Monday, February 25, 2013

Macro Pivot: The Rebalancing of Indian Economy


       The global financial crisis hit India along with many other countries across the World. Liquidity collapsed, World demand for tradable goods and services shrank and growth fell.  As soon as the shock was appreciated, the RBI responded by expanding liquidity and access to domestic funds. Despite the urgings of market analysts, multilateral institutions (World Bank, IMF) and many Indian academics that India had no "Fiscal space," we in Economic Division of  the Finance Ministry advised the decision makers to let the fiscal deficit double to 5% of GDP in 2008-9 to counter the precipitous fall in aggregate demand.  This involved not only politically driven expenditure measures but also temporary reductions in excise duties. The very difficult technical task of explaining this reversal of the signal achievement of the FRBM in 2007-08, a central fiscal deficit of 2.7% of GDP, was left to the chief economic advisor. Despite an even higher actual deficit of 6% of GDP, this was successfully accomplished by convincing financial analysts, investors and the media. A V shaped growth recovery from 3.9% in 2008-9 to 8.5% in 2009-10, led by an increase in the rate of growth of capital formation (investment) from -5.2% in 2008-9 to 17.3% in 2009-10, was the reward for these measures.  Though WPI inflation fell sharply from 8.1%  in 2008-9 to 3.8% in 2009-10, CPI IW inflation rose further from 9.1% to 12.4%, suggesting that retail margins may be expanding because of rising transport costs between the periphery and the Center of urban agglomerations and the rising cost of land and real estate in urban areas.

Fiscal Bubble

Of-setting this achievement in 2008-9, was a failure to convince the bureaucratic and political leadership in 2009 (till my departure in November), that the Fiscal deficit of the Center and the States be brought back expeditiously to below 3% (respectively) as soon as  8% growth was restored. Instead of reversing the temporary excise tax reductions and expenditure/subsidy increases, the deficit rose further to 6.5% of GDP in 2009-10.  This set the stage for a bubble in 2010-11 that raised WPI inflation to 9.6%, CPI IW inflation to 10.4%, and growth of investment and GDP to 15.2% and 10.5% respectively. Though the current account deficit remained at a historically high level of 2.8% of GDP it reached in 2009-10 this was due in 2010-11 to an unbelievable 40.5% growth in exports.  Some of the analysts who had opposed the fiscal expansion in 2008-9, justified the fiscal expansion in 2009-10, and are now again criticizing the fiscal expansion in 2008-9.  It is a serious macro-economic error to think that the best macro policy for India was the same in 2010-11 as it was in 2008-9, or that the best macro policy for India is the same as that for the USA or EU. 

Macro-economic Re-balancing

     The need for re-balancing fiscal and monetary policy has become progressively more urgent since 2010-11.  With a projected fall in the growth rate of GDPMP to 3.3% in 2012-13 and CPI IW inflation stubbornly high at 10%, an immediate re-balancing of fiscal and monetary policy is needed in India.  A macro-pivot, which reduces the fiscal deficit and puts it on a clear downtrend to 3% of GDP accompanied by an equally sharp loosening of the monetary policy.  This will have the effect of reducing demand for non-tradable goods (natural plus artificial like QR constrained agriculture) and to stimulate private investment and demand for consumer durables.  This will help correct the cyclical elements of the problem. 
    Much more policy, regulatory and institutional reform (referred to in the US and EU as structural reform) will be needed to remove sectoral bottlenecks and put the economy on a sustained 8% growth path.

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