Budget 2020 | India’s Economic Slump: Should Policymakers Go Above And Beyond?

One of the starkest features of the economic slump that India finds itself in the middle of is the fall in the nominal rate of growth of gross domestic product.

Based on the first advance estimates released on Tuesday, nominal GDP growth will fall to 7.5 percent in FY20 from 11.2 percent last year — a decline of nearly 400 basis points. That decline, together with other factors playing out in the economy, tell you that the growth slowdown India is witnessing is more than just a mid-cycle slowdown.

There are various aspects here that need to be appreciated.

1. While an almost a synchronised global slowdown in manufacturing and trade that has contributed to this decline, the intensity of India's slowdown versus its own history is much sharper and is largely owing to domestic factors.
2. The large contributory factors (income slowdown and balance sheet impairments) will likely have some persistency and will be slower to reverse.
3. The counter-cyclical measures taken—monetary and fiscal—so far, while large, may not be adequate when seen in context to the size of the slowdown and how far we may be from our so-called potential growth rate, which is admittedly a hard rate to measure.

Monetary Policy: In Defense Of ‘Twist'

Lets start with monetary policy.

The 135 basis points in interest rate cuts administered thus far by the Monetary Policy Committee may sound significant on a standalone basis. But when looked at in the context of how far below potential growth we may be, it may not look excessively large.

Of course, the rate cuts aren't all that monetary policy has done. Importantly, forward guidance has been aligned and liquidity kept abundantly surplus to supplement the rate cuts. Also an unconventional tool (Operation Twist) has been launched for the first time to address term spreads on sovereign bonds directly, where the RBI is selling very short-tenor bonds from its books and buying medium-to-long tenor bonds from the market. This last move has had appreciation and criticism in almost equal measures.

Much of the criticism is around the unconventionality of the measure and the fear that gives the government cover to be more relaxed on the fiscal front. Another question raised has been whether a fall in long-term government bond yields will actually help the economy.

There are, however, justifications for the RBI's actions.

First, if this were a normal mid-cycle slowdown, largely synchronous with the rest of the world, we wouldn't worry as much. However, the extent and nature of the current slowdown is somewhat exceptional for India and probably deserves a deeper counter-cyclical response.

As a thought experiment, if the RBI were to get more aggressive on rate cuts alone, they would not be seen as irresponsible given the current context. However, the cuts will likely be wasted to a large extent and most may not be transmitted even to the sovereign bond market rates. So, the RBI is choosing another tool that has higher probability of greater transmission.

Of course, ‘Operation Twist' does not resolve all problems of weak monetary transmission.

To recall, the lack of transmission included both an elevated term-spread as well as an elevated credit-spread. Admittedly, the latter is more relevant but it also comes with much greater moral hazard issues, should the RBI choose to intervene here directly. Addressing term spreads can be done with lesser hazard and to the extent it transmits to the risk-worthy borrowers, it should incentivise some incremental demand for loans.

It has also been said that loan pricing is determined by short-term rates and not long term-rates. However, to the extent that long-tenor loans should have some sane risk spreads over the risk-free government bond, the yields on long-tenor sovereign bonds do matter. Also, long-tenor issuers in the corporate bond market will directly benefit, although probably by not the same amount as the fall in the underlying sovereign yields.

Fiscal Policy: A Case For Nuance

Against this backdrop of a sharp and possibly prolonged slowdown in growth, if the government opts for some modest fiscal expansion, then one cannot fault this on a macro logic.

Higher public deficit has, in some ways, compensated for impairments in traditional lending over the past few years. The slowdown we have witnessed has been despite this higher public spending and would probably have been much sharper had the government not done this. Thus, it is only the additional expansion here that matters since the 8 percent plus effective public deficit already being run today is already ‘in the price' as far as the current GDP growth rates are concerned.

The problem rather is with respect to the opacity of the deficit, and the seeming lack of a firm plan with respect to its future path. More generally, we worry about the impact on interest rates should fiscal be further expanded.

Already, nominal interest rates even on government bonds are close to nominal GDP growth rates, thereby bringing debt sustainability issues back to the fore for anyone who borrows at a spread to government bond yields.

Going Above And Beyond...

In our view, India is witnessing an exceptional growth slowdown which requires a deeper counter-cyclical response. As such, a modest fiscal expansion over the previously indicated glide path along with the unconventional monetary support announced so far may be justified.

The question is more of efficacy and space.

In the near term, India has the benefit of significant external stability on account of a cyclically lower current account deficit as well as a probable benign global dollar environment. This provides a good cover to step up counter-cyclical responses (Geo-political risks can somewhat alter this scenario but are difficult to account for in a traditional framework given their varying probability, intensity, and duration of impact).

As such, monetary policy's continued focus on improving transmission, where credit perception is not an issue, would be welcome. So is expansionary fiscal policy to some extent, provided it is done transparently and in a rule-based fashion, and doesn't start to undo effective monetary easing.

To address the risk of fiscal policy playing spoiler to monetary policy, an enhanced role of foreign capital should be actively explored in our view.

Finally, policy needs to be forward looking and requires a clear intuitive sense on when to remove the proverbial punch bowl.

Suyash Choudhary is Head – Fixed Income at IDFC AMC.

The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.