The fiscal and the meta-fiscal
Indian Express, 8 December 2008
The government has announced a big fiscal stimulus package. In addition, RBI has taken further steps to reduce interest rates and raise liquidity in the economy. This adds to the number of steps the RBI has already taken to ensure adequate rupee liquidity. However, the contribution that domestic monetary policy can make in averting the slowdown is limited. Apart from the tax cuts which will have immediate impact, fiscal policy is limited not only by the size of the deficit, but even more by the capacity of the government to spend quickly.
The standard macroeconomic policy recipe for a country that faces a downturn, is to ease monetary policy by cutting interest rates and to ease fiscal policy by spending more and taxing less. There are many problems with this recipe in the present Indian context. By and large, RBI has done the right things in terms of ensuring adequate rupee liquidity. From mid-October onwards, RBI has come up with a slew of responses, some unorthodox, which have delivered a call money rate which is within its `LAF corridor' and driven down the short-term interest rate in the economy. The speed and size of RBI's responses have pleasantly surprised the private sector and shown India in good light.
If RBI had made mistakes, and the call rate had persisted at 20%, a financial crisis in private banks and mutual funds would have come about. This has been forestalled. But when RBI cuts rates, the positive impact upon the economy is limited. India lacks the `Bond-Currency-Derivatives (BCD) Nexus'. As we have seen in recent weeks with bank lending rates not coming down, the mechanism through which changes in the policy rate impact other interest rates in the economy. As a consequence, the effectiveness of monetary policy is limited. RBI can and should continue to cut rates, but this does not imply that a lot of interest rates across the economy will necessarily go down in proportion.
The positive contribution of fiscal policy is limited for two reasons. First, India already has a large consolidated deficit. Enlarging the deficit would make private markets more nervous about India's solvency, and drive up the cost of borrowing for Indian firms. Further, even if the money was available, the institutional mechanisms for spending it are weak. Roughly 10 years after the idea of NHDP was first mooted, NHAI processes Rs.12,000 crore a year, or 0.25% of GDP. To spend an additional 1% of GDP in calendar 2009, or roughly Rs.55,000 crore, is not within the capabilities of the government.
What can be done in terms of further policy responses to the downturn?
In a downturn, companies come under pressure. In the short term, sacking workers or closing factories is difficult. Finance plays a critical role in absorbing the difficulties of a downturn. At the same time, the financial sector needs to be discriminating about which firms get help. It is normal and healthy for some firms to die in a downturn. A capitalism in which all firms are protected amounts to socialism for the rich. The brutal competition of a downturn brings out new heights of innovation and cost-cutting from firms -- as was seen in India's last downturn during 1997-2002. In this environment better firms have to be given equity and debt capital. Inefficient firms have to go through sale of assets, restructuring and closure. To make this possible, government needs to rapidly phase out capital controls. This will open up fresh sources of both equity and debt capital. One element of this is placing foreign investment in rupee denominated bonds on par with foreign investment in equities. Another element of this is revamping the FII framework, which has long outlived its utility. The third key area which requires work is opening up fully to private equity. The main reason why removing capital controls is required is to bring foreign capital, and foreign financial firms, into the role of looking at Indian companies and putting capital into the good ones.
India has succeeded in building a strong equity market. But 15 years of work on trying to build a bond market have failed. In a downturn, firms require debt capital. There is an urgent need to move forward on the Bond-Currency-Derivatives Nexus as mapped out by the R. H. Patil, Percy Mistry and Raghuram Rajan reports. More generally, the rigidities and contortions of India's financial regulation will come in the way of the job that finance has to do, of carefully looking at companies and rescuing the good ones. A rapid effort of financial sector reforms, implementing the three committee reports which are at hand, is now urgently required.
The third area for work is optimism and confidence on the part of domestic and foreign investors. India has an investment rate of 38% of GDP of which the corporate sector accounts for 16%. If private corporate investment drops by 10 percentage points of GDP - which is not inconceivable - this will deliver a blow to the macroeconomy. A key goal of government must be to improve the optimism of the private sector. Long term projects should be pushed with further urgency. Roads, freight corridors and other infrastucture projects should be pushed with urgency. Projects such as those with the Japanese, the World Bank should be pushed and greater viability gap funding should be provided. Long term prospects of the Indian economy are still excellent and a positive sentiment can, along with the availability of funds and public sector funding, can help ensure that these continue to be so.
The respect that India gets - in comparison with other countries - will determine whether domestic and foreign investors choose to invest in India. It is, hence, crucial to keep up a rapid pace of economic reform on a wide array of issues. So far, India is looking good. Other countries have made many mistakes such as banning short selling or closing down markets. India must stay the course of doing the right thing, of chipping away at liberal economic reforms, of pushing India forward towards becoming a mature market economy, and thus earn the respect of domestic and foreign investors. Important positive announcements must come out in every single week. This will create a climate of confidence and optimism in which investment will take place in the downturn.
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