My last column appeared less than a month ago, on the eve of the British referendum. Like most commentators, and many investors, I made the wrong call on the outcome of the referendum. The plunge in the sterling-dollar rate (referred to as 'cable' by traders) immediately following the vote was apparently triggered by over-confident hedge funds who had bet in anticipation of a vote for "Remain". On the whole, the immediate financial market shock has been relatively moderate globally, with the exception perhaps of the sterling, which has plunged to post-crisis lows, and shares of British-based banks. The longer-term impact is another matter, to which I return below.
Locally, the recent period has also been eventful. Among other things it has been marked by the Reserve Bank of India governor announcing his intention to return to teaching. A major Cabinet reshuffle has confirmed the finance minister in his post, while making other important changes in the finance ministry. Official comments also suggest that the announcement of members of the Monetary Policy Committee is imminent. This is an important development in the macroeconomic constitution of the country, one which will free up the incoming governor to spend more time on cleaning up the banks, even if she is an economist, as is being currently indicated.
The Brexit vote reminds us that, eight years after the 2008 collapse of Lehman Brothers, we are in for a period of continued uncertainty (and volatility), where the global economy is concerned. As RBI Governor Raghuram Rajan has forcefully noted (at the cost of some international popularity), while many of these after-shocks originate in the policies and politics of the advanced countries, they carry significant collateral consequences (sometimes negative and sometimes positive) even for well-managed poor countries.
As we have recently seen, even the mighty US Federal Reserve has been deflected from its intended trajectory of interest rate tightening by the turbulence in international markets. India's own relative strength over these last two years derives from the decline in oil prices and its relatively low exposure to the slowdown in the Chinese economy. Neither of these developments was widely foreseen before they happened, and the first at least can easily be reversed.
For the foreseeable future India will need a macroeconomic framework that takes into account global uncertainty, over and above its traditional focus on domestic supply-side shocks. Given India's increasing global importance, (in real terms it is now a far bigger economy than Japan) it is important not only that this framework exists within the bowels of the policy system, but that it is actively communicated to the markets in order to manage and calm expectations.
Owing to its greater flexibility it is usually monetary policy that carries the burden of accommodating such external shocks. But fiscal performance can also be flattered by unusually benign circumstances. This has been well recognised by Latin American economists analysing the effects of commodity booms and capital flow surges. With India having formally committed itself to an inflation-targeting regime, consistent and predictable fiscal outcomes are an integral element of the machinery of expectations management at the root of inflation targeting. The issue is how to interpret "consistent and predictable" in the uncertain global environment likely to prevail over the remainder of the life of this government.
The appointment of the N K Singh committee to review the Fiscal Responsibility and Budget Management Act provides an interesting opportunity to address this issue. As indicated on the Press Information Bureau website, in its terms of reference the committee is explicitly tasked to keep in view changes to the Act in "the context of the uncertainty and volatility in the global economy" as well as to "examine the need and feasibility of having a 'fiscal deficit range' as the target in place of the existing fixed numbers (percentage of gross domestic product) as fiscal deficit target". The committee is to report in time for its recommendations to be available for the 2017-18 Budget.
These rather imaginative terms of reference prompt several reflections. The key word here is "uncertainty", and the challenge is to make this tractable in a decision-making environment. Having just been at Shell, I am of course attracted to the idea of using a scenario approach, though I do not wish to minimise or trivialise the work involved particularly when first getting started.
Scenarios attempt to manage uncertainty by stretching the bounds of plausibility, rather than getting tempted by probability.
In Shell's case its global scenarios ultimately drive alternative views of the future of energy. In India's case the driver might be to retain and protect policy autonomy across a range of global scenarios while maintaining the momentum of India's economic and social transformation.
To be helpful, a scenario approach would need to be medium-term in its horizon (a minimum of five years in my opinion, and perhaps even 10), which is appropriate given the aspirations of successive Finance Commissions, and of the Department of Economic Affairs in the ministry itself, for a medium-term perspective over the cycle.
Embarking on a scenario course requires addressing at least three operational issues: who would generate credible, independent scenarios; would these be confidential or public; and how would the scenarios generate decision parameters for the Budget? All three are matters on which there is no "right" answer and practice would evolve in light of experience. In my view, the scenarios could be the output of a mixed government/academic team (including for these purposes the finance ministry, RBI and NITI Aayog as official members). It would be ideal if the scenarios could be a matter for public debate, but this might be a stretch at the beginning. The hardest part will be to map from the scenarios to actual fiscal guidance, since an intrinsic part of the scenario discipline, at least at Shell, is to avoid assigning probabilities to scenarios. On this there are no recipes to offer, but it seems to me that a range contingent on global and domestic developments would be preferable to a single value target.
The writer is Senior Fellow, Mastercard Center for Inclusive Growth and Non-resident Fellow, Bruegel (Brussels)
These views are his own
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