Policy and growth dynamics

By M H Ahssan

In the domain of policy making and governmental initiative, the right way ahead to predict the future is to essay shaping it. Already, it’s back to the future in North Block with the new finance minister once again in charge, after two whole decades and more. Since then, much water has flowed in the Yamuna in terms of policy change. What’s required for the FM is to step up reform measures, policy-induce lower interest rates and boost economic growth.

Back in the early 1980s, in fact throughout the decade, the Indian economy was characterised by high taxes, steep tariffs and, in particular, rigorous financial repression. The latter meant that nominal interest rates on government debt was kept below the inflation rate — which implies negative real interest rates. The other notable feature of public finances at the Centre, in the eighties, was the glaring presence of very large fiscal deficits. It is, broadly speaking, the difference between the Centre’s expenditure and revenue. That was then.

Fast forward to the here and now, and it is plain that there are far less distortions in policy terms. The economy is more open, taxes and duties are much lower, and interest rates on government debt is no longer determined by fiat.

But the more things change, the more they seem to remain the same even in the realm of policy design. Witness the eightieslike high fiscal deficit of the Centre. But it ought to be stated upfront that back then the foreign debt component and short-term borrowings were much too high and clearly unsustainable. Now to finance the deficit reasonably prudently, the government must borrow. It has three sources of funding: borrowing from abroad, from domestic households and corporates, and tapping the monetary system.

The fact remains that over the years large fiscal deficits have been damaging the investment climate in India, and persistently high deficits do mean reckless piling up of governmental debt, and worse: such as a macroeconomic crisis, as happened in 1991. For policy purposes, it pays to hive off the fiscal deficit into two components — that of interest payments on the existing debt, and the rest of the corpus. The latter is the primary deficit. It follows that a high interest rate regime and a bloated primary deficit means a high fiscal deficit. It implies a rising debt to GDP ratio. However, a high growth rate has the opposite effect. So what’s clear is that the budget needs to be growth enhancing.

Actually, given the pressing need for corporates to rev up investment, households to shore up savings including for the longterm, and for the government to stem its fiscal deficit, what’s surely required is better financial intermediation so as to better match demand for financial resources with requisite supply, at fine rates. In tandem, what’s required is for the monetary authority, the Reserve Bank of India, to further indicate lower interest rates by purposefully lowering its policy rates, the rate at which it injects short-term liquidity into the banking system — the repo rate — and the rate at which it likewise accepts deposits from banks, or the reverse repo rate. Given that producer-price inflation is now near zero — for months — the RBI needs to significantly bring down its policy rates to step up demand for loanable funds from business and industry.

Besides, in the midst of an unprecedented global economic slowdown, the central bank’s practice of reducing the policy rates in small homeopathic doses of 25 basis points — or a quarter of a percentage point — needs to be urgently reconsidered. Also required is attandent reduction in the cash reserve ratio of banks so as to proactively ease liquidity in the banking and financial system, especially given the heightened supply of government paper in the offing.

The consequent lower interest rates would lead to an increase in both consumer spending and fixed capital investment, both of which stand to boost current national income. Additionally, since investment outlays lead to a larger capital stock, it implies that incomes, savings and capital formation in the foreseeable future and beyond could also be higher. It is reasonable to expect that as undertaking capital investment requires multiyear planning, it may take some time before reduction in interest rates bring about increased investment spending on the ground. However, a more focused infrastructure implementation policy ought to coagulate funds for roads, power et al on the quick.

Meanwhile, an expansionary fiscal policy, read an increase in government spending, along with two stimulus packages last fiscal, does seem to have shored up the growth momentum. The fact of the matter is that cuts in direct and indirect taxation, as was carried out more than once last fiscal, does feed through into the economy rather quickly. The bottom line is that both interest rates and fiscal deficits respond to cyclical changes in economic activity, and so it’s vital to use the instrumentality of the latter to shore up economic growth, especially in a downturn.