Reviving growth requires better coordination between fiscal and monetary policies

Neelkanth Mishra
Even as the governments have tried to rein in spending to control the fiscal deficit, the easing this should have caused on the monetary side has not occurred.

To get one of the largest economies in the world to maintain a seven to eight per cent growth pace requires effort, in the form of continuous reforms. With election results expected in about five weeks, the discourse must now move to the reforms or just administrative steps that are imperative to stem the steady decline in momentum we have seen recently in India, and hopefully reverse it. Growth expectations for the current year have already fallen from 7.4 per cent to 7 per cent, and are likely to slip further.

The current slowdown is baffling to many. Unlike in the 2011 to 2014 period, there are no smoking guns: There is no crisis with the currency that warrants a sharp slowdown in domestic demand, no freeze in decision-making driven by successive corruption scandals, or no uncoordinated over-investment in sectors like power generation that created significant overcapacity. This year, while nearly every company one talks to complains of slowing demand, almost no one is able to explain why.

A major cause very likely is shortage of money. For the last few years, retailers and distributors have continued to complain of there not being enough money to get the markets to function smoothly: "Market mein paisa nahin hai", they say. But how can there be a shortage of money when the RBI is printing so much that currency in circulation is 17 per cent higher than at the same time last year? That is a fair question.

The answer lies in understanding the different measures of money. Currency in circulation is about Rs 21 trillion currently, but the money that much of the formal economy uses for transactions, and see as bank deposits, is around Rs 154 trillion. This is called M3. The system that converts base money (M0: This is mainly currency in circulation) to M3 is currently not functioning: This is the financial system. When banks give new loans, they "create" money. When the financial system is not functioning effectively, this process of money creation slows down, and the ratio of M3 to M0 (also called the money multiplier) falls.

This exposes the risk of attempting a stealth privatisation of the banking system. In the aftermath of the surge in non-performing loans, most of which seemed to be with government-owned (PSU) banks, there was a realisation of structural problems with a state-owned banking system. But explicitly selling off these banks is politically difficult, and therefore it was assumed that the financial sector would get privatised slowly through the PSU banks losing market share. After all, such an approach had worked in airlines (Air India) and telecom (BSNL). However, unlike in airlines and telecom, a slowdown in credit availability could hurt economic momentum. For a few years, non-banking finance companies (NBFCs) stepped in to support aggregate credit growth, but starting late last year, as they got pulled into a funding crunch, and eschewed growth to ensure survival, system-wide credit growth has slowed sharply.

This leaves the government on the horns of a dilemma: If the PSU banks are asked to grow again, one runs the risk of another build-up of bad loans; but if they do not grow, economic growth slows further. Removing the logjam from the largely private NBFCs may also be a solution, but involves some moral hazard, and could open another can of worms. Whatever the approach, this issue needs resolution.

A second challenge is in better coordination of fiscal and monetary policies, starting with improved communication. Currently, government bond yields, which form the benchmark for the interest rates on a lot of debt in India, are significantly higher than the rates set by the Monetary Policy Committee (MPC). This gap, called the term premium, has come down from a recent peak, but is still among the highest recorded this decade.

Two major reasons come to mind: First, the market's fear of fiscal slippage. As discussed in this column earlier as well, India's general government (that is, central plus state) fiscal deficits are among the highest in the world, but compared to India's own history, the targets for this year are the third lowest ever. There has been some concern on excessive borrowing by public sector enterprises, but at least till two years back, for which comprehensive data is available, aggregate public sector savings were still positive. Further, forward-looking analysis of fiscal trends must incorporate the fiscal space that opens up with the pay commission now behind us. In the fifth and sixth pay commissions, the increase in the combined salary and pension bill of central and state governments was two to two-and-a-half percent of GDP: On both occasions the fiscal deficit had shot up. The seventh pay commission is now over, and the aggregate deficit is still unchanged. Till the eighth pay commission in 2026, as salaries and pensions rise slower than nominal GDP growth, significant fiscal space would open up.

The second reason is a reported drop in the households' financial savings to GDP ratio in 2017 to 9.4 per cent: The argument being that there aren't enough savings available for both the government and the private sector to be funded adequately. However, a deeper dig into the estimation of financial savings shows possible under-estimation, primarily with respect to mutual fund inflows (these have been very strong, but not visible in the savings data as reported), and small savings schemes which have now crossed one per cent of the GDP. Even assuming that there are no errors, the reported ratio has jumped to 11.1 per cent in 2018, and we estimate may have improved further to 11.3 per cent in 2019, a nine-year high.

Due to confusion on both these issues, even as the governments have tried to rein in spending to control the fiscal deficit, the easing this should have caused on the monetary side has not occurred. The constraints in the financial system have further worsened the monetary tightness. As growth continues to slow and inflation stays below the target, interest rates may keep falling, but likely not fast enough to revive growth quickly.

Several other challenges are well-flagged and often discussed: A weak and ailing real-estate market, problems in agriculture, worrying levels of external dependence in India's energy ecosystem, crumbling municipal infrastructure, and stagnating capital flows, among several others. But easing monetary conditions may be paramount to stemming the current growth slowdown.

This article first appeared in the print edition on April 17, 2019, under the title ‘No more half-measures’. The writer is co-head of Asia Pacific Strategy and India Strategist for Credit Suisse.