It is the fiscal policy, stupid

Fiscal deficits, fiscal dominance and the resultant financial repression are the two principal factors behind India’s current economic malaise.

In the last week of August, the Government of India announced that the growth rate of the Indian economy in real terms slowed to 4.4 percent (y/y) in the second quarter (April – June) of 2013. Measured as other countries do, the growth rate was actually 2.5 percent (Figure 1). Without prolific government spending that India is burdened with, the growth rate would have been 1.4 percent. The blame game had to begin.


Figure 1: India’s real GDP growth slows to 2.5 percent in the second quarter of 2013.

In an interesting Op-Ed, Dr Surjit Bhalla blamed high real interest rates in India for the growth slowdown. According to him, real rates in India were too high, if one looked at the GDP deflator. Yes, the Gross Domestic Product (GDP) Deflator (the index of prices that is used to convert nominal into real values at some constant prices) was only 5.8 percent at the end of Q2. However, the annual increase in the consumer price index (CPI) is around 9.8 percent. The difference is due to the weight of food. In the former, it is around 20 percent . In the latter, it is 50 percent. But, core CPI inflation, excluding food and energy is 8.2 percent. India’s wholesale price inflation is 5.8 percent. Non-food manufacturing inflation per the Wholesale Price Index (WPI) is around 2.4 percent. So, the menu is varied and we can pick the inflation rate we like, to make the argument we wish to make.

Fiscal d

Before we get to the issue of whether real rates are too high and hence choking India’s gross fixed capital formation, we must quote the most colourful paragraph of his piece that we wholeheartedly agree with:

UPA 2 regime has been responsible for possibly the worst fiscal policy that India has endured, and I would hazard a guess that outside of Venezuela, possibly the worst fiscal policy of any modern economy. And the nightmare just does not end. We have just witnessed the passage of two more populist bills, bills of a kind that would have severely embarrassed, had he been alive, the last of the great populists, Hugo Chavez of Venezuela.

Then, he goes on to question monetary policy too. Dr Subbarao, the outgoing RBI Governor has been criticised for having tightened monetary policy too late in 2009 10. He has accepted the criticism. But, Mr Bhalla criticises him for having tightened too much!

If one looked at the real rate of interest (Prime Lending Rate – GDP deflator), it had shot up only in the last quarter. Otherwise, it was low too and hovered around its long-term average of 6.25 percent. I have used data from 1997Q2 until 2013Q2. Post-crisis, for at least for two full years, the real rate remained well below its long-term average (2009 Q3 to 2011 Q3). However, real gross fixed capital formation (GFCF) had peaked in 2010Q1 and had dropped to 4.2 percent (y/y) in 2011Q3, well before real prime lending rate began climbing above its long-term average.

Interestingly, if one looked at contemporaneous correlation or correlation lagged up to four quarters, real GFCF and real prime lending rate are not correlated at all, except for contemporaneous correlation at -0.49. The nominal prime lending rate and real GFCF show far better correlation, even up to 4-quarter lags. The same holds true for nominal prime lending rate and nominal GFCF. The correlation has the expected negative sign.

No surprises there. We agree that interest rates matter for economic growth through capital formation. The question is whether monetary policy was the culprit for high nominal and real rates of interest. That is where I differ completely with Dr Bhalla.

The correlation between the prime lending rate and the policy rate (repo rate) is rather low.  It is about 27 percent at best. Using monthly data, I calculate the correlation up to six month lag. That is, the repo rate is lagged up to six months to see the delayed impact, if any, on the prime lending rate. There was none. If anything, the correlation drops. The data I had goes from the year 2000 (March) to the year 2013 (August). (I did not run any regression since a reduced form model is not the best way to calculate the impacts from lending rate to capital formation and from policy rate to lending rate because one has to control for other factors that impact both).

One should hazard a guess that the rise in the prime lending rate and its persistence at a high level despite the policy rate having come down by 125 basis points in the last one year suggests that the problem lies somewhere else.

Let us recall Dr Subbarao’s last speech: Yes, growth has moderated, but to attribute all of that moderation to tight monetary policy would be inaccurate, unfair, and importantly, misleading as a policy lesson. India’s economic activity slowed owing to a host of supply side constraints and governance issues, clearly beyond the purview of the Reserve Bank. If the Reserve Bank’s repo rate was the only factor inhibiting growth, growth should have responded to our rate cuts of 125 bps between April 2012 and May 2013, CRR cut of 200 bps and open market operations (OMOs) of INR1.5 trillion last year.

The real culprit is the big spender – the Government of India. It has denied the corporate sector resources to invest, created tightness in liquidity and, not to be left out, place a lot of other obstacles on investment activity through its hyper-activism on the environmental front, on the tax front and through retrospective cancellation of licenses. Basically, the government did not view business as a partner for economic growth but as an adversary.

