Unshackling the Indian Rupee

Indian Express November 9, 2024

Recently, there have been several reports about the stability of the rupee against the US dollar. This is typically described as a positive development. But the central bank’s decision to control the exchange rate is in fact deeply problematic.

Admittedly, the Reserve Bank of India (RBI) has always intervened in the foreign exchange market to smooth out fluctuations of the rupee. However, since 1991, the intervention has never been as great as it is today. The data speaks for itself. Over the two decades through 2020, the average annual volatility (that is to say, the movement) of the rupee-dollar (INR-USD) rate typically ran around 5 percent. But between April 2023 and August 2024, the average volatility collapsed to only 1.9 percent, a level that is extraordinarily low not only compared to India’s own past but also to all of its emerging economy peers.

To be clear, if exchange rate stability comes about as a natural outcome of market forces, then it is welcome. For example, the euro-dollar exchange rate is one of the most stable in the world, not because their central banks regularly intervene in the market—they do not—but because a vast number of players are freely able to take money in and out of these financial markets, creating huge but roughly balanced cross-border movements of capital which in turn keep the exchange rate stable.

The rupee's recent stability, however, has not been driven by market forces. On the contrary, it has come about due to an apparent change in the RBI’s currency policy. Since late 2022, the RBI has decided to actively intervene on both sides of the foreign exchange market, on some days buying dollars to prevent the rupee from appreciating and on other days selling dollars to prevent the rupee from depreciating. It is only a small exaggeration to say that without any announcement or public debate, the rupee has become pegged to the dollar.

There are several fundamental problems with this change in currency policy.

To begin with, it goes against basic economic principles. In any country that aspires to reach the ranks of the developed economies, the price of any good, service or asset should not be determined by the State. Just as we do not want the price of tomatoes or computers or restaurant meals to be fixed by the State, it is not a good idea to fix the price of the rupee either. The price should instead be left to the market.

This is because the price system in a market economy performs a crucial function: it conveys information about demand and supply to buyers and sellers, who can then adjust their behaviour accordingly. For example, a high price signals to sellers that they should supply more, while telling buyers that they should hold off on their purchases. As each group responds to this signal, demand is gradually brought into balance with supply.

In contrast, when the State sets the price, the information system gets distorted. One only needs to look at India’s own history to see what can go wrong. In the pre-1991 era, controlled prices led to shortages of nearly every major good that people wanted to buy, such as cars or telephones. Most scarce of all were imports, which people could not obtain easily because the pegged exchange rate led to shortages of foreign exchange. Ultimately, these problems led to the crisis of 1991, when the entire system broke down.

This is not a uniquely Indian story. The list of countries that got into serious trouble after pegging their exchange rate is a long one, including major economies such as Argentina, Brazil, Mexico, Russia, South Korea, Thailand, and Turkey. That is why nearly all emerging economies have decided in recent years to free their exchange rates.

So much for theoretical principles. What about practice? After all, sometimes the practical problems of a theoretically-best policy can be so large that it simply needs to be abandoned. But that was not the case here, which brings us to the next problem with the new currency policy: it did away with a long-standing system that was working perfectly well.

The previous flexible exchange rate policy had two practical advantages. First, the exchange rate moved up or down over the business cycle which in turn helped smooth out output fluctuations. During periods of high growth when exports were growing and foreign capital was flowing in, the rupee appreciated which prevented the economy from overheating. And when the economy was in a downturn, the rupee depreciated, making Indian goods and services more attractive to foreigners, thereby promoting an export-led recovery.

Second, because these ups and downs balanced each other out, over long periods there was stability in the real exchange rate, that is the exchange rate adjusted for the difference in inflation between India and its trading partners. In contrast, the new inflexible system has already led to a significant real exchange rate appreciation, thereby making India’s exports more costly to foreigners, and potentially undermining the Make in India drive.

All these bring us to the final problem, namely the lack of transparency. The central bank seldom communicates about its currency policy. As a result, it is not well understood why the RBI felt the need to break with a long-standing practice and bind the rupee so tightly to the dollar. It is also not clear whether this is a temporary policy or a more long-lasting change.

Consequently, private sector participants in the foreign exchange market are confused. They need to guess when they see imbalances in the market, such as capital flows exerting pressure on the exchange rate. Will the central bank intervene to prevent the exchange rate from moving? If so, when or by how much or in which direction? No one knows. So, they do not know how to respond.

