By: Punam Sharma
A lot of India’s macro-economic ills over the past 4 years can be attributed to pro-cyclical fiscal and monetary policies. Our recovery from 2008’s global financial crisis was quite sharp since domestic drivers had remained broadly intact and had resurfaced strongly as the external shock abated. However, both monetary and fiscal policies remained pro-cyclically ultra-loose much beyond when recovery had taken hold. This is known better with the benefit of hindsight while then presumably policy makers were reluctant to reduce the stimulus in case the economy slid into another spiral. The point is evident in the graph below which shows a V-shaped recovery in industrial production (IIP) even as fiscal spending continued at an elevated pace and overnight rate hikes followed a ‘baby-step’ approach even from emergency low levels that they were cut to in response to the 2008 crisis.
Source: CEIC and Internal research
While these policies facilitated a demand revival, unfortunately supply responses continued to deteriorate in the face of myriad issues including those of government policy and confidence. It is widely acknowledged now that had monetary and fiscal policies been counter-cyclical then (that is, tighter in the face of strong demand revival and weak supply responses), India would possible not be faced with the current degree of its entrenched trilemma of high inflation, high credit to deposit ratio, and high external imbalance; all in the face of very weak growth.
The Case Today
Market, researchers, and economic entities have reacted in various ways to the recent surprise pause from RBI in its December policy. While there has been visible relief from some quarters, some others have followed surprise with admonishment on the central bank’s reluctance even in the face of 11% plus CPI inflation. Arguments in favor of decisive rate hikes range from entrenched inflation causing second round effects, to high inflationary expectations of households, to the urgent need to provide positive ‘real rates’ to savers. All these arguments are very important and hold merit; just as they did 6 – 7 months back when some of the same community were gleefully egging RBI on to cut rates and restore positive liquidity. However, underneath this all, a question needs answering: How pro-cyclical can policy afford to be? Given the learning from post the 2008 episode, the importance of this question cannot be understated.
The graphs below show the current economic slowdown in terms of high frequency indicators. The one on the left tracks auto sales, industrial production, and non-oil and non-gold imports. All show a continued weak trend. Non-oil and non-gold imports have shown a negative growth most of this financial year with the weakness picking up pace in recent months. This partly explains why trade deficit numbers have continued to be benign despite export growth losing some momentum recently. Auto sales picked up some pace into festive season only to lose most of it subsequently. The graph on the right tracks credit and deposit growth rates. The fall-off in credit growth rate is noticeable lately and is largely explained by the unwinding of temporary lines drawn by institutions post the spike in money market rates from mid-July. Indeed, recent media reports tracking home loan rate cuts by leading banks suggest almost a complete absence of large ticket off-take. The sharp deposit growth in the chart is flattered by the massive pick up under FCNR. However, the net effect is still deposit growth outpacing credit growth after a long hiatus.
Source: CEIC and Internal research
While the context of weak growth is quite evident, the graph below charts some of the internal dynamics of inflation. Thus while the volatile vegetable inflation has galloped to 60% with most the spike happening over the last 3 months, CPI excluding fruits and vegetables has been declining steadily for most of this financial year. Within this, core CPI has also been quite stable lately and has in fact fallen over past 3 months even as the headline has spiked. Now that vegetable prices seem to be falling finally, the prognosis for headline CPI going ahead has turned as well. Thus, along with most in the market, media reports quote Rangarjan, a top policy advisor, estimating drastic falls in the next readings for both WPI and CPI.
Source: CEIC and Internal research
We have summarized above the experience with pro-cyclical monetary and fiscal policies (looser policy in face of stronger growth) pursued in the first phase post the 2008 crisis. These encouraged the building of persistent macro-economic imbalances the effect of which has finally been brought home to us this year. On hind-sight, there was scope for more emphatic counter-cyclical action (earlier tightening) which may have alleviated some of the pain being faced today. An obvious outcome of this phase was tighter policy for longer, notwithstanding the aggressive easing bandwagon that many analysts and observers had hitched themselves to earlier in this financial year. Now the chorus is in the other direction; to rectify all our built up imbalances over short period monetary remedies which again by definition will be pro-cyclical (tighter policy in the face of very weak growth). We have no dispute with the logic that India’s macro-economic imbalances are substantial and need to be corrected sooner rather than later if we are to have sustained growth and avoid future economic accidents. For this we do need higher rates for longer; again one of our pet themes (refer our note “Can aggressive monetary easing create a funding problem in India?” dated 29th May 2013 for details). However, what also needs to be recognized is that any incremental tightening now is being done pro-cyclically when underlying growth impulses are weak. In fact, with the government set to sharply curb fiscal spending over the next few months, impulses on the services sector may get weaker still. This by definition limits the overall room available for tightening or, put another way, sets the bar for further tightening fairly high. It is heartening to see RBI Governor Rajan displaying a healthy respect for this fact, even as he remains vigilant on future risks to inflation. Obviously, if inflation doesn’t fall as anticipated, he will be forced to respond and thereby accept an even more sub-optimal trade-off and settle for weaker growth still. However, given the limited room for pro-cyclical policies, it is prudent to wait to be sure. Also, if the anticipated softening of prices indeed materializes, the Governor would have added to instead of deleting from the RBI’s store of credibility.
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