Macro balancing act in 2024

The combined role of fiscal and monetary policy has been crucial in shepherding India’s economy out of the pandemic. The capex push by the central government over the last four years has been relentless and a key driver of the recovery. Equally, the rapid normalisation of monetary policy in 2022 was crucial to preventing inflation pressures from getting entrenched. Both have contributed to the current outcomes.

With gross domestic product (GDP) growth estimated close to 7 per cent in 2023-24, core inflation below 4 per cent, and headline consumer price inflation (CPI) expected to soften to a 4-5 per cent range this year, it would seem that fiscal and monetary settings have been calibrated to a nicety. But beneath the surface, both fiscal and monetary policy will face new trade-offs in 2024, and will need to be navigated carefully.

Policy imperatives of the last two years were unambiguous: Boosting growth and containing inflation. The imperatives for 2024 are more nuanced: Nurturing recovery while ensuring public debt is stabilised and financial exuberance contained

Fiscal: Symmetrical counter cyclicality
 

On its part, fiscal policy will have to achieve a careful balance between continuing to nurture the recovery but while ensuring that deficits and debt are on a sustainable path. India’s upside growth surprise in 2024 has been very encouraging. Despite that, output still remains below the pre-pandemic path, private investment needs to get stronger and more broad-based, and blue-collar job creation needs to be a constant focus area. It is therefore crucial to keep the government’s impressive capex push going to eventually crowd in private investment. Equally, investments in health and education are crucial to boosting medium-term growth. So the fiscal’s work is by no means done and policy support cannot be withdrawn too abruptly.
 

But four years after the pandemic, other considerations will now need to gain importance in the policy calculus. Recall, 

India’s public debt — underpinned by the pre-pandemic slowdown and then the pandemic — surged from 70 per cent of GDP in 2018-19 to almost 90 per cent in 2020-21. Since then, however, the growth rebound from the pandemic and high inflation meant nominal GDP growth averaged 17 per cent for two years and pulled down public debt/GDP back towards 81 per cent (approx). This year, however, public debt is expected to tick up to 83 per cent (approx) of GDP from 81 per cent (approx) of GDP last year, as nominal GDP growth has mean-reverted to more normal levels of 9 per cent.
 

A small increase in debt ratios is, by itself, not worrying in a world where public debt/GDP has gone up across the board. But the important learning from this development is that India’s consolidated fiscal deficit (Centre and state) may be too large for peace time (that is, when nominal GDP growth is more normal) — from a debt sustainability perspective.
 

To be sure, the Centre’s fiscal deficit is expected to narrow in line with budgeted estimates from 6.4 per cent of GDP last year to 5.9 per cent in 2023-24. Simultaneously, however, state deficits are poised to rise this fiscal to 3.1 per cent of GDP — and possibly higher — from 2.8 per cent last year, as states press on the capex pedal but also grapple with lower revenues. As such, the consolidated central and state deficit is expected to remain around 9 per cent of GDP this year. The broader public sector borrowing requirements (which includes public sector enterprise borrowing) is therefore expected to remain sticky around 10 per cent of GDP this year, bucking expectations of some narrowing this year.

How much consolidation?
 

As we approach this week’s Budget, therefore, the policy question that emerges is what fiscal path in the coming years will stabilise public debt, and then bring it down to create fiscal space for the next shock, under reasonable growth assumptions. Recall, public debt evolves on the interplay of three variables: The consolidated primary deficit (fiscal deficit net of interest), nominal GDP growth, and the average cost of debt. Though interest rate changes also have a bearing, their role is often overstated, given that the average maturity of India’s central debt has been increased to 12 years — which, by itself, is a very healthy development. The implication is that potential interest rate changes will take a long time to permeate the entire debt stock. Instead, the real question is what combination of future deficits and growth is required to stabilise public debt in the medium term.
 

So what do we find?
 

>> Under the government’s current fiscal road map, the central fiscal deficit will be brought down to at least 4.5 per cent of GDP by financial year 2025-26. If state deficits also go back to their pre-pandemic average of 2.5 per cent (approx) of GDP, the consolidated fiscal deficit would reduce to 7 per cent of GDP over the next two years, from 9 per cent this year. In this scenario, public/debt would stabilise at the current levels of about 83 per cent (approx) over the medium term, if nominal GDP growth averages 9.5 per cent.
 