The exchange rate is the most important price in a market economy. If India wants to become a high- income economy, the exchange rate needs to be able to respond freely to market forces, sending appropriate signals to market participants. If instead the market gets distorted merely to stabilise the currency, this may prove costly in the long-run.

Why going back on inflation targeting could erode credibility of RBI

Indian Express September 24, 2024

Should India modify its inflation targeting (IT) framework, or even abandon it completely? Several commentators have raised this question recently, ahead of an official review of the monetary policy framework due in March 2025. Without doubt, periodic policy reviews are important – that’s why they are mandated in the IT law. And it’s also true that policies can always be improved. But the big picture needs to be kept in mind, which in this case is that IT has succeeded beyond expectations, making it one of the most important reforms of the last decade. Going back on this reform or making substantial changes to "loosen" the framework would erode the credibility of the central bank, damage the economy, and backfire in a political sense. Let’s consider how.

Before going into the debate, it is important to recognise what the upcoming review entails. According to the amended RBI Act, "the Central Government shall, in consultation with the Reserve Bank of India, determine the inflation target in terms of the Consumer Price Index, once in every five years". Strictly speaking, this refers to the numerical target of 4 percent with a band of plus or minus 2 percentage points on either side. However, this instruction can also be interpreted more broadly. Hence, the debate triggered by the Chief Economic Advisor needs be taken seriously. If some of the changes proposed are adopted – in particular, the suggestion that the RBI target only a subset of the CPI, excluding food prices--they would soon have enormous impact on the public.

Three points are worth noting in the context of this debate.

First, it is important to remember why IT was implemented in the first place. During 2009-2012, the UPA-2 government let inflation go out of control. CPI inflation reached 15 percent in March 2010, the highest among all the major G20 countries. And yet no one was held responsible, because the RBI was following a “multiple objectives” approach, under which it wasn’t firmly committed to any particular target. The resulting public outcry was so strong that the UPA was voted out of office (for this and other reasons) and a new government voted in, which pledged it would not allow such an episode to occur on its watch. To make this promise concrete, it enshrined IT into law.

Second, the reform has proved successful, far more so than many people anticipated at the time IT was adopted. The RBI has generally kept inflation within the 4-6 percent band; even when inflation has breached the upper limit, the deviations have been modest. Notably, inflation has never gone back to double digits, despite the serious food, oil, and pandemic shocks of the last few years.

Third, this success has brought benefits, both economic and political. Price stability has helped fuel growth, because it has allowed businesses to plan without worrying too much that their projections will be upset by surging costs. It has also reduced interest rates because it has improved central bank credibility, meaning that the RBI no longer needs to raise interest rates by as much as it did in the 2010s to convince people that it is serious about tackling inflation. Recent research conducted by Vaishali Garga, Aeimit Lakdawala and myself shows that market participants view RBI’s commitment to IT as credible. And price stability has paid political dividends, or at least allowed the NDA to avoid the political costs of high inflation suffered by the UPA.

But what about the argument that the RBI should narrow its target, to exclude food prices which it cannot control? The problem is this is a theoretical argument. And in the end, the theoretical points are not relevant. After all, the purpose of a government is to provide services that the public needs and desires. And the Indian public has made it clear that it desires price stability. Not for a subset but for its entire consumption basket, especially including food. Put another way, there’s a reason why all major central banks target inflation. And there’s a reason why they all include food in their target indices. Because it is what the public wants, indeed demands.

That said, there are indeed theoretical factors that the RBI cannot ignore. Central banks worry about rising food prices because of what is referred to as “second-round effects” such as the spillover of food inflation to non-food inflation through a wage-price spiral. Workers faced with higher food prices, demand higher wages in order to compensate for their rising cost of living and this in turn pushes inflation up even more. Some commentators have argued this consideration does not apply in India, noting that recent food price increases have not had any spillover. That may be true, but again is irrelevant, as it confuses the particular for the general.

