Monetary policy that hunts with the advanced economy “hounds”—via symmetric upward adjustments in policy interest rates over the last year—and simultaneously runs with developing country “hares”—by desperately trying to revive stalling growth—has contradictions just waiting to come home to roost.
That growth in India is stalling is clear from the RBI Monetary statement on 6 April 2023. The First Advance Estimate of the government in January 2023 estimated growth in 2022-23 at 7 percent. The RBI forecast for 2023-24 is 6.5 percent with a declining trend ending at 5.8 percent in Q4 of that fiscal. IMF and Independent Observers peg it even lower.
Growth and trade pangs
To be sure, India does relatively better than most economies. The International Monetary Fund (IMF) estimates “…global growth to remain around 3% over the next five years…our lowest medium-term growth forecast since 1990, and well below the average of 3.8% from the past two decades.” Lower global growth translates into lower global demand for imports, which constrains the opportunities for export-led growth. India aspires to be a US$ 2-trillion export economy (US$ 1 trillion in merchandise and another US$ 1trillion in services) in seven years by 2030 from a likely base (subject to confirmation once final data becomes available) of US $447 billion in 2022-23. It seems to be a stretch target of an average 24 percent per year growth over the next seven years with the first few years promising unsure rewards. Large current account deficits should continue to be factored in for stability, backstopped by sufficient foreign exchange reserves, which were US $578 billion on 31 March 2023.
Mind the interest gap
The problem is, if India delinks from symmetric upward interest rate adjustments with the Federal Reserve and allows the interest differential—presently 1.6 percent (down from a differential of 3.5 percent in April 2022)—to reduce further to 1 percentage point or less, the impact on investor sentiment is unknown. Prior to the cheap money stance adopted by the Federal Reserve from August 2019 to February 2022, the interest rate differential between the Fed Rate and the Repo rate ranged between a low of 3 to a high of 5 percent. Investor sentiment might baulk at insufficient risk-weighted returns from investment in India at wafer-thin interest differentials.
Poor fiscal metrics require higher risk premiums embedded in policy interest rates.
A low interest differential would matter less if growth was robust or with better fiscal metrics . A combined fiscal deficit (FD of states and Union) of 6 percent, logging a sustained revenue surplus and inflation between 2 to 4 percent would help. But the plan for FD reductions targets below 4.5 percent levels only by 2025-26. Poor fiscal metrics, high inflation – RBI projects inflation levels for 2023-24 at 5.2 percent, which is cold comfort – and uncertain growth prospects, all present an unresolved dilemma of growth versus stability.
We lack the structural advantages of the United States
The United States (US) continues to enjoy economic growth and more than full employment. India, like many developing economies, faces an uncertain growth outlook. Keeping step with the US in trying to squeeze out inflation by increasing the policy rate was always going to become impossible, once the Federal Reserve rate hikes started appearing interminable—possibly continuing through 2023-24. To his credit Jerome Powell, the Federal Reserve Chair, has maintained consistently that they are not soothsayers and cannot predict when the rate increases will end. They have a job to do and that is to use monetary policy till inflation is crushed to the 2-percent level. Of course, it is easy to take a tough stance whilst growth remains benign and employment full, despite a rate increase of 4.65 percent over one year between April 2022 to 2023. Nevertheless, pushback is growing within the US about the feasibility of a “win-win” “soft landing” post-inflation taming. The belief is growing that significant economic harm is the natural consequence of an extended period of high-interest rates.
Sadly, India does not have the economic cushion to apply monetary policy steadfastly till inflation is down to below 4 percent. Core inflation—a better indicator of the underlying consumer prices baked into the system after seasonal variations due to good or bad harvests are stripped away—is running above 6 percent.
