Ashima Goyal

Pitfalls of too much conservatism

Ashima Goyal | Updated on September 30, 2018

Troubling times The Indian economy is beset with falling rupee, rising trade deficit and liquidity stress   -  iStockImages

Conservative fiscal and monetary policies have hurt industry, ramping up NPAs and worsening external account imbalances

The story we were told, when India embarked on a conservative fiscal-monetary policy with structural reform in 2011 — and re-emphasised in 2013 — was that this would lead to sustainable high growth and low inflation.

India did all that the conservative view demanded — flexible inflation targeting was strictly implemented, fiscal consolidation and many structural reforms were undertaken.

There were clear macroeconomic vulnerabilities in 2011 — twin deficits, and the threat of outflows of foreign capital. Yet after seven long years of growth sacrifice, the current account deficit has again widened and there is the threat of outflows. Despite lower inflation and fiscal deficits 10-year government security yields have gone above eight per cent. The rupee has depreciated sharply. The sacrifices have not been able to prevent a return of macroeconomic vulnerability.

Conservatives, of course would say India did not do enough. They will not admit to the possibility that the country is now facing ‘unpleasant monetarist arithmetic’ — that too much conservatism can also create macroeconomic vulnerability. The term was originally coined in a famous academic paper that showed if large deficits are not monetised, higher interest rates and inflation may be necessary to induce the public to hold government bonds, implying that tight monetary policy will result in inflation.

Perverse outcomes

Such perverse outcomes can be seen in many areas in India.

Fiscal deficits are more difficult to reduce under slower growth, and if higher interest rates raise government borrowing costs. Therefore, consolidation has occurred but more slowly than in the mid-2000s. The rise in 10-year G-secs rates from 6.5 to above 8 per cent over 2016-18, as monetary policy tightened, suggest all is not well. Government interest payments peaked as a percentage of GDP at 4.6 in the early 2000s, then came down rapidly in the high growth period to 3.0 in 2010-11, but rose after that and have averaged 3.2 over 2012-18. Thus inflation targeting was supposed to bring down the cost of government borrowing by reducing interest rates as inflation fell, but has not done so.

CAD worries

Current account deficit (CAD): Since 2011 the Indian industry has faced adverse macroeconomic and regulatory conditions, while consumption has been stimulated. Bank credit growth was largely in the retail segment. Some key government reforms are long-term positive for industry but also have short-term costs. As a result imports have grown faster than exports, when expansion in exports from sectors where we have a comparative advantage is essential to finance net imports in the oil sector.

The conservative view wants a depreciation to switch domestic demand away from imports and increase international demand for exports, while interest rates rise to reduce domestic demand releasing production for the exports that become more profitable.

But this package will have perverse effects in India since oil imports are price inelastic in the short run, trade wars are raising barriers to exports, and it is oil prices rather than excess demand that is raising the CAD. A rise in interest rates will hurt leveraged firms. Rupee depreciation will hit firms with foreign currency loans thus further raising NPAs.

The rupee: When it comes to rupee movement, the conservative view believes markets know best. Certainly, markets have a vital role in price discovery. But they do tend to over-react. Sudden sharp changes in the rupee value do not help markets or exporters. In 2011 when the RBI said it was unable to intervene the rupee sank. In 2013 when it conveyed its firm backing the rupee recovered. One-way momentum can set in if the central bank disappears from the market in times of excess volatility.

The NPA minefield

Non-performing assets (NPAs): The conservative view believes that allowing weak firms and banks to die will release resources for more efficient firms. Bank credit growth to firms was killed so NBFCs stepped in. The conservative view also likes to keep liquidity tight. But if you allow NBFCs to substitute for banks and then don’t provide them with lender of last resort liquidity, illiquidity can turn into insolvency, as we are seeing in the case of the beleaguered IL&FS, with the contagion spreading through the market.

The microeconomic and finance perspective of the conservative view has no appreciation of systemic spillovers or of the necessity of countercyclical macroeconomic policy and financial regulation. They refuse to see that tight financial conditions under ongoing corporate stress are just ideal for contagion and persistent distress.

Asymmetric tightening

The conservative view has a bias towards tight money. It is essential to reduce macroeconomic vulnerabilities and decrease inflation, and inflation targeting can help anchor expectations, but it has to be flexibly interpreted in Indian conditions where inflation is mainly due to cost push and there is large unemployment.

Foreign inflows are regarded as inflationary so the RBI reduces money supply by selling G-secs. But when there are outflows it wants to give them inducements to stay so it also tightens, raising interest rates. It can make up for shrinking of money supply due to its dollar sales by buying G-secs in OMOs but refuses to fully compensate. If sterilisation is costly then reverse symmetric swapping of foreign for Indian G-secs under outflows should be profitable, but that is regarded as financing fiscal deficits and is not done. It is acceptable to finance US government deficits but not Indian deficits. If you tighten both when there are inflows and outflows, when do you loosen?

So the cost of government borrowing rises, while pro-cyclical regulatory tightening, such as the February 12 RBI circular that retrospectively sent all very different past schemes to an overburdened NCLT, raises NPAs and recapitalisation requirements. But in the conservative view, the government must reduce deficits also to keep foreign investors coming in; implying it is expected to spend only on the financial sector.

The balance

The problem is if the real sector suffers financial returns also will not sustain. A balanced symmetric approach is required. At the current juncture rising G-sec yields are already giving higher returns to foreign investors, the rupee has depreciated over fair value and a likely reversal, provided the RBI stays in the market, again raises returns to new investors. As two back-to-back policy rate hikes have not reduced volatility there should be caution in thinking of a third one. Since the gap between Indian and US Fed rates was kept too large earlier it can safely shrink a little now. Tightening liquidity to defend the rupee will lead to a market collapse and more outflows.

The writer is a part-time member of EAC-PM. The views are personal.

Published on September 30, 2018

Follow us on Telegram, Facebook, Twitter, Instagram, YouTube and Linkedin. You can also download our Android App or IOS App.

This article is closed for comments.
Please Email the Editor