In recent months in India, declining core (non-food, non-fuel) inflation implies that the second round effect is weaker right now. This is because there is pervasive unemployment in the economy. When there is surplus labour or a lack of adequate jobs, as is the case now in India, the workers are not in a good position to demand. They have less bargaining power to demand higher wages when food prices go up. In such a situation the wage-price spiral may not get triggered and hence we are not seeing steep increases in non-food inflation. But in the mid 2000s when the economy was booming and the labour market was tight, high food prices set off a wage-price spiral. This situation could easily recur if the economy grows rapidly over the medium-term, in which case changing the framework to tell the RBI to ignore signals from rising food prices could prove disastrous.

What is instead required is for the RBI to strengthen its analytical framework, given that its inflation and growth forecasts have frequently been subject to large errors. This in turn requires improving the underlying data, especially the CPI and GDP, which are outdated and have methodological issues. And it also requires a better understanding of agriculture, to assess whether food inflation is temporary or a reflection of some deeper, structural issues.

Implementing reforms in a messy democracy like India requires years of work and discussion. Even after a decade, the IT framework is still in its nascent stages and is being put to test by various shocks. It’s important to let it mature, making incremental rather than major changes that would endanger the overarching goal of price stability. As they say: if it isn’t broken, don’t fix it.

Why RBI’s attempts to control the Rupee can have adverse consequences

Indian Express August 24, 2024

The Indian rupee follows a managed floating exchange rate regime. This means that the central bank intervenes in the foreign exchange market to buy or sell dollars in order to stabilise the value of the rupee. In recent times, however, the RBI seems to be using its regulatory powers to gain greater control over the rupee. We argue that currency management must not entail the use of regulations. The purpose of regulations is to address market failures. Currency volatility is not a market failure — it is the fluctuation of the currency in response to demand and supply forces. The use of regulatory powers for currency management introduces uncertainty in the central bank's currency policy, and also increases the cost of doing business in RBI-regulated sectors. We discuss three such regulatory measures and the problems associated with them.

First, prohibiting speculative trades on exchanges. This exacerbates the difficulties of taking rupee exposure in India. In 2008, the RBI allowed Indian exchanges to launch a currency derivatives segment. At that time, the RBI’s guidelines on currency Futures and Options allowed Indian residents to participate in this market "to hedge an exposure to foreign exchange rate risk or otherwise". While the RBI continued to prescribe the product design, position limits, and trading hours, the general trend was towards opening up this market. The idea was that as India became more globally integrated, the demand for such instruments and for liquidity in the derivatives market would increase. At some point, the 2008 guidelines were overtaken by several circulars, with the last version issued in 2016 having been amended at least 11 times. These regulations explicitly allowed taking positions in rupee-linked currency derivatives up to $100 million across all exchanges, ``without having to establish existence of underlying exposure".

Earlier this year, however, the RBI explicitly mandated exchanges to inform users that they "should be in a position to establish the existence of a valid underlying contracted exposure, if required". This warning compelled the bulk of retail traders to wind up their positions as a result of which trading volumes collapsed by about 80 per cent across all exchanges. This regulatory measure essentially restricts speculators from trading in the onshore rupee market. It overlooks the fact that a liquid market requires all kinds of traders, including speculators, who act as de facto market makers. This move is an irreversible blow to a reasonably liquid market, which allowed hedgers to take positions on the rupee at low costs. It is likely to drive away volumes to the offshore currency derivatives market.

Second, regulating offshore trading platforms. The RBI proposed to regulate offshore electronic trading platforms (ETPs), which facilitate rupee-linked derivative transactions. Published on its website in April 2024, this proposal seeks to empower the RBI to oversee the offshore currency forwards market, commonly called the non-deliverable forwards (NDF) market. The NDF market allows people to trade in the rupee without undertaking any physical delivery of the currency, thereby reducing the cost of trading. In the last few years, the rupee NDF market has grown substantially in size, and is now reported to be almost thrice as large as the onshore market. This has led to concerns in the RBI that the offshore market, over which it has no direct oversight or control, could be playing a significant role in determining the rupee’s value. The recent regulatory proposal requires ETPs to register themselves with the RBI, and confers fairly extensive powers on the central bank, such as the power to refuse registration, seek information, specify "eligible instruments" that Indian residents may trade in, and impose additional terms and conditions.

Legally, the RBI can restrict Indian entities’ rights to deal with non-residents or to transact in foreign currencies, but it is a jurisdictional leap to regulate offshore platforms on which Indian residents trade. This is akin to Sebi asking the New York Stock Exchange to register with itself, simply because Indian residents trade at these venues. Instead of expanding its regulatory powers, the RBI must make it easier for people to trade the rupee in India. This will help bring back rupee linked trading volumes and allied businesses onshore.