Savour this information: The size of the government’s net market borrowing programme (dated securities) increased nearly 9.7 times in eight years to INR4.9 trillion in 2012-13. In addition, the government resorted to an additional funding of INR1.16 trillion through 364- day treasury bills. (Source: Chapter 3 of the RBI Report on Currency and Finance 2009-2012)

I ended up reading this chapter thanks to a crisp blog post by Gavyn Davies in the Financial Times based on this chapter. The title of his post says that India needs to end fiscal dominance over the central bank. That sums up everything.

What is fiscal dominance (of monetary policy)?

Loosely, it is the influence or distortion that a large fiscal deficit of the government exerts on the conduct of the monetary policy by the Central Bank. Just to make it clear, fiscal policy refers to taxation and spending policies of the elected (or otherwise) government. Monetary policy deals with issues relating to interest rates and money supply that are in the domain of the Central Bank of the country.

According to the Chapter 3 cited above, Fiscal dominance of monetary policy goes beyond the monetisation issue. It occurs in several forms. Large fiscal deficits have inflationary consequences even when they are not financed by the Central Bank. For instance, suppressed inflation remains a significant drag on inflation management even after the government has taken some steps to deregulate administered prices in the energy sector. At the first stage, suppressed inflation feeds into inflation as the subsidies necessitated by the price rigidity widen the fiscal deficit. At the second stage, as subsidies become unsustainable, they sooner or later necessitate large discrete price adjustment that feeds into inflation expectations. At the current juncture, if prices are adjusted in one go to remove total under-recovery of the oil marketing companies and prices of coal and electricity are adjusted upwards by a moderate 10 per cent each, the direct impact would increase wholesale price index (WPI) by 4 percent. This suggests the persistence of fiscal dominance of monetary policy.

In terms of the Fiscal Theory of Price Level (FTPL), fiscal dominance occurs in a weak or a strong form. In the weak form, fiscal dominance occurs when money growth rises to accommodate fiscal deficit and so exerts upward pressure on inflation. In the strong form, even if the level of money supply does not change in response to the fiscal gap, the latter independently raises the level of inflation because of its impact through aggregate demand. The weak form suggests that a central bank cannot target inflation because it cannot control money supply under the fiscal dominance. The strong form implies that inflation is not necessarily a monetary phenomenon and fiscal policy instead drives inflation.

A substantial portion of government debt has ended up in the books of the RBI, eventually, even if it is no longer buying them in the primary market. That is the most direct form of fiscal dominance. What would be the benchmark interest rate on government borrowings if RBI had not conducted Open Market Operations to the extent it did, buying government debt in the market or if the Statutory Liquidity Ratio was not at 25 percent but a lot lower? How would lower policy rates have helped? If anything, it would have dented credibility of the Central Bank to lower rates when fiscal policy has remained reckless. No economist should commit the folly of recommending a loose monetary policy to go along with reckless fiscal policy. Remember that the core CPI inflation rate is still 8.2 percent.

Given, as Dr Bhalla has written, that India has the worst fiscal policy outside of Venezuela, what is the fair compensation on Indian government debt? Should it have been 7 percent that prevailed until recently? Had the government debt been priced fairly in a proper market, where would other lending rates have been? Private market interest rates would have been much higher, with or without the central bank tightening monetary policy. Fiscal populism and fiscal cronyism of the last nine years lie at the root of India’s present economic (and other) woes.

In fact, in a show of restrained candour, the aforementioned chapter has this to say on the fiscal roadmap unveiled last summer/autumn: The road map does not sufficiently address the issue of quality of fiscal consolidation. There has been over-dependence on non-durable resources of revenue, inadequate pruning of subsidies and undesirable reduction in capital spending as part of this fiscal consolidation strategy.

Whether or not RBI monetary policy is effective against structural drivers of food inflation, what would have been the incentive for Indian savers to keep money in Indian banks had the rates been lowered? Already, they are voting with their feet buying gold since the real value of their savings is being eroded daily. By cutting interest rates as Dr Bhalla advocates, if RBI had rendered the real return on such savings more negative (remember even if the GDP deflator is around 5.8 percent, the consumer price inflation rate is now 9.8 percent and that is the inflation rate households face), what would have happened to bank savings deposits? Would they not have rushed for the exit and into gold?

The tight liquidity faced by the market thanks to the colossal increase in government borrowings in the last eight years would have become even tighter, forcing the RBI to conduct more OMOs and provide more liquidity and generate more inflation in the process. One cannot imagine a surer method than this to lose the confidence of the domestic population and foreign investors.

If there is a counter-argument that lower rates would have set in motion a virtuous circle of higher capital formation, higher growth, higher stock market returns and hence resulting in diminished need to seek gold, all that one has to do is an honest reality check of such a scenario emerging under this government.

Let me quote what Mr Ratan Tata said few days ago: “The government has issued policy which vested interests, quite often in private sector have changed, delayed or manipulated that policy. So, for one reason or the other, the government has swayed with those forces,” Tata said.

Yes, India could have enjoyed lower inflation, lower interest rates and higher economic growth but the blame for preventing India from experiencing these has to be on a government that increased its borrowing at an annual rate of 33 percent for eight years. Fiscal deficits, fiscal dominance and the resultant financial repression are the two principal factors behind India’s current economic malaise.

Photo: Niklas Morberg