to improve their operational efficiency. Over the last three years, banks have improved their asset portfolios and provisioned for losses. Whether prudent lending has been institutionalized is unclear. RBI needs to compress the cushion in the operating margin of banks to contain the impact of rising interest rates on growth.
Suppressed inflation pressures
Inflation pressures are building, contrary to RBI expectations of inflation at 6.7 percent this fiscal and 5 percent in 2023-24. Policy induced inflation pressure emanates from higher import taxes and administered retail pricing regimes which have not passed through imported inflation fully in oil, fertilizer, and food. These pressures reflect in the expanded fiscal deficit of the government, at a combined (Union plus state governments) level of 10 percent plus of GDP, 4 percent points higher than the outer sustainable levels. Some of the buoyancy in the tax revenue from ad valorem indirect taxes (GST) is also due to inflation getting baked into the price of goods and services, thereby conveying an overgenerous impression of macroeconomic stability.
External account stability hinges around export growth
The Governor RBI listed some positives on the external front. Foreign Exchange reserves at US$ 537 billion remain adequate for more than eight months of import. Other positive metrics relate to the low volume of external debt to GDP and the low share of short-term debt. But the trade deficit at 8 percent in Q1 2022-23 and current account deficit of 2.58 percent remain worrisome, especially since export growth is constrained by lower demand overseas. The stock market, albeit volatile, remains resilient, relative to the turmoil overseas, and both FDI and portfolio inflows remain encouraging.
The bottom line is that the India story remains a fair one, both for domestic and overseas investors. Nevertheless, options for additional tax revenues being limited, this is a good time to deleverage and slim public budgetary outlays by enhancing the efficiency of public expenditure and looking closely at the efficacy and fiscal sustainability of hyperactive industrial policy in manufacturing and renewable energy. Rationalizing GST and bringing import taxes in line with international best practice, would impact revenue in the short term. However, this remains the best way to cut back on domestic price pressure, boost retail demand by leaving more surplus with the consumer and provide the competitive pressure to make domestic industry more efficient. The ball now lies squarely with fiscal policy.
This opinion piece first appeared in http://www.orfonline.org on September 3, 2022 https://www.orfonline.org/expert-speak/monetary-policy-must-be-complemented-by-fiscal-policy/