Ideas for India: A lot on the plate for NDA government

Above everything else, we must understand that over the last few years we have been held hostage to economic ideas that were governed more by rhetoric than by data-based evidence

With the NDA government set to assume office, there is a lot of chatter about the reform agenda. While some of that is purely repetitive, we first need to understand that in last few years we have been held hostage to economic ideas that are governed purely by rhetoric and less by data based evidence. This will also help us identify the immediate priorities of the government. 

First, the idea that high real rate of interest is a strong enabling factor for savings is a misconstrued fallacy in the Indian context and it has done enough harm. It may be note that such a debate was first initiated by former Reserve Bank of India governor Raghuram Rajan and has been emphasised repeatedly. Interestingly, in a recent RBI paper it has been conclusively argued that income is the primary determinant of savings in India. Even the empirical evidence in Indian context strongly supports the contention that savings is insignificantly small related to real interest. In fact, the actual coefficients are significantly small and insignificant in most of the cases, suggesting a large change of as much as 3 per cent to 10 per cent in real deposit rates will be needed to change savings rate by 1 per cent and small changes will hardly make any difference, if any. This is perhaps the primary reason why real interest rates in India are so high for the wrong reasons thus hurting investments even as inflation has been materially overshooting. A singleminded focus on moving towards a 4 per cent inflation may have also resulted in keeping real interest rates at a high level. 

So, the first thing, the government and the RBI needs to do is to have an honest debate about the sanctity of the 4 per cent inflation target. In 1980s and 1990s, monetary policy in India was subordinated to fiscal policy, but now monetary policy clearly dominates fiscal policy, instead of complementing it. We need to have lower rates, coupled with adequate liquidity and an instruction from RBI to banks for transmission by linking repo rates to an external benchmark like CASA. 

Second, the clamour for a faster fiscal consolidation. While the idea for fiscal consolidation in the Indian context is always welcome, the problem is that such consolidation often becomes a constraint (as is currently in the quest for government to push growth). 

With global debt, currently at close to $250 trillion, there have been a couple of insightful commentaries on the role of debt and fiscal policy recently. Most recently, noted economist Olivier Blanchard in his presidential address to AEA reemphasised that high public debt is not catastrophic, if it justified by clear tangible benefits in the form of public investment. Blanchard also added that aggressive contingent fiscal rules are more important than the level of debt as a percentage of GDP itself and even steady fiscal austerity.  

Even Paul Krugman has repeatedly emphasised that governments should be spending money on infrastructure and on health care and education that have huge long-run payoffs. 

Back home, a recent RBI paper on emerging market economies using the structural balance approach to fiscal deficit found that in the post-Lehman years (2008-10), the impact of fiscal stimulus turned out to be positive and statistically significant. The study concludes that the observed slump in growth in the post-crisis period would have been much sharper in the absence of stimulus, implying that fiscal activism pursued by these emerging market economies, including India, was largely successful in arresting the growth downslide. 

Here is our contention: How far and how fast we can go below current 3.4 per cent as far as the centre’s fiscal deficit is concerned against the current demand slowdown? Do we stay put at 3.4 per cent (assuming it is met) for the first two years of the current government and then move down aggressively, as growth comes back to the system? We propose a radical shift in thinking as far as fiscal is concerned. The alternative to targeting fiscal deficit is that like most advanced economies and several emerging market economies India should target a structural deficit, which serves as an automatic counter-cyclical stabiliser. 

The FRBM targets that have been set from the outset as a fixed percentage of GDP do just the opposite. The deficit shrinks when growth dips and balloons when growth rises. This pro-cyclical target setting has forced successive finance ministers to look for creative ways of getting around such FRBM straitjacket (off balance sheet financing for example). 

Even IMF comes up with the structural fiscal balance for every country. Based on such, projected balance for India as per IMF comes to an average of – 6.3 per cent for the 2018-23 period. Clearly, it looks even the IMF finds it difficult for consolidated deficit to decline meaningfully below 6 per cent in the next couple of years. The question is therefore, do we keep it at current level of 6-6.5 per cent, or go down the FRBM glide path to 5 per cent? 

The ideal fiscal rule we must debate is that India sets its own fiscal benchmarks (and not as defined by Maastricht treaty at 3 per cent) but then enact fiscal rules to ensure strict compliance. The policy makers in India thus have two options — to continue to deviate from FRBM-mandated targets or enact country-mandated credible, transparent and achievable fiscal rules. 

Apart from these basic initiatives, the government should now find a way to address the issues in the NBFC sector. Does the government issue long tenure bonds to infuse liquidity to take advantage of the current low spreads at long end? These are some of the issues that can be debated. 

The other reforms that the government could do is related to the rural sector, banking sector and a comprehensive set of legal, administrative, judicial and police reforms. The government must create a repository of all existing central and state laws, rules and regulations and address the backlog of pending cases. 

Clearly, a lot on the plate for the second term of the NDA government. 

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Soumya Kanti Ghosh is group chief economic advisor, State Bank of India; Pulak Ghosh is professor, IIM Bangalore. Views are personal