Third, the RBI's instructions to banks. Earlier this month, when the rupee-dollar exchange rate depreciated close to the 84 mark in the spot market, the RBI is reported to have orally instructed some large commercial banks to not add to their existing trading positions against the rupee. This step seems to have been taken to stem further rupee depreciation. On August 16, the RBI similarly instructed banks that handle trade with the United Arab Emirates to partially settle their trade payments using rupee instead of the dollar. This means that banks should directly convert rupees into dirhams and vice versa without first converting them into dollars. One objective of this move seems to be to reduce dollar dependence in international trade. But settling trade in rupee also helps insulate the currency from the impact of dollar outflows, that is, lower the extent of rupee depreciation against the dollar. In other words, this is yet another regulatory measure that helps to manage the currency.

Notwithstanding the debate on the costs and benefits of a "managed" currency for an emerging economy like India, the RBI must not seek to manage the rupee’s volatility through an indiscriminate expansion of its regulatory powers. Regulations are the rules of the game. Unlike market operations that involve central banks buying or selling the currency in the foreign exchange markets, changes to the rules of the game can have a more permanent, damaging effect on the incentives and the costs of doing business in the country.

Budget Hits and Misses

Indian Express July 27, 2024

The Union Budget presented yesterday was expected to set out a roadmap for the country’s growth and development. Did it live up to expectations?

To answer this question it is important to understand the economic context in which the Budget was presented. Despite official data showing that the Indian economy grew at 8.2 percent in 2023-24, evidence suggests a worrisome slowdown in aggregate demand. Concerns have already been expressed about consumption. In 2023-24, private consumption is estimated to have grown by a mere 4 percent, a steep decline from the 11 percent growth rate in 2021-22 when the economy was recovering from the pandemic. Much of this slowdown can be attributed to economic distress in rural India.

In addition, the two biggest drivers of growth, private investment and exports have not been performing well. The government has consistently increased its spending on infrastructure since 2020-21 in the hope that this would “crowd-in” private investment. However private investment continues to be weak, with no sign that things are going to turn around any time soon. In fact new project announcements (as measured by CMIE) have been declining since September 2023, suggesting that private investment might even start falling. The news is not great on the exports front either. Merchandise exports fell by 3 percent in US dollar terms during 2023-24. While services exports have been doing better, they have also slowed considerably.

The demand slowdown has created a jobs crisis, perhaps the biggest challenge confronting this government. By June 2024, India’s unemployment rate had increased to 9.2 percent according to CMIE data, up from 8 percent in 2023.

The ask from the Union Budget therefore was a policy framework that would encourage the private sector to expand capacity, generate employment and thereby pave the way for sustained, rapid growth. This growth strategy had to be accompanied by fiscal consolidation to bring down deficits and debt levels that have been running high since the pandemic.

Analysed against this ask, the Budget was characterised by both hits and misses.

From the macro stability perspective, this Budget exceeded expectations. It reduced the projected fiscal deficit for 2024-25 to 4.9 percent of GDP from 5.1 percent announced in the interim budget earlier. As a result, the government is now in a better position to achieve its long-stated goal of reducing the deficit to less than 4.5 percent of GDP in 2025-26. The Budget also improved the quality of government expenditure, increasing the share of capital expenditure in total expense to 23 percent in 2024-25, from 12.5 percent in 2019-20. This is the highest share of capex in 3 decades.

From the growth perspective the government, perhaps for the first time, acknowledged the problems in the Indian economy, albeit indirectly. The government's concerns showed in the announcement of a slew of measures targeted towards agriculture, employment, skilling, MSMEs, and even the tweaks in the direct tax regime. The concerns were also reflected in the decision to keep capex unchanged at Rs 11 lakh crore, the same level as the interim budget. Had the economy truly been growing rapidly, there would hardly be a need for the government to continue to stimulate it, especially given the fiscal constraints.

Having said that, the Budget did not outline an economic strategy to tackle the problems nor did it lay out an economic vision for the next few years. Instead, the plan seemed to be to address the deeper structural problems using schemes. It is not clear how these schemes will solve the problems, or even, how they will really work.

