Macro stability at risk

Govt should let the rupee depreciate, speed up GST refunds, maintain fiscal prudence, persevere with IBC and avoid policy mistakes

A few months ago, at the start of calendar 2018, India’s macroeconomy seemed in reasonable shape. The world economy was growing at its fastest in a decade, India’s economic growth was recovering quite well from the twin shocks of demonetisation and the transition to the Goods and Services Tax (GST), inflation was well below 5 per cent, fiscal trends were reasonable, and the balance of payments looked quite manageable with capital inflows well in excess of the current account deficit (CAD).

All that has changed in the last six months. Inexorably rising oil prices and an escalating threat of a serious trade war between the Donald Trump-led United States on the one side and her major trading partners of the European Union (EU) and China, on the other, have darkened the prospects for the growth of world output and trade, and damped capital flows to emerging countries (including India) as edgy investors seek safe haven in America. The rupee has depreciated significantly as $9 billion of portfolio capital (about two-thirds in debt and the rest in equity) has flown out in the first quarter of financial year 2018-19 (FY19), inflation is creeping up, the fiscal situation looks stressed and interest rates have risen. The balance of payments has clearly come under pressure.

What’s happening? Most commentaries have focused on the adverse external factors noted above. In my view, major medium-term weaknesses in India’s macroeconomy are playing at least as important a role. The two biggest such weaknesses in recent years have been the deep and long-drawn crisis in India’s public sector banks (PSBs) and the big deficit in foreign trade, caused, in large part, by the unfortunate stagnation in India’s merchandise exports, the largest single foreign exchange earning item in the balance of payments. While the roots of both problems go back to the time of the previous government, it must be said that the present government (and the Reserve Bank of India) has allowed them to drag on.

On the massive bad loan problems of commercial banks, especially of PSBs, the government and RBI have acted (since early 2015) to speed up recognition of non-performing assets (NPAs), provide capital to PSBs and enact the Insolvency and Bankruptcy Code (IBC) to facilitate resolution and recovery. Last week, the Sunil Mehta panel recommended (and the government accepted) a five-pronged approach to accelerate resolution in PSBs, though its effectiveness is yet to be tested and there are concerns that it might weaken the extant IBC approach. Despite these initiatives, the RBI’s June 2018 Financial Stability Report foresees a further increase in the banks’ gross NPA ratio from 11.6 per cent in March 2018 to 12.2 per cent in March 2019.  For 11 PSBs under “prompt corrective action”, the ratio is expected to climb from a very high 21.0 per cent to 22.3 per cent. All this is in the RBI’s base case scenario, which has generally proven to be optimistic in the past.

The bottom line is that the banking system (especially the PSBs, which account for about 70 per cent of all bank loans) will continue to be seriously stressed in the next 2-3 years. Loan growth will be constrained, the fiscal burden of support and recapitalisation will continue to be heavy and the bank appetite for government bonds will remain subdued, thus putting upward pressure on interest rates.

India’s external payments situation has also been deteriorating over the past few years, as the table shows. As ratios to GDP, the goods trade deficit increased to 6.2 per cent in 2017-18, as imports rose and the export ratio dropped below 12 per cent for the first time in 14 years. Astonishingly, the dollar value of India’s exports was marginally lower in 2017-18 than in 2011-12!  Nor is oil the sole culprit of recent trends: At 3.4 per cent of GDP the non-oil trade deficit in 2017-18 was at its highest level since 2012-13 and the non-oil export ratio of 10.2 per cent in 2017-18 was at its lowest level in 15 years. Most likely, the authorities (Government of India and RBI)  allowing appreciation in the real effective exchange rate of the rupee by about 20 per cent (according to the RBI’s 36-country index) between January 2014 and January 2018 played a significant role in this worsening of India’s trade performance.

Furthermore, there has been a steady decline in the net “invisibles” ratio from 6.2 per cent in 2013-14 to 4.3 per cent in 2017-18, exactly mirroring the fall in the combined ratio of the two big earners, software exports and private transfers (remittances from abroad) from 7.1 per cent to 5.2 per cent. With these trends in trade and invisibles ratios, it is no surprise that the CAD rose sharply to 1.9 per cent in 2017-18 and is projected to widen further to 2.5-3.0 per cent in 2018-19.

It is the combination of these unresolved medium-term macro weaknesses with the more recent, adverse, external developments of rising oil prices, the unfolding of a possibly major international trade war and tightening international liquidity that are threatening India’s macroeconomic stability. Predictably, the pressure points are the rupee’s exchange rate, inflation and interest rates. All three are signalling difficult times, now and ahead.

So, what’s to be done? Ideally, we shouldn’t have let the real exchange rate of the rupee appreciate so much in the last four years. And we should have acted much sooner and more effectively to recognise and resolve the banking system stresses. But we didn’t; so we are in a tougher spot today. What should we do now? Here is my preferred package, though some of it will be challenging in a pre-election year:

• Let the rupee depreciate in response to market pressures, with some moderation of volatility through RBI interventions;
• Speed up GST refunds to exporters on a war footing; 
• Try very hard to maintain fiscal prudence at both central and state government levels. Recent actions, such as the large minimum support price increases for crops and the proliferation of state-level loan waivers, suggest that fiscal deficits will be higher than targeted, requiring higher government borrowing and, therefore, higher interest rates. Stability will be stressed;
• Persevere strongly with the IBC approach to resolve the “twin balance sheet” problems of banks and borrower companies;
• Avoid hard-to-defend policy actions, such as the majority acquisition of IDBI Bank shares by the Life Insurance Corporation of India, since government’s policy credibility is at a premium when macro stability is under pressure.

The writer is honorary professor at ICRIER and former Chief Economic Advisor to the Government of India. Views are personal