Banking on the RBI
The failure of medium-sized banks in the US because of poor treasury operations and the mercy merger of Credit Suisse—a storied Swiss bank—with UBS is an unsettling signal that only deep, professional oversight across the banking system can uncover the chinks through which risk infiltrates the banking system. The Indian banking system is over-regulated on paper but whether the oversight is deep and nimble enough to detect red flags before crises snowball can only be hoped for. In the run-up to elections, “quick wins” that get money out of the door and into the hands of voters or into projects which signal new jobs, are favored.
Switch from a focus on revenue to inflation busting by reducing indirect tax
All through the pandemic, the Finance Ministry focused on not letting tax revenues dwindle. This was essential to enhance outlays on social protection and ensure that incremental debt did not become unsustainable. This tightrope walk was performed very well by the Ministry of Finance. Now, with the economy normalizing, suitable reductions in the indirect tax regime (import duty, excise tax on petroleum products and GST on manufactured goods) should be considered to deflate consumer prices permanently.
Use tax revenues better
The Union government earned around INR 4.3 trillion (2021-22) or 1.8 percent of GDP by taxing petroleum products. But the energy-based ministries (petroleum, power, and renewable energy) were allocated just INR 0.35 trillion or just 8 percent of the revenue receipts they generated. Coal India, the primary producer of coal in India, provided INR 0.58 trillion to the Union and state governments in excise tax and other levies in 2021-22. Yet the allocation to the ministry was a mere INR 0.5 billion, even though the bulk of the trauma of energy transition—just a decade away—will be borne by coal unless detailed plans for a “just” transition are developed.
Taxes and levies on fossil fuels are considered to be a proxy carbon tax. But unlike a carbon tax, which is sequestered for specified uses only, petroleum taxes are not used for decarbonizing energy systems or making renewable energy affordable despite its variable supply pattern. Similarly, grid enhancement with better management of reactive power (to control frequency) and research on “grid forming” as opposed to “grid following” balancing equipment, which automatically compensates for gaps in supply and demand, need much more research and investment via compensating subsidies for investors undertaking such front-line ventures. It is these grounded investments which can ensure a smooth energy transition till hydrogen-based energy becomes commercially available around 2035 and beyond.
Two is better than one
In recent times, the RBI and the Ministry of Finance have worked well as a team. Teamwork is essential because financial stability and fiscal stability are joined at the hip. Now the RBI has transitioned its inflation management stance from one of actively staunching inflation via higher interest rates, to a watch-and-wait “machan oriented” one wherein it expects the inflation tiger to show up in its gunsights on its own. RBI needs drum beaters to nudge the inflation tiger into a tight corner from which there is no escape.
Cutting back on high rates of tax on intermediate goods and services and on consumer goods is a good option for deflating embedded high prices. The ensuing resource constraint for public capital expenditure might also be a blessing. Public investment is an expensive growth option with long-term consequences via the draft that debt repayments and interest payments impose on future revenues.
Presently, interest payments already crowd out other priorities, being a high 31 percent of revenue expenditure. Productivity enhancement—a medium-term initiative which needs to be implemented consistently and scaled up to cover all sectors and enterprises—is the other missing link. The effective revenue deficit (revenue deficit less grants-in-aid to state governments which are for capital expenditure) for 2023-24 is at 1.7 percent down from 3.3 percent in 2021-22. Squeezing the effective revenue deficit to zero in the near term can eliminate much fat which creeps into large, pancaked budget outlays without affecting vital flagship social spending.
Wrestling inflation below 4 percent is a fit metric for both responsive monetary policy and responsible fiscal policy. Placing reliance on just monetary policy can cost valuable votes in the 2024 elections in the unlikely event that the RBI mimics the Federal Reserve by using the blunt lever of higher policy interest rates. The win-win solution is for fiscal policy to sacrifice some tax revenue, focus on generating compensating non-tax revenue and cut back on indirect tax, giving customers and businesses, particularly those in the small, medium, and micro sectors, a break from the punitive taxation of recent years.
This opinion piece first appeared in orfonline.org https://www.orfonline.org/expert-speak/sans-a-supportive-fiscal-policy-monetary-policy/