The recovery risks

Economic management in India will remain tricky

The Joe Biden administration plans to spend $1.9 trillion to stimulate economic activity in the US. Such a large fiscal programme would have perhaps lifted confidence in a pandemic-battered economy even until a few months ago. But things have changed quickly: Economic activity is picking up and the expected return of demand with the ongoing vaccination programme is fuelling inflation fears. The 10-year US government bond yields have increased to about 1.5 per cent, compared to a low of about 0.5 per cent in August 2020. Higher inflation and sustained increase in bond yields will have wider implications, not only for the US but also for emerging market countries like India.

However, both the US Federal Reserve Chairman Jerome Powell and Treasury Secretary Janet Yellen have downplayed inflation concerns. Ms Yellen, for instance, recently noted that such fears were misplaced. It is possible that inflation will not significantly overshoot — it has mostly remained below the 2 per cent target since the global financial crisis of 2008 — but financial markets are pricing in higher inflation. Global commodity prices — including that of crude oil — are increasing. Besides, there is an added policy uncertainty. The US Fed has shifted to average inflation targeting, which means it will allow inflation to move above the 2 per cent mark for at least some time. It is not clear how this will play out in the financial markets.

Uncertainty around the inflation outlook and comparatively higher bond yields in the US will have implications for both financial markets and economic policy management in India. For instance, higher than expected demand in the US and other large markets would open up export opportunities. The Indian policy establishment would do well to take advantage of this prospect. Higher yield in the US market would also result in lower capital inflows. This would reduce pressure on the rupee and help exports. Foreign portfolio investors have sold bonds worth about a billion dollars so far this month. The Reserve Bank of India (RBI) had to make large interventions in 2020 to absorb excess foreign flows to contain the pressure on the currency. But capital outflow would tighten liquidity in the domestic market at a time when the RBI is also expected to reverse some of the emergency measures of 2020. Thus, the central bank will need to make sure that there is sufficient liquidity in the system.

However, more broadly, a significant reduction in the availability of foreign savings would increase the cost of money. The availability of domestic financial savings will also come down as demand revives. As a result, financing the large fiscal deficit along with the needs of the private sector could become more challenging. Also, large open market operations by the RBI to manage yields could create inflationary pressures, particularly at a time of increasing commodity prices. The inevitable increase in the cost of money will not only be a risk for economic recovery but also make debt servicing more difficult. The total public debt is expected to expand to about 90 per cent of gross domestic product in the current year. Slower growth along with higher interest rates would keep the level of debt elevated for an extended period, which can become a big constraint for fiscal policy. Thus, while the worst of the Covid crisis is over, economic management would remain fairly tricky in the foreseeable future.