>> With India’s GDP deflator averaging about 3.3 per cent in the five years before the pandemic, and assuming inflation asymptotes back to those rates, this would imply real GDP growth needing to average 6-6.5 per cent in the medium term to stabilise public debt/GDP.
 

>> Ideally, however, the policy would want to go beyond just stabilising debt, and to progressively pare it down to create fiscal 

space for future shocks.
 

>> For this to happen, one of two things would need to happen. If real GDP growth averages 7-7.5 per cent on a sustained basis, then debt/GDP would reduce to 75 per cent of GDP over the next decade even if the consolidated deficit was at 7 per cent of GDP.
 

>> Alternatively, if growth averages 6-6.5 per cent in real terms, an extra percentage point of fiscal consolidation will be needed, such that the consolidated fiscal deficit is brought down to 6 per cent of GDP, about three percentage points below current levels.
 

Policy Implications
 

Against this backdrop, the immediate imperative would be to prioritise central fiscal consolidation over the next two years and achieve the 2025-26 target of 4.5 per cent of GDP. This would entail reducing the deficit by a non-trivial 1.4 per cent of GDP over the next two years.
 

Second, while the cap on state deficits is 3 per cent of GDP, the effective cap has risen to 3.75 per cent of GDP in recent years, contingent on certain state reforms. Incentivising state reforms is important and desirable. But from a debt sustainability perspective, the consolidated deficit will need to be reduced to 7 per cent of GDP, at a minimum. So if states are given more leeway, the Centre will need to adjust commensurately, and vice-versa. This will need to be a holistic, collaborative effort to generate equitable burden sharing.
 

Third, once the Centre achieves its 4.5 per cent of GDP fiscal deficit target in two years, it should take stock and re-assess whether another percentage point of fiscal consolidation is needed to ensure debt/GDP decisively declines in the coming years under realistic growth assumption.
 

Details apart, the larger principle of “symmetrical counter-cyclicality” is important. The need to use firepower during slowdowns and crisis is well understood. But the act of amassing gunpowder during peace time — creating fiscal space when growth recovers — is often underappreciated. 

Consolidation without compression
 

It is one thing to identify the level to which deficits need to be reduced, and another to find ways to get there by minimising the contractionary impact on growth. In India’s case, there should be no let-up on the capex push for now, given its large multipliers on economic activity. Additionally, targeted fiscal support for the bottom of the pyramid will need to continue in a post-pandemic world. Finally, much-needed investments in health and education will need to continue being a priority in the coming years. So the expenditure side has its work cut out. To be sure, central government expenditure is about 2.5 per cent of GDP above pre-pandemic levels. But about 1.7 per cent of that is higher capex — which should be persevered with. And 0.5 per cent of GDP is on account of higher interest payments. In the case of states, capex — despite this year’s push — will be modestly above pre-pandemic levels, while revenue expenditures are already lower than pre-pandemic levels.
 

The larger point, therefore, is that there is limited space on the expenditure side to achieve fiscal consolidation in the coming years. Instead, the bulk of the consolidation will need to be done on the revenue side. This is also desirable from a growth perspective, because expenditure multipliers tend to be higher than revenue multipliers.
 

To be sure, combined tax/GDP has shown an encouraging increase in recent years. Combined central and state taxes rose from 17.3 per cent of GDP pre-pandemic to 17.8 per cent in 2021-22 — a ratio last seen in 2007-08. Furthermore, this year, a surge in personal income taxes has meant that central gross taxes could rise to 11.6 per cent of GDP, potentially taking combined gross taxes above 18 per cent of GDP for the first time.
 

But gross tax/GDP will need to be increased further in the coming years to enable the necessary fiscal consolidation. While broadening and simplifying the GST to achieve full efficiencies and improving compliance is crucial, the temptation to grow tax/GDP through indirect taxes should be avoided given the regressivity of indirect taxes and their still-high ratio of total taxes in the Indian context.
 

Finally, boosting asset sales in 2024-25 should be an integral part of raising revenues, given the buoyancy of markets and the attractiveness of valuations. It is important to underscore that using asset sales is the least growth-impinging way of reducing the deficit.

