Fight against the last vestiges of inflation threatens to undo significant policy gains of recent years
Neelkanth Mishra | Last Updated at June 5, 2019 02:18 IST
(This was published in the Business Standard: link)
It is rare for consensus to emerge among hundreds of millions of humans. When it does, like it did in the recent general elections, it is natural for expectations of significant economic change to rise. As prescriptions and hopes turn into predictions, a clamor has arisen for the government to “do something” to address the ongoing economic slowdown.
One must be careful what one wishes for. While there clearly are measures the government can take, a significant fiscal stimulus would be ill-advised, and the solution is monetary.
For several decades now, reports analysing India’s weak manufacturing competitiveness have, in addition to the oft-quoted complaints of regulatory hurdles, weak infrastructure and poor worker skills, lamented high interest rates. If Indian manufacturers borrow at, say 12 per cent, and the Chinese at, say 6 per cent, and it takes much longer to set up factories in India (so the higher rates get compounded), how can factories in India produce competitively? So the argument went. With chronically high inflation (CPI has averaged 7.5 per cent since 1960), and persistently high fiscal deficits that forced the Reserve Bank of India (RBI) to monetise them, interest rates could not have come down.
Thus, to get rates to fall, both inflation and the fiscal deficit needed to fall. Given that the two are also related, with higher fiscal deficits often associated with higher inflation, fiscal improvement needed to occur first, but a surplus in food production was necessary too.
And corrected they have: Inflation has averaged 3.5 per cent over the past three years, and the average over the past four years is below 4 per cent. The fiscal deficit ratio is the third lowest in India’s history even though it is still high compared to other nations. Once adjusted for the pay commission cycle (the decadal pay hikes for government servants can boost the salary and pension bill by up to 2.5 per cent of GDP; the seventh pay commission implementation just got over), it is perhaps the lowest in India’s history. Votaries of higher interest rates make much of extra-budgetary spending by state and central governments. This is undoubtedly an issue of lack of transparency, but this spend is not abnormally high, is productive, and cannot justify the really high interest rates for borrowers in the economy, in our view.
Despite these remarkable achievements, and nominal growth slowing, the prevailing interest rate environment remains excessively tight for borrowers. Revenue growth for firms may have slowed in the low inflation environment, but their interest costs have not: Not only does this hurt the bottom line and thus investible capital, it also reduces risk appetite. All three components of interest rates other than inflation: The real repo rate, the term premium (difference between the 10-year government bond yield and the repo rate) and credit spreads have been at elevated levels.
The stimulus should be monetary, not fiscalIllustration by Binay SinhaSo, the economy has seen the negative effect of low food inflation: Weak farm incomes as the transfer from the rich to the poor through higher food prices was stalled; but no benefits, as the cost of borrowing has not fallen commensurately. Similarly, the consumption stimulus in the form of a large pay commission handout to government employees was much weaker than usual in the seventh pay commission. Unlike in the sixth commission, where a large stimulus took several years to run through the system, the growth boost from the seventh has already faded. And yet, there are no parallel gains, with the term premium unchanged.
Not surprisingly, then, even before the non-banking finance companies (NBFCs) braked sharply starting September last year, economic growth had started to weaken. That it has been mostly below the 8 per cent a year target clearly has several important drivers, but a fiscal pullback without a parallel relaxation of borrowing rates is one of them.
There is no doubt that the risk of inflation flaring up again remains, and one needs to stay on guard: The recent hike in milk prices after a hiatus of two years, and a possible spike in fruits inflation (mangoes, for example, due to weather disruptions) need to be monitored carefully, for example. However, one must also be cognizant of political economy considerations and the risks they pose. If growth remains tepid for too long, and the significant interest rate reductions that are possible do not happen (for the borrower, not just in the repo rate), political pressure could push the government back to a high fiscal deficit regime (and possibly high inflation too), undoing the policy gains of the last several years. Inflation being high and volatile for most of India’s independent history was perhaps because it was politically necessary: Real output growth in agriculture averaged 2.5 per cent a year since 1960, and yet the agriculture workforce grew at 1.6 per cent a year. Without high food prices that engineered income transfers from the rich to the poor, this would have created significant social stress.
The process of interest rate correction appears to have started, with government bond yields falling by nearly 40 basis points in the last few weeks. This appears to be in anticipation of a repo rate cut on June 6, but likely also reflects relief among bond investors that the elections did not force a change at the Centre, and that the political alternative would have meant a step up in government spending.
This has a long way to go. As explained in last month’s column, borrowing rates can be up to 2 percentage points lower if the real repo rate, the term premium and credit spreads all just fall back to normal levels. Even if the Indian economy is not as rate sensitive as some others are, this scale of rate reduction can be stimulatory. If for argument’s sake mortgage rates were to fall by two percentage points, for example, it would help ease the logjam in the real estate segment a bit.
To get rates down by this extent would necessitate not just a normalisation of real repo rates, but better signaling, as well as improvement in financial system capacity. These steps need to be on the policy agenda, and not any pressure to increase consumption-boosting spending by the government.