In India’s battle with Covid-19, recovery was largely under-predicted and financial sector distress over-predicted. Because of the slowdown through the 2010s, structural features were thought to limit growth, while financial sector malfunction lowered monetary transmission. Therefore the reliance on the latter, while fiscal policy remained conservative, was expected to give a weak recovery.

The inference from better-than-expected outcomes is that supply-side reforms have reached a threshold that allows higher growth and low real rates aligned with surplus liquidity to raise demand and output. Sufficient diversity and deepening have occurred to make the financial sector more stable and less dependent on banks for financing.

It was tight monetary-financial conditions through the past decade, along with shocks that were not smoothed, that reduced growth. A turnaround in liquidity in 2019 had led to a rise in high frequency indicators by the end of the year before Covid-19 hit. Similarly, it aided better-than-expected recovery after each Covid-19 wave.

More than fundamental reforms, sustaining Indian growth requires continued fiscal supply-side action that reduces costs of doing business and therefore inflation. This allows monetary policy to keep real interests at a level that stimulates demand. Such monetary-fiscal coordination works best in Indian conditions of migration to higher productivity employment amid supply bottlenecks. External shocks have to be smoothed and large domestic policy shocks avoided to lower growth volatility.

Feasible reforms

We briefly discuss the continuing reforms that can deliver and how they are supported by softening of traditional macroeconomic constraints.

Reforms are necessary to sustain growth and employment. But the focus should be on feasible reforms that build on current trends and opportunities. For India these are in the large share of youth in our population in the context of developments in technology. Digitalisation and outsourcing have got a fillip from the Covid-19 period. Many Indian unicorns have been created and are using the boom in equities and venture financing to float IPOs.

Covid-19 induced supply chain diversification, together with the government’s PLI scheme and other incentives for firms may help India create jobs in labour intensive manufacturing that it has so far missed. This phase of export competition must be distinguished from the pre-liberalisation import substitution. Schemes must be well-targeted and transient with minimal distortions of tariffs. Reforms to enhance opportunities are in education, skilling, infrastructure, institutions, empowerment, improvements in governance, including at the third tier — many initiatives have been taken in these areas. Central and State governments have large assets built up over the Plan years that are utilised poorly.

This dormant wealth is being creatively monetised to restructure the fisc towards infrastructure, health and education expenditure that has higher growth spillovers and improves productivity. Other advantages are it can create opportunities for private business, if the allocation of risk is correctly done and regulation strengthened, while reducing current financing requirements and limiting debt increase.

Monetary-fiscal coordination

If continuing improvement in supply conditions reduce costs of doing business and inflation, then monetary policy can keep real interest rates below growth rates. This is the snowball effect that reduces debt ratios. It has been used to justify more government borrowing in advanced economies for Covid-19 stimulus and protection spending. While this combination often holds in emerging markets, high volatility in growth and real interest rates limits its benefits. Therefore countercyclical macroeconomic policy has to smooth shocks. Indian policy has the degrees of freedom to do so.

Monetary transmission to output is effective, with the share of retail loans growing. Housing and consumer durable loans are reviving as well as investment in specific sectors. Higher government debt and interest payment burden limit fiscal demand stimulus. Fiscal deficits cannot expand beyond a point. Reforms to improve the supply-side are feasible, however. This is the monetary-fiscal coordination required in Indian conditions. After Covid-19 demand and supply shocks, advanced economies have begun to talk of the necessity of monetary-fiscal coordination; in India, these justifications held earlier also. Higher growth is feasible also since the major constraints that aborted such cycles in the past are waning. Among these constraints are commodity price shocks and other supply-side bottlenecks, financial inadequacies and macroeconomic volatility.

Low relative food prices are essential for sustained growth in populous countries where food has a large share in the consumption basket. Therefore a rise in agricultural productivity has to precede a growth surge. A jump in food inflation contributed to halting India’s high growth phase in the 2000s. By the mid-2010s, however, India seems to have entered a period of agricultural surpluses. There is evidence of rising productivity and diversification to horticulture, aquaculture, etc., that have multiple crop cycles.

India’s dependence on oil imports makes it vulnerable to oil price shocks. But shale oil, which has a more elastic supply response, and climate change related efforts to develop green alternatives reduce the power of the OPEC lobby. This change in the political economy of oil pricing has the potential to relax a major constraint for India, despite the current shortages and spikes. OPEC itself does not like excessive spikes since they encourage substitution away from oil. Moreover, oil efficiency is rising steadily so that higher oil prices have less impact on prices.

The financial sector has developed to a stage where it can avoid the problems that come from government dominance and discretion as well as those from excess market volatility and exclusion. There is more diversity and institutional deepening. PSBs remain essential for many development tasks, but they are now doing risk-based sustainable lending. Net NPAs have fallen to low levels, they have made good recoveries, provisioning and capital buffers are high and their boards are stronger and more independent.

Government warranties are a healthier way to finance small enterprises, allowing private banks to also participate. The bankruptcy code was an essential reform. The modern development finance institution being set up, on the lines of the successful Chinese and German development banks, will help with infrastructure financing, leverage many opportunities in green finance, as well as revive the corporate bond market. Ongoing improvements in corporate governance are also critical for successful corporate bond markets. Multiple participant sets make equity markets less volatile.

The sheer size and diversity of a $2 trillion economy creates much more depth and resilience and the ability to absorb shocks, with the appropriate countercyclical policy. India thus has reached the stage where it can make major contributions to global growth. Its demographic profile, added to openness, transparent rule of law and democracy can make it an innovation hub that helps find solutions to global problems.


The writer is Emeritus Professor, IGIDR. Views are personal