Monetary: Of instruments and objectives
 

Prima facie, the Reserve Bank of India finds itself in a sweet spot. It now expects 2023-24 growth to be close to 7 per cent, even as core inflation has dipped below 4 per cent for the first time in four years. This vindicates the RBI’s rapid normali­sation in 2022 and its holding tough on real rates in 2023. Meanwhile, pre-emptive government actions on food prices have meant that food inflation has begun to soften, despite the impact of El Niño. Consequently, headline inflation is expected to be in the 4-5 per cent range through most of 2024, barring fresh shocks.
 

But success creates its own pressures. With headline CPI expected to finally be back in the 4 per cent handle, an inevitable market chorus is building for the RBI to ease monetary policy. But the central bank will be well justified in hanging tough and not easing pre-emptively. Inflation has averaged 5-6 per cent over the last four years. It will therefore be important to let inflation get more entrenched towards the 4 per cent target before any easing is contemplated.
 

A second consideration the RBI will have to be mindful of is financial stability. There are potential risks of excessive financial sector exuberance as banks and NBFCs — whose balance sheets are the healthiest in years — seek to aggressively pursue growth. Consequently, bank credit growth (15-16 per cent) is running much above nominal GDP growth (9 per cent) this fiscal — a multiple last seen in 2007. NBFC credit offtake is even stronger. Furthermore, much of the credit offtake is in the form 

of unsecured lending to households, where growth rates are at 25 per cent. To be sure, some of the credit deepening 

is because banks potentially have access to better credit infrastructure and information on borrowers. But such a rapid acceleration of credit also creates the risk of excessively-easy lending standards.
 

The RBI will therefore need to keep a close eye on financial exuberance to prevent excessive risk-taking. To be sure, consistent with the Tinbergen Principle, multiple objectives should be address­ed through multiple instruments. 
 

A puritanical approach would suggest “separability” between monetary policy and financial stability — with monetary policy tools (rates and liquidity) deployed towards the inflation targeting framework and macro-prudential tools deployed to contain excessive risk-taking in sectors. Thus far, the RBI has pursued that approach with risk-weights being increased for unsecured lending and bank lending to NBFCs and restrictions being imposed on bank/NBFC investments in alternative investment funds (AIF) to prevent evergreening of loans.
 

But “separability” — while clean in theory — is messier in practice. As former Fed Chairman Ben Bernanke acknowledges, there is growing evidence that monetary easing promotes increased private-sector risk taking, dubbed the “risk-taking channel of monetary policy”. The implication is, even if macro prudential measures are deployed for financial stability, they risk being undermined if monetary policy is simultaneously being eased. In theory, any easing would need to be accompanied by a further tightening of macro prudential measures.
 

There are also other dimensions to consider. Macro prudential measures may not be able to reach or be efficacious across all parts of the financial system. In contrast, as former Fed Chair Jeremy Stein notes, monetary policy “gets into all the cracks”. So monetary policy and financial stability can never be fully mutually exclusive, in practice.
 

This is not to suggest India’s inflation targeting framework should be burdened by “financial dominance”. The framework has worked well and should focus primarily on its inflation targeting mandate, with macro prudential measures used as the first line of defence for financial stability. But there may be occasions when monetary policy will need to internalise the implications of its actions on financial stability and lean against the wind (what Ben Bernanke terms “Situational Leaning Against the Wind”), and 2024 may be one such occasion in India.
 

More generally, the challenge for the RBI in 2024 is likely to be less about containing elevated inflation and more about curbing excessive financial market exuberance and a “problem of plenty”.
 

Take the external sector. Like this year, the current account deficit (CAD) in 2024-25 is likely to print much below 1.5 per cent of GDP, barring a surge in crude prices. In contrast, the capital account — notwithstanding the FDI slowdown — will be a beneficiary of bond index inclusion and associated catalytic flows in 2024 and is likely to be further buoyed by “risk-on” flows if the Fed is easing and prospects of a global soft landing take hold. One can therefore easily envisage a large BoP surplus in this environment, with the RBI intervening aggressively in the foreign exchange market to prevent rupee appreciation. That, however, would have implications for forward premia and rupee liquidity that could complicate monetary management.

All stated, the policy imperatives of the last two years were unambiguous: Boosting growth and containing inflation. The imperatives for 2024 are more nuanced: Nurturing the recovery but while ensuring public debt is stabilised, any excessive financial exuberance is contained, and asset prices do not run too far ahead of the underlying fundamentals.

The writer is chief India economist for JP Morgan. 

The views are personal