In bad times, we have to cut the deficit

Business Standard, 7 March 2016

If conditions in India are pretty bad, is this not a time for loose fiscal policy? The standard prescription from economics textbooks does not carry forward into the Indian setting. As we have messed up our foundations of macro and finance, when the going gets tough, fiscal policy has to become more conservative.

Once we look past our press releases, macroeconomic conditions in India are daunting. The recession which began in early 2012 has deepened. There is a balance sheet crisis in a significant subset of the corporations and in a substantial subset of the banks. Conditions are reminiscent of the 1998-2002 recession.

The textbooks suggest fiscal easing. In places like the US, left economists are advocating fiscal stimulus. However, the economies analysed in the textbooks are very different from India. Those economies have fiscal soundness. This is not the case in India, where we run a chronic primary deficit. Come rain or shine, on average, we are fiscally profligate.

The numbers work out for Indian debt dynamics only through the magic of high GDP growth and periodic bouts of inflation. If GDP growth is high, we are allowed to get away with chronic deficits. But when GDP growth slows down, the fiscal dynamics becomes dangerous and we have to scramble to respond.

Two one-off factors have worsened the situation. The biggest single decision in India's history, in terms of fiscal damage, was one-rank-one-pension. Our failures on bank regulation and governance have created a hole of between Rs.4 trillion and Rs.8 trillion.

When debt dynamics goes bad, all sorts of unpleasant things start happening. One proximate threat is a credit rating downgrade. Hundreds of billions of dollars of lending into India is by persons who are prohibited from investing in a sub-investment grade country. As India is chronically unwell, we are always close to being pushed into sub-investment grade. When this event becomes proximate, we are forced into scrambling for fiscal consolidation. There is a nonlinearity: we are relaxed about fiscal problems all the way till the brink, but when the threat of being downgraded into sub-investment grade is real, we are much more prudent.

More important than foreign investors is the domestic private sector. The private sector is rational and sees the government's predicament. Here, we go into two lines of thought.

The first problem is financial repression. We actually don't have a bond market in India. We have a system where banks and insurance companies are forced to buy government bonds. We run a Potemkin village of a bond market, with computer screens that are exhibited to ignorant visitors. RBI runs the exchange, RBI runs the depository, RBI trades on the market, RBI regulates the market, RBI blocks most people from expressing their views on the market. Contrast this with SEBI and the equity market, where SEBI does only one thing: regulate the market. There are few voluntary participants on the bond market, nor is there genuine price discovery.

This creates a second nonlinearity. We can push a certain amount of bonds down the throats of banks and insurance companies, but when their capacity is exhausted, long term interest rates rise dramatically as there is a feeble voluntary market beyond. Under financial repression and a fake bond market, public debt management (which is done by RBI) is exceedingly easy when selling a small amount of bonds, but the choice of surging the public debt under special circumstances has been taken away from the government.

The second problem is inflation. India has a long history of inflation being used as a tool to solve debt crises. When there is fiscal stress, there is the danger of higher inflation. With the Monetary Policy Framework Agreement (Feb 2015) and the Finance Bill of Feb 2016, we are re-imagining RBI around a 4% CPI inflation target. These are important achievements. However, merely asserting a target does not get the job done. Inflation targeting requires commensurate institutional machinery in RBI. This work has not begun. Hence, there is little credibility that the target will be consistently achieved. As an example, we have fared well on inflation in the past year, but from October 2015 to February 2016, the 10 year rate has gone up by 50 basis points.

Thus there are four features of India which are unlike mature market economies:

  1. Chronically unsound fiscal policy;
  2. Nonlinearity when faced with the Damocles sword of a sub-investment grade rating;
  3. The nonlinear capacity constraints in debt management when we have financial repression and a fake bond market; and
  4. The threat of inflation with a badly structured central bank which has the conflict of interest of also doing debt management.

Nobody enjoys doing tight fiscal policy in a recession. The economists who plead for prudence base their thinking on the messy realities of the Indian economy, and not on textbooks written about well structured mature market economies.

We have been through this debate twice in the last 20 years and each time the outcome was the same. When Yashwant Sinha was Finance Minister in the late 1990s, as the economy worsened, fiscal policy had to become more conservative and not less. In mid 2012, P. Chidambaram became Finance Minister. With the benefit of hindsight, we know that in early 2012, a recession had begun. He setup a group led by Vijay Kelkar to design a fiscal consolidation trajectory.

As the recession worsens, we will have to cut back expenses more. In the short term, there is no way out of the vise. The way out of the vise is to undertake reforms on five fronts:

  1. Setup the PDMA;
  2. Shift bond market regulation from RBI to SEBI;
  3. End financial repression;
  4. Build the institutional machinery for inflation targeting at RBI; and
  5. Undertake a sustained fiscal correction of roughly 1.75% of GDP, so that in each decade, on average, we have a primary surplus of 0.25% of GDP.

The time to fix the roof is when the sun is shining. We didn't fix the roof when the sun was shining, and now we have to cut expenses when it is raining.

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