For instance, one of the main Employment Linked Incentive schemes is to give Rs 15,000 to new employees in the formal sector. It is not clear who is the targeted beneficiary of this incentive given that availability of formal sector jobs itself is a big problem. Likewise, reimbursing employers for their EPFO contributions on new employees for two years (upto Rs 3,000 per month) is likely to have only a marginal impact on the cost to companies and hence on job creation.

The other schemes also seem too small to address the problems. In the agricultural sector, the budgetary allocation for NREGA was kept unchanged at the same nominal level as in the interim budget, even though the rural economy is in significant stress. The tweaks in the direct tax slabs under the new tax regime are also likely to have only a marginal impact on household demand. Similarly, the Budget announced that additional tribunals would be set up to speed up resolution under the Insolvency and Bankruptcy Code (IBC, 2016), even though the real problem lies in staffing of the existing tribunals.

A glaring gap in the budget was a lack of mention of privatisation. PSUs have been witnessing high valuations in the stock market making it an opportune moment to sell them off to interested buyers. This could also help boost private investment. A good example of this has been Air India privatisation where the new owners have been making huge investments to turn around the company.

Another big miss was not providing a strong fillip to merchandise exports and making the most of foreign demand for goods, given sluggish domestic demand. The Budget did announce reductions in customs duties for some items but given the state of the economy, the need of the hour was a major reversal of the protectionist stance adopted since 2015 by significantly lowering import tariffs, dismantling trade barriers, and signing free trade agreements with major trading partners.

In summary, the Union Budget scored well on fiscal stability but could have done better by setting out a well-defined growth strategy. The Finance Minister did mention that the government is working on some fundamental, structural reforms without mentioning any details or timelines. We can only hope that these reforms will demonstrate that the government has a better grasp on the economy’s underlying problems.

RBI’s surplus: To spend or not to spend

Indian Express July 4, 2024

With a new government at the Centre, the economic policy discourse has now shifted to speculating about the Union Budget for 2024-25. This year’s budget is especially important for one specific reason. In an unexpected turn of events, the RBI announced last month that it is transferring a sizeable dividend to the government, significantly more than what was anticipated. This has triggered much discussion about how the government can spend this windfall. We need to ask a more fundamental question: Should the government spend it at all?

Fiscal management should be guided by two general principles. First, deficits should be kept at prudent levels. In India, that level should ideally be around three per cent of GDP for the Centre according to the long-standing Fiscal Responsibility and Budget Management (FRBM) Act. Second, governments should spend a bit more than this norm when the economy is doing badly and a bit less when the economy is doing well.

The purpose of varying the deficit, as specified by the second principle, is to stabilise the economy. In bad times, when private sector demand is falling, the government needs to step in and boost demand to prop up the economy. The needs are reversed when the economy starts to recover. As private demand revives, the government needs to curtail its spending lest overall demand races ahead of supply, fostering inflation. A critical aspect of this second principle is that policies must be symmetric. Larger-than-normal deficits need to be followed by smaller-than-normal deficits so that government debt gets stabilised instead of spiralling upwards.

Following these two principles can keep a country out of debt problems while stabilising the ups and downs of growth cycles. That is why these principles are followed in prudent countries all over the world.

But not in India. Here, governments have always struggled to spend within their means, irrespective of whether the economy is slowing or booming. In the 20-year period from 2000-01 to 2019-20, the average fiscal deficit of the Centre was 4.6 per cent of GDP, much higher than the three per cent medium-term target set by the FRBM Act.

During the pandemic, the deficit shot up to 9.2 per cent of GDP in 2020-21, a large increase but a reasonable one, considering the size of the shock to the economy. But curiously even after the economy recovered, the deficit has been slow to come down. In the Interim Budget presented earlier this year, the Finance Minister announced that the government was targeting a deficit of 5.1 per cent for 2024-25. In other words, three years after the pandemic ended, the deficit is still higher than the pre-pandemic levels, and nowhere close to the FRBM norm.

For this reason, a standard way for economists to assess the success of monetary policy is by looking at core inflation. If core (that is, underlying) inflation is close to the target, it suggests that monetary policy is doing its job of controlling demand, notwithstanding any temporary deviations caused by flare ups in food or commodity prices. For instance, in the US, after several quarters of aggressive monetary tightening, headline inflation has cooled down quite a bit. Annual inflation in the US fell to 3.1 per cent in January, compared to 6.4 per cent a year ago. However, core inflation continues to be sticky and has been rising more than expected. Also, wages in the services sector have been persistently high. Both these indicate that demand conditions remain strong, thereby causing the US Fed to delay rate cuts.

