The rebalancing act

Excess policy accommodation will affect growth

The Reserve Bank of India’s (RBI’s) new Report on Currency and Finance (RCF), released last week, presented a welcome analytical assessment of macroeconomic management with an indicative medium-term road map for policy intervention. Though the report does not represent the official view of the central bank, it deserves a careful reading by policymakers. Economists at the Department of Economic and Policy Research of the RBI have strongly advocated the rebalancing of both monetary and fiscal policy as the economy recovers from the pandemic-induced disruption. A delay could increase macroeconomic challenges. The RBI, for instance, responded aggressively in the initial phase of the pandemic to contain the damage by cutting the policy rate and flooding the system with liquidity. Government spending was also increased to save both lives and livelihoods. However, both the government and the RBI seem reluctant to withdraw policy accommodation as the economy is recovering from the shock.

This reluctance is not very difficult to understand. Both the fiscal and monetary authorities want to support economic recovery. But it is important to recognise that excessive policy accommodation for too long can create macroeconomic imbalances and defeat the original purpose. India delayed policy rebalancing in the aftermath of the global financial crisis and paid the price. It should not repeat the mistake and quickly course correct. The inflation rate, for instance, has been running above the tolerance band. Private sector estimates suggest that the rate will remain above the 6 per cent mark for three consecutive quarters, which, according to the law, will be seen as a failure to attain the inflation target. Consequent legal requirements would put enormous pressure on the central bank to protect its credibility. The RBI has been underestimating inflationary pressures for quite some time, which has delayed the withdrawal of policy accommodation. As the RCF notes, if surplus liquidity persists above 1.5 per cent of net demand and time liabilities, every percentage point increase in liquidity could push up the inflation rate by 60 basis points in a year. The RBI has been maintaining a much higher level of liquidity.

In the context of fiscal policy, the report notes that consolidation is unlikely to hold back growth. The fiscal multiplier changes depending on the state of the economy. While it is greater than one during the crisis, it can be less than one or even negative during expansion. India also now has a problem of excess public debt. The report notes that every percentage point increase in the debt-to-gross domestic product (GDP) ratio beyond 66 per cent negatively affects growth. India’s debt-to-GDP increased to 89.4 per cent in 2020-21, and is unlikely to come below 75 per cent over the next five years. Higher public debt, thus, will be a drag on growth. The empirical assessment suggests that India needs a credible medium-term fiscal consolidation plan to safeguard its growth trajectory.

Therefore, it is vital to readjust both fiscal and monetary policies to protect medium-term potential growth. In terms of economic recovery, a scenario analysis in the report suggests that India’s feasible range for medium-term growth is 8.6-6.5 per cent. Given the global economic uncertainty and domestic debt overhang, maintaining growth even at the lower end of the range would be an achievement. The trend growth rate between 2012-13 and 2019-20 was 6.6 per cent.