Policy challenges with 5 per cent growth

The Indian economy, according to the first advance estimates of gross domestic product (GDP) for the current financial year, is expected to expand by 5 per cent, compared with 6.8 per cent last year. The nominal growth is likely to slip to 7.5 per cent, compared with the assumption of 12 per cent in the July Budget. The decline in growth can lead to a variety of problems, particularly in managing corporate and government finances. While growth estimates did not surprise anyone, the big question is: How fast can India return to a higher growth path? Therefore, in the given backdrop, 2020 will perhaps be the most important year for economic policy in recent times. The first stop will be the Union Budget. 

Government finances are in stress and revenue collection might fall short by at least Rs 2 trillion in the current financial year. Although the government is reportedly compressing expenditure, most analysts expect it to overshoot the fiscal deficit target of 3.3 per cent of GDP. However, it will now be important to see how the government intends to manage its finances in the next financial year, and beyond. Some commentators have argued in favour of running a higher deficit to support demand. It is being suggested that the government should not worry about the fiscal deficit and focus on reviving growth. The government would be well advised to carefully evaluate its options and not fall for what now looks like a popular demand. It is worth highlighting that if the actual public sector deficit of 8-9 per cent of GDP is not able to push demand adequately, it is highly unlikely that further expansion of, say, worth 1-1.5 per cent of GDP will sustainably revive economic activity. Also, the government should not be seen as taking fiscal constraints lightly. Both international and domestic financial markets care deeply about government borrowing and debt sustainability. Loss of confidence, or a possibility of a ratings downgrade, will significantly increase risks to macroeconomic stability and affect growth outlook in the medium term. Besides, additional government borrowings will choke the financial system, crowd out the private sector, and increase challenges for the Reserve Bank of India (RBI) in conducting monetary policy.

The policy path for the RBI will not be easy, anyway. After cutting the policy rate by 135 basis points in the current cycle, it is now trying to influence yields by intervening in the bond market. Since the accommodative stance of large central banks, particularly the US Federal Reserve, would lead to a continued inflow of foreign funds — assuming the situation in West Asia will not result in higher risk aversion — liquidity management will become tricky for the RBI. Necessary intervention in the currency market to avoid rupee appreciation will add to excess domestic liquidity. The monetary policy committee (MPC) did not cut policy rate in its last meeting, largely because of inflation risks, but excess liquidity in the system for too long can complicate policy management. Further, given the uncertainties, it will be difficult for the MPC to cut rates in the near term. However, if it decides to ignore inflation for a while to support growth, it will need to effectively communicate how far it intends to go, as the RBI’s credibility as an inflation-targeting central bank will be at risk.

Since the scope of supporting growth through fiscal and monetary policy is fairly limited, economic revival will ultimately depend on policy reforms. Excessive policy accommodation might lift growth in the short run, but it may not sustain and end up increasing risks to macroeconomic stability. It is important to note that an external risk, like a sustained increase in crude oil prices, can make India vulnerable very quickly.

  

In terms of reforms, the government has been criticised for intervening on the supply side when the problem is seen to be of inadequate demand. India needs large scale supply-side reforms. For instance, it is well accepted that no country can grow at higher rates sustainably without strong exports. One of the biggest reasons why India decided to stay away from the Regional Comprehensive Economic Partnership was the fear of imports. If India is not expected to compete with members of this group for years to come, then the problem is certainly not limited to domestic demand. As economist Amita Batra has shown in these pages, India’s global value chain integration is not only low but has declined over the years (“India’s exports and Factory Asia”, September 3, 2019.) As a result, while India’s exports have been virtually stagnant over the past several years, countries such as Vietnam and Bangladesh are moving ahead  (“Why neglect exports?” by Shankar Acharya, Business Standard, December 12, 2019). This indicates India needs wider structural reforms to improve efficiency and compete in the global market.

Another round of fiscal and monetary push may not take India too far and increase risks to financial stability. Thus, policy decisions in the coming months, to a large extent, will decide the trajectory of the Indian economy in the medium term.