Background
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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