Since the Centre has been slow to reduce its deficit, India’s fiscal metrics have deteriorated. The consolidated central and state government deficit is now around 8.5-9 per cent of GDP (compared to the six per cent recommended by the FRBM Act). Total government debt has been more than 80 per cent of GDP over the last few years, compared to an average of 74 per cent in the period from 2010-11 to 2019-20.

It is against this background that the RBI announced last month that it will transfer Rs 2.11 lakh crore to the central government as dividend, double the amount that had been budgeted. The crucial question now is: What should the government do with this unexpected bounty?

According to some commentators, the government should increase its capital expenditure (capex). As per the Interim Budget, the capex growth rate is supposed to slow down in 2024-25. But now with this surplus dividend, the government may be tempted to step up its capex spending. That would be a mistake.

The general sentiment in India seems to be that any spending on capex is great news. This is not correct. Look at China, for example. As part of their infrastructure building spree, they built two to three airports in the same city and are now struggling to repay the debt that was incurred for these projects. What is therefore needed in India is to calculate how much capex is truly needed and of what kind.

Governments spend on capex for two reasons: To stimulate growth and to meet the needs of the economy. Let’s address the second criterion first. Infrastructure in India is definitely a problem that needs to be solved. But not all at once. Since the pandemic, the government’s capex spending has been growing at an average annual rate of 30 per cent. It is not obvious that this pace needs to be increased, or even sustained. On the contrary, recent developments demonstrate that the speed of construction — and focus on new projects, rather than maintenance — has serious downsides.

In addition, not all capex is essential for growth. For example, using Rs 1.6 lakh crore to revitalise telecom MTNL and BSNL is surely not critical, especially when affordable cellphone services are being provided throughout the country by private operators. Likewise, it is not obvious that spending lakhs of crores on bullet trains can be justified in a country whose per capita income is less than $2,500.

Regarding the first criterion, we have to ask the question again: Why does the government need to stimulate an economy that is doing so well? Given the strong economic performance, it should instead use the surplus dividend from the RBI to bring the fiscal deficit down closer to three per cent.

There is, however, a caveat to this discussion. And this relates to the true state of the Indian economy. What if the economy is actually weaker than what the 7-8 per cent growth figures suggest? Then there may be a case for the government to keep spending to support the economy.

There seems to be a lack of consensus on this fundamental point. If the economy is not doing very well, then we should not be surprised if the budget uses the surplusdividend to announce a further increase in infrastructure spending.

Inflation is under control. What’s next?

Indian Express February 20, 2024

Recently released data reaffirms that inflation in India is much less of a problem now than it was a year ago, in part, thanks to the monetary policy stance of the RBI. But what is the right policy going forward? The answer is not obvious — perhaps not even to the RBI.

Over the past three years, India experienced high and persistent inflation. Between April 2021 and September 2022, the wholesale price index (WPI) inflation averaged 13 per cent, the highest in more than a decade, triggered by the pandemic disruptions and the Russia-Ukraine war. Surges in wholesale prices normally suggest “inflation in the pipeline” and indeed, they soon translated into high retail inflation. During the first three calendar quarters of 2022, consumer price index (CPI) inflation averaged 7 per cent. Even excluding the rise in food and fuel prices, core inflation still hovered above 6 per cent for nearly every month from May 2021 to March 2023.

The persistence of core price pressures implied that high inflation had become embedded in the system. It seemed as if inflation had become the Achilles heel of the Indian economy’s recovery from the pandemic. Since then, the inflation dynamic seems to have changed. Starting April 2023, wholesale price inflation turned negative. According to the latest data, headline CPI inflation fell to 5.1 per cent in January 2024, the lowest in three months. With this, inflation has now been within the RBI’s tolerance band of 2 to 6 per cent for five consecutive months. Even more striking, core inflation came down to only 3.6 per cent in January, its lowest rate since the start of the pandemic. While there is still some way to go before the target of 4 per cent can be achieved on a sustained basis, it now seems much closer than it did two years ago.

