Departing from the strict interpretations of fiscal responsibility and inflation targeting, respectively, has subjected fiscal and monetary policy to two kinds of criticisms. Conservatives are horrified at deviations from the straight and narrow paths. That those paths contributed to the growth tanking below 5 per cent while supply-shocks raised inflation anyway, and that no country in the world follows such strict rules that prevent a counter-cyclical stimulus, does not concern them. They foresee a rapid descent to the bad old days of macro-economic instability as policy discretion succumbs to political pressure. In their view, macroeconomic policy can never substitute for, or even facilitate the hard structural reforms that India needs.
The second criticism comes from those who see continued policy tightness as totally inappropriate when growth is low. In this view, policy is not providing the counter to the cycle required to create wealth from underutilised resources and to raise growth. That the Central plus State deficit is already about 8 per cent and the cost of government borrowing is high, does not concern them.
The first view would point to large deficits and say that if even these do not raise growth, then it cannot rise without further structural reforms. But it is not a coincidence that the 2010s, when the ‘reform’ view came to dominate, was a lost decade for Indian growth. In an overreaction to excessive post-global financial crisis stimulus, the decade had only reform and tight macroeconomic policy — and therefore low growth. The first view is asking for more of the same. Moreover, even sincere attempts at fiscal consolidation are bound to fail in a slowdown.
Ideological extremes neglect and do not respond to facts on the ground. This cannot work in a complex country like India. Softening of macroeconomic policy is not a deviation but a necessary course correction. Too strict rules are unsustainable and tweaking them becomes necessary for sustainability. But that they have not been abandoned indicates overreaction has been avoided this time. Policy is moving towards the required better balance. Some examples from monetary and fiscal policy illustrate this argument.
Liquidity management
The Monetary Policy Committee in February did not lower the repo rate, but the RBI announced innovative measures to improve transmission that were widely welcomed but market purists disliked as an alarming display of discretion. An internal working group to review the liquidity management framework had taken its only objective as aligning liquidity management with the repo rate set by the MPC. This was in line with the thinking in the 2010s, which kept durable liquidity in deficit to validate the repo as the binding policy rate. Its recommendations were diluted after taking the feedback into account.
There are structural reasons why durable liquidity needs to be in surplus in India, especially in periods of loosening. Only banks have access to RBI liquidity. The market for bank reserves is narrow, covering only banks while many formal and informal institutions are out of it. Liquidity provision through banks often does not meet the needs of the broader economy. Banks themselves do not pursue lending aggressively when they have to borrow short-term to meet their daily reserve requirements.
Another structural reason is the sharper and less-predictable autonomous shocks to durable liquidity in India due to volatile cross-border flows, cash balances and currency demand. Shortfalls in durable liquidity in 2018 as foreign capital flowed out with rising oil prices aggravated sectoral shortages following problems in IL&FS, leading to a sharp slowdown in credit growth. Complaints of no cash or credit continue in rural areas.
In the report’s view, assured short-term liquidity provision led to holding of excess reserves — banks borrow as well as lend to the RBI. But research shows that maintaining the call money rate in the middle of the liquidity adjustment facility (LAF) band with market borrowing requires good forecasting of and adjustment of durable liquidity to autonomous liquidity shocks. This creates a norm for banks to borrow from each other, and anchors market rates in the middle of the band. If the change in demand for durable liquidity is not accommodated, a system in overall deficit with high uncertainty would lead to excess borrowing from the RBI LAF. That most borrowing was from the LAF and the call money market remained thin with falling turnover supports the above analysis.
The changes to the liquidity framework announced now promise adequate durable liquidity, communication and interaction with markets, and do away with keeping the LAF in deficit. Tighter liquidity management may, over time, reduce the tendency to both borrow from and lend to the RBI. The liquidity surplus can also then fall. Excessive liquidity creates its own risk, but at present is required to nudge banks towards more lending. Other schemes have also been announced with this purpose.
Advanced economies acted on liquidity when they hit the zero bound. In India, our effective lower bound may kick in at positive nominal interest rates since there is resistance to lower deposit rates in the absence of social security. There is also competition for household savings. Moreover, interest rate spreads tend to be large in thin markets, especially as risk aversion is high. Policy efforts to reduce them using liquidity are valid.
Budget stimulus
There is a debate on whether the Budget provides sufficient stimulus to revive growth. Although the fiscal deficit proper rose by only the 0.5 per cent allowed by the fiscal responsibility law, including off-budget sheet items communicated clearly this time, it comes to 4.6 per cent of the GDP. Assuming a conservative multiplier of 1.3, this gives a rate of growth of 6 per cent. With the wider public sector and States’ borrowing and possible revenue shortfalls, the figure was even higher. Why then is growth only at 4.5 per cent?
Subsidy payments to finance, excess stocks of foodgrains or large interest payments on G-Secs to banks who are not lending do not stimulate demand. Reducing these major components of revenue deficits requires subsidy rationalisation, RBI support to the G-Secs market through open market operations (OMOs) as well as restraining of government borrowing. The direct benefit transfer, which has reduced the leakages that used to fertilise the economy, needs to be increased. Governments have many types of unspent cash balances. Multipliers are much higher on basic infrastructure and transfers to the poor. Under extreme risk aversion, there is hardly any lending to private industry.
This restructuring of government expenditure and prompt payments and transfers are the key to generating stimulus from the Budget. And it does make efforts in these directions. Borrowing from the market has not increased.
However, because of frontloading, expenditure may slow in Q4. It is all the more urgent to — consistent with longer-term reform — keep the liquidity in surplus, conduct OMOs, push banks, and revive non-bank channels that can reach money to where it will be spent. Monetary measures can act fast while fiscal changes take longer. Continuing reform to reduce the cost of doing business, while avoiding controversies, takes even longer.
The writer is Professor, IGIDR, and Member, EAC-PM. Views are personal