How the finance minister should respond to India’s economic crisis
Prepare for adverse contingencies, give critical support in tough times, facilitate organic recovery
As finance minister Nirmala Sitharaman rises to present her second budget, she will be dealing with a combination of problems: A slowdown in growth, stagnant corporate investment, tepid consumption demand and declining savings. The re-emergence of inflation as a macroeconomic worry and a brief spike in geopolitical tensions in West Asia, with adverse implications for the price of crude oil and remittances, must be additional factors weighing on her mind.
In fact, the symptoms of the malaise afflicting the economy are eerily similar to what Richard Koo, the chief economist of Nomura Research Institute, once called the balance sheet recession, in the particular context of Japan. With stressed balance sheets and looming uncertainties, non-financial corporate firms have become riskaverse. They are trying to minimise debt instead of maximising profit. The result is that demand for credit is lukewarm, as the focus of firms is on paying back accumulated debt (deleveraging), rather than on investing in greenfield projects.
What should be the optimal response of the government in these troubled times? Economic policymaking is the slow boring of hard boards. It requires steady and round-the-clock engagement. Nevertheless, the presentation of the Union Budget is an important occasion to signal intent and back it up with credible fiscal commitments.
The government response should be in three forms. Be prepared for adverse contingencies. Provide critical support during the troubled phase. And finally, facilitate an organic recovery by dealing with the structural problems. Let us look at them one by one.
The first job should be to avoid the worst. The decoupling of the stock market indices from real economic activities should be a cause for concern. If and when there is a correction, typically, consumers will respond by slashing their consumption expenditure. This is called the wealth effect.
Second, some banks with multi-trillion balance sheets are undergoing turmoil. Any disruption in these banks may have spillover effects, both by directly affecting other institutions and through psychological channels. The budget should be mindful of these contingencies.
For supporting growth, the normal advice during an economic downturn is to increase the extent of the fiscal deficit. When the demand for loans from creditworthy businesses is low, the government should be able to fill the gap, so the argument goes. There is a problem with this advice now. India’s nominal GDP growth is going down, and the government’s borrowing cost remains stubbornly high. When the nominal growth rate is lower than the government borrowing cost, and the government is running a primary deficit, the debtto-GDP ratio may blow up rather quickly.
There are two ways of dealing with this situation, neither of which is riskless. One option is to tap into global savings. For example, the yield on the 10-year benchmark Indian government security is about 6.58%. This contrasts sharply with the advanced economies where borrowing costs are hovering around zero, and in some extreme cases, are even negative. Ways to utilise this arbitrage opportunity should be found, without running into macroeconomic vulnerabilities. In the last budget,
Sitharaman mooted the proposal to issue foreign currency-denominated bonds. However, it will be more prudent to have these sovereign obligations issued in domestic currency. An accommodative monetary policy supporting the fiscal deficit may be another way of relaxing this constraint. Again, this will depend on the instrument available with the central bank and its willingness to monetise the fiscal deficit.
Finally, the budget should take steps to facilitate an organic recovery. Revenue generation without creating distortions and uncertainty should be a priority, even if it might involve foregoing some revenue in the short-run. A strong commitment to make taxation procedures prospective and predictable will go a long way towards restoring the confidence of investors. There should be a careful cost-benefit analysis of the budgetary measures.
Historically, the budget has not merely been used as an accounting exercise, but also as an occasion to announce major reforms such as the overhaul of the industrial policy. The present budget may make similar announcements to revive animal spirits in the economy.
Admittedly, the task ahead for the finance minister is difficult. To use an analogy from cricket, the Indian economy’s current position is akin to a team that has lost early wickets while chasing a big target. Now, it has to maintain the required run rate without further losing wickets. Needless to say, such a performance requires considerable skill and focus.