The Hindu Business Line : Monetary policy and fiscal consolidation

Leakages cannot be cited as an argument against government spending, when the Government is short of meeting its commitments in health and education. The Government and the RBI would know that the rhetoric of inclusive growth and fiscal consolidation cannot go hand-in-hand, say and A. SRINIVAS
C. SHIVKUMAR.

The jury is out on whether the Reserve Bank of India got its inflation-growth balance right in its busy season review of Monetary Policy. However, there can be no denying that at least in the short-term the growth impulses will have to come from the Government.

This is evident from three indicators: The deceleration in the growth of private final consumption expenditure; the deceleration in the rate of growth of gross fixed capital formation, and the slump in the growth of credit. If there are any signs of a pick-up in credit growth, this can be attributed to the recent rise in government spending, leading to a growth in demand. For this growth impetus to be sustained at a time when agriculture is in a bad state and exports are not looking up, government spending will have to continue in the present vein. The RBI might be right when it talks of a ‘calibrated exit’ with reference to mopping up liquidity when there is no private demand for credit. But if an exit portends higher yields on government borrowings, it is unwelcome.

Credit controls

One of the relieving features of last week’s monetary review is that there is no indication of the latter. The immediate task before the central bank is to hold the yields on Government securities in the face of higher borrowings, rather than give ‘signals’ to the Government with a view to achieving “fiscal consolidation”, preventing “crowding out” and curbing inflation.

If inflation does rear its head every now and then, it is more a result of endemic supply-side problems or rent-seeking behaviour arising out of inept governance, both of which are best addressed by specific rather than general measures on the monetary side, accompanied by a long-term fiscal response.

While the RBI has done well to deflate asset bubbles, it has fallen short of implementing selective credit controls.

Therefore, the RBI might be better off trying to make credit available on reasonable terms to the Government, micro and medium enterprises and the agriculture sector, and fretting less over the size of the government borrowing programme.

Govt borrowings

Till October 30, the Government completed about Rs 3.35 lakh crore of borrowings or about 74 per cent of its target. The estimate for the current fiscal is Rs 4.51 lakh crore. However, the hike in the Statutory Liquidity Ratio (SLR) — mandated investments in government securities as a component of deposits — by one percentage point, as opposed to market speculation of a Cash Reserve Ratio hike, is a yield-cap signal to facilitate this remaining 26 per cent.

A hike in the CRR (zero interest cash balances to be maintained by banks with the RBI) would have pushed up yields.

States are expected to raise their market borrowings considerably during the current fiscal. Their borrowings are estimated at Rs 1.2 -1.5 lakh crore through State Development Loans (SDLs). SDLs are eligible for repurchase through the RBI Liquidity Adjustment Facility window.

States have raised a little over Rs 80,000 crore so far. The cost of state borrowings is escalating. Despite their SLR status, the bid-to-cover ratio (a measurement of interest in securities at auctions) has remained abysmally low. The ratio is lower than 100 per cent. The low interest in the securities also reflected in high yields. SDL yields are close to the small savings rate and spreads over the year sovereign yield is over 1 per cent. The high costs have prompted States such as West Bengal to put in early exit options for lower pricing.

However, the SLR hike is not significant in itself; it is only an indication that more such measures could be in the offing. Most banks have a government security investment deposit ratio of 33 per cent. This implied that the banking system was awash with SLR securities, with yields near the 7.5 per cent level. However, with the borrowing programme expected to overshoot the target, further yield-cap measures cannot be ruled out.

FISCAL DISCIPLINE

The RBI says in its review that there can be no debate on the need to achieve fiscal consolidation. However, it is by no means an established fact that government spending crowds out private spending, or that fiscal ‘irresponsibility’ contributes to inflation. There is plenty of elbow room for both government and private players to undertake investment in an economy that is nowhere near full employment. However, current monetary policy moves are based on the crowding out principle.

The view that the fiscal deficit must be restricted to a certain percentage of the gross domestic product is based on two assumptions: Its benefits are limited as the multiplier effect of government spending is diluted in an open economy (a view expressed by the Finance Ministry in its fiscal responsibility legislation document); and Government spending is riddled with and leakages.

In principle, fiscal deficits can lead to crowding out, or higher interest rates, when private savings generated out of the deficit leave the country. As pointed out by eminent economists Prof Prabhat Patnaik and Prof Surajit Das, in a closed economy, the private savings will be equal to the deficit, thanks to the multiplier. Therefore, interest rates will remain the same.

Besides, even when savings do leave the country, pushing up the domestic interest rate, this can be an issue only when private investment demand is robust. Therefore, ‘crowding out’ only works in a situation where open economies are going through a boom. It is inappropriate to apply it to the current context.

Rise in demand

If the increase in demand, generated by the deficit, is tackled through higher price rather than output, there is inflation. However, such a price rise ought to be a short-term problem in a demand-constrained economy.

Short-term inflation is not a monetary but a political phenomenon in a developing economy like India replete with distorted markets and information asymmetries.

There can be no arguing that there are leakages in Government spending. But this cannot be cited against government spending per se, when the Government is woefully short of meeting its commitments in health, education and poverty alleviation. Both the Government and the RBI would know that the rhetoric of inclusive growth and fiscal consolidation cannot go hand-in-hand.

The fiscal disciplinarians are under challenge. The ongoing economic and financial crisis has led to a growing realisation that open, globally integrated economies have their downside. It is not just that everyone swims or sinks in tandem; when the contagion of deflation hits, fiscal policy will not work if it translates into demand for other countries’ products.

The US and the EU have turned more protectionist essentially to make their stimulus packages work. If India were to evaluate its experience, it might draw similar conclusions — that an open economy is not an unmixed blessing. Once this is accepted, its perception of fiscal policy will also undergo a change.

blfeedback@thehindu.co.in

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