This remarkable achievement can clearly be attributed to two factors: RBI’s dogged pursuit of a tight monetary policy and the softening of commodity prices.

However, going forward, the conduct of monetary policy might get complicated owing to a set of puzzles. To understand this, we need to consider how monetary policy gets transmitted to the wider economy. Let’s revisit the basics.

When the RBI pursues contractionary monetary policy, it gets transmitted to the rest of the economy through financial intermediaries such as the banking sector. In response to the RBI’s hikes in the policy repo rate, banks promptly raise their lending rates and eventually, their deposit rates. The rise in the bank lending rate increases the cost of borrowing. As households and businesses borrow less, they also spend less which in turn weakens demand. Additionally, as deposit rates go up, households find it more attractive to deposit their savings in the banks, rather than spending it in the shops. As a result, both consumption and investment start slowing. And as aggregate demand starts falling, prices start coming down, assuming that there are no disruptions on the supply side. In other words, monetary tightening operates by weakening demand, thereby slowing down both GDP growth and inflation.

For this reason, a standard way for economists to assess the success of monetary policy is by looking at core inflation. If core (that is, underlying) inflation is close to the target, it suggests that monetary policy is doing its job of controlling demand, notwithstanding any temporary deviations caused by flare ups in food or commodity prices. For instance, in the US, after several quarters of aggressive monetary tightening, headline inflation has cooled down quite a bit. Annual inflation in the US fell to 3.1 per cent in January, compared to 6.4 per cent a year ago. However, core inflation continues to be sticky and has been rising more than expected. Also, wages in the services sector have been persistently high. Both these indicate that demand conditions remain strong, thereby causing the US Fed to delay rate cuts.

Now let’s turn to what’s been happening in India.

Between May 2022 and April 2023, the RBI raised the policy repo rate by 250 basis points. Since then, it has held the repo rate constant at 6.5 per cent. In response, the weighted average lending rate in the banking sector has gone up by less than 200 basis points while the average deposit rate has gone up by more than 200 basis points. Even though the transmission remains incomplete, the resultant decline in demand seems to have started softening prices. This is evident from the decline in core inflation in recent months and from the RBI’s latest forecast, which shows that CPI inflation will come down to 4.5 per cent in 2024-25, much closer to the target. So far, so good.

The story however gets confusing if we look at the RBI’s GDP growth forecast. The economy is expected to grow at 7 per cent in 2024-25 amidst a slowing global economy, implying that domestic demand will be quite strong. This raises a set of puzzling questions: If indeed monetary policy is slowing demand down and cooling off inflation, how can GDP growth continue to be high? Alternatively, if demand will somehow be strong next year, then why would inflation continue to fall?

The recent MPC statements are silent on this. In particular, they do not mention the lagged impact of tight monetary policy on the growth outlook. This seems like an important omission especially since the passthrough is not yet complete and will most likely continue to work through the system over the next few months, thereby further dampening demand.

Given that the legal mandate of the inflation targeting framework is``price stability with an eye on growth", these puzzles need to be resolved before the RBI can figure out the appropriate stance of monetary policy.

Consider the following: If indeed the economy is expected to perform well in 2024-25, there is no imminent need for a rate cut. We may even see a resurgence of inflation, given that demand conditions are predicted to remain strong. If, however, the underlying demand conditions are weakening, then a rate cut may be needed sooner. After all, the last thing a slowing economy needs is a tight monetary policy. It will be interesting to see how monetary policy responds to this conundrum.

The what-if of growth

Indian Express February 2, 2024

In the run-up to the Union interim budget presented by the Finance Minister on 1 February 2024, the three pertinent questions in the policy discourse were: i) would the government stick to the tradition of an interim budget and refrain from making any major announcements? ii) would they continue on the path of fiscal consolidation and if so, at what pace? iii) would their fiscal consolidation roadmap be based on reasonable assumptions? The answer to the first two questions has been a resounding yes. The budget has ticked all the right boxes and prioritised fiscal prudence. The third question merits a deeper analysis.

Interim budgets are presented close to a national election. Unlike a full term budget, an interim budget does not usually contain new expenditure plans or new taxation proposals; instead it is an interim measure to keep the current government going for one more quarter before the elections take place. Sticking to tradition, the FM presented a ‘vote on account’ budget and did not announce major schemes or tax changes.

This strategy allowed the government to fulfil its promise of fiscal consolidation. For the past few years, the central government has run a fiscal deficit much higher than the 3 percent medium term target set by the Fiscal Responsibility and Budget Management (FRBM) Act of 2003. This was necessary and inevitable during the pandemic period. But given that the economy has been growing rapidly, it makes little sense for the government to keep running a high deficit. The government too has clearly reiterated its commitment to achieve fiscal consolidation. This is of crucial importance because persistently high fiscal deficits create a number of problems. At the most basic level, they raise concerns about financial and macroeconomic stability, and can be detrimental to the economy’s growth. At a more day-to-day level, they increase the government’s indebtedness.

Since the pandemic, India’s debt to GDP ratio has been 80-85 percent, compared to the long-term average of 65-70 percent. This has two adverse consequences: it crowds out borrowing by the private sector by raising their cost of borrowing in the bond market, and it also increases the government’s interest expenses. On average, roughly 40 percent of the non-debt receipts of the government has been going towards interest payments on debt. Bringing the fiscal deficit down is therefore needed to also create more room for the government to spend during future crises.

Hence, an important question was whether the government would continue on the path of fiscal consolidation that it had embarked upon in 2022-23.

In this respect the interim budget not only met but exceeded expectations.

It is important to recognise the achievement here. It is true that the fiscal math for this 2023-24 was helped by robust direct and indirect tax collections. But on the other hand, nominal GDP growth rate at 8.9 percent has been markedly lower than the government’s estimate of 10.5 percent. Despite this challenge, the Finance Minister announced that this year’s fiscal deficit would be held to 5.8 percent, against the targeted 5.9 percent. This was largely facilitated by lower than budgeted capital expenditure and high growth in non-tax revenues (including surplus cash transfer from the RBI and dividend payments by public sector enterprises), which pushed up non-debt receipts.

Even more striking, the budget projects a fiscal deficit of 5.1 percent for 2024-25, implying a 0.7 percent reduction from this year’s deficit. Given that most analysts were expecting the fiscal deficit target for 2024-25 to be around 5.5 percent, this is a positive surprise. One particularly welcome reason is that the government resisted announcing populist measures to appease specific electoral constituencies, even though elections are round the corner. But there are two other critical parameters.

The interim budget assumes that the tax revenues for 2024-25 will continue to exhibit a strong growth. And it assumes that capital spending will slow sharply. A crucial question then, is: how credible are these assumptions?

Start with revenue. Between 2022-23 (actuals) and 2023-24 RE, tax receipts grew at 10.8 percent. This is expected to increase to 11.9 percent between the RE of 2023-24 and BE of 2024-25.

It is important to understand that the robust growth in tax revenues in the last year was the result of two windfalls, both of which are likely to be temporary: a boom in service sector exports and a decline in commodity prices. The first phenomenon sharply increased the incomes of individuals associated with Global Capability Centres (GCC) and consulting services, thereby expanding the income tax base and giving a boost to direct tax revenues. It also pushed up indirect tax revenues because high income earners began spending more on high-value items that carry higher GST rates, such as luxury cars, SUVs etc.

The second phenomenon, the fall in commodity prices, led to the expansion of corporate margins, boosting profits and thereby corporate income tax revenues. There is no reason to expect both these phenomena to continue in a similar fashion in 2024-25 as well. In fact, services exports have already been plateauing and corporate margins are narrowing.

The other important factor backing up the 5.1 percent deficit projection is the drastic reduction in capital expenditure. From an average year on year growth rate of 30 percent or more over the last three years, the interim budget announced that capex spending by the government will grow by only 16.9 percent in 2024-25 compared to the RE of 2023-24. With the drastic reduction in government capex, the drivers of growth for the Indian economy might be called into question, given that private investment is still moderate and an exports boom is unlikely amidst a global slowdown.

Summing up, if the tax revenue growth for the next fiscal is not as strong as expected, the onus of the 0.7 percent reduction in fiscal deficit will fall on capex, as well as another sizeable transfer of surplus from the RBI to the government. This also implies that there is no room left for the government to incur any additional spending in 2024-25.

While the interim budget has checked all the right boxes, it will be interesting to see to what extent the government is able to adhere to the plan especially when the full budget is presented post elections.