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.

Emergence of a private credit market in India

Emergence of a private credit market in India, Ideas for India, Jan 30, 2024.

On defaulters, RBI prioritises public interest

Indian Express June 20, 2023

On June 8, 2023 the Reserve Bank of India set out a framework for bank settlements with defaulters. This circular has triggered widespread criticism because it covers settlements with fraudulent and wilful defaulters implying to some that the RBI is condoning their crimes. This interpretation is not correct. On the contrary, the point of the circular is to establish safeguards so that public interest is protected when banks make such settlements. That said the circular has once again brought to fore two deeper issues in the Indian banking system: government ownership of banks and weaknesses in regulatory governance.

Let's first understand why this issue has even arisen. Why should banks settle with defaulters?

When there is a default, the primary objective of a bank is to recover as much of the loan as possible. Various options might be available to the bank for recovering the loan. The bank decides which strategy would work best, based purely on commercial judgement. For instance, the bank may want to trigger the Insolvency and Bankruptcy Code (IBC, 2016) against the borrower. Alternatively, in some cases, the bank may decide to pursue a “compromise settlement” wherein the bank and the borrower negotiate a settlement amount. It is wrong to think that the RBI has permitted something unusual. One-time settlements are part and parcel of the business of banking. The RBI has simply given a formal regulatory structure to a standard banking practice.

Some of these settlements can indeed be with wilful and fraudulent defaulters. When trying to recover a loan, a bank should not make any distinction between whether the default is wilful, fraudulent or otherwise. Irrespective of the nature of the default, it is upto the bank to decide whether a settlement is a better and quicker option instead of triggering the IBC or pursuing some other strategy. The sole motivation behind such a decision should be to maximize recovery, as speedily as possible. This will help unlock banking capital that is stuck in the wilful default or fraud categories.

What about the crimes that these defaulters may have committed?

The RBI circular makes it clear that banks should feel free to file cases against fraudulent or wilful defaulters. It explicitly states that banks will undertake settlements “without prejudice to the criminal proceeding underway against such debtors.” This separates the criminality of a particular default case from the commercial aspect of it. In other words, no, the circular does not condone any crimes. But the pursuit of a criminal action against a defaulter should not necessitate suspending commercial judgement. This distinction is vital.

That said, there are some valid concerns. One apprehension stems from the government control over the boards of public sector banks. This creates a risk that the settlement process might be misused to favour politically connected defaulters at the cost of the banks’ commercial interests. This concern may not be wholly without merits, and it is therefore incumbent upon the RBI to allow the commercially prudent decisions and prevent the politically motivated ones. Only time will tell whether the requirements and safeguards laid down by the circular will be sufficient for this purpose.

In addition, there are some broader issues that need to be highlighted.

There is ample anecdotal evidence that private sector banks have been settling with wilful defaulters for a while now. So, if banks have already been doing such settlements and various instructions to this effect have already been issued by the RBI to banks over the years, then one might ask: what was the need for this circular?

The answer possibly lies in the fact that two-thirds of the Indian banking system is owned by the government and public sector banks are more likely to come under the scrutiny of investigative agencies for any action they take. The RBI circular gives these banks the regulatory cover for settlement related decisions. In a narrow sense therefore the circular merely levels the playing field. But from a wider perspective, the fact that a circular needed to be issued underscores the distortions that the Indian banking system suffers from owing to the government ownership of banks. In a fully privately-owned banking system there would be no need for such a circular and the ensuing controversy could have been avoided.

The second broad issue concerns regulatory governance. A year ago, the RBI's Regulations Review Authority 2.0 recommended that the RBI place all draft instructions on its website for stakeholder comments and finalise them after considering the feedback. Exceptions should be made only in special circumstances. There do not appear to have been any special circumstances surrounding the June 8 circular. There were no issues related to financial stability, or fiduciary duty, or confidentiality. There does not even appear to have been any pressing urgency. At the same time, the circular is of great public interest since it applies to entities against whom criminal proceedings are underway.

Hence, the draft circular could and should have been placed on the RBI’s website for public consultation along with a discussion paper clearly explaining its rationale. Concerned stakeholders could have expressed their concerns and the RBI would have had the opportunity to assuage their misgivings by making suitable clarifications to the draft circular before notifying it. That would have saved much trouble for both the central bank and the government.

Banks are commercial enterprises and should be allowed to operate accordingly. In principle, separating a commercial decision such as loan recovery from criminal proceedings against wilful defaulters is a step in the right direction. However the situation in India is unduly complicated because of government ownership of commercial enterprises and gaps in regulatory governance. Future public discourse should focus on these fundamental problems, and not on how banks or RBI could play the role of moral police.

Is the good run of the Indian banking sector over?

Is the good run of the Indian banking sector over?, MoneyControl, June 6, 2023.

Currency withdrawal, TCS will revive uncertainty, not economy

Times of India May 24, 2023

On May 16 the government of India announced that it would impose a TCS (tax collected at source) of 20% on all international credit and debit card transactions made by Indians on their foreign travels from July 1, 2023 onwards. On May 19, the Reserve Bank of India announced that the 2000 rupee notes would be withdrawn from circulation though they would continue to be legal tender. The general consensus seems to be that both these are non-events. They will not impact many people and will not cause any real damage to the Indian economy. These predictions may well prove correct. But the interpretation misses the wood for the trees. We need to take a step back and understand that both announcements are problematic.

First, it is not clear why either of these announcements was necessary. The 2000 rupee note was introduced during the demonetisation episode of 2016 partly as a means to rapidly remonetise the economy till the time that currency notes of other denominations became available. As per the RBI’s recent notification, these notes have served their purpose, and are no longer commonly used for transactions. If this claim is correct, then why was there a need to withdraw them from circulation now instead of letting the notes become naturally redundant over time? The RBI could have simply instructed the banks to stop dispensing these notes.

Moreover, since the notes are not being demonetised and will continue to retain their value, the RBI could have also allowed users to exchange or deposit them over an unlimited period of time, instead of imposing a deadline of September 30, 2023 to do so. It is not clear why this deadline is necessary, nor is it clear why this announcement was sprung as a surprise instead of giving the users and the banks ample notice so that they could prepare for the change. Even if the 2000 rupee notes account for only 10.8% of the total notes in circulation, withdrawing them in this manner will cause inconvenience for many people, especially those in the cash-based informal sector that is still recovering from the devastating impact of the pandemic.

The rationale behind the imposition of TCS is even less clear. If the purpose is to collect information about a few people who are allegedly spending large amounts abroad using credit or debit cards thereby bypassing the foreign purchase limit of $2,50,000 permitted under the LRS (Liberalised Remittance Scheme), then this announcement is a disproportionate response because it will end up penalising every Indian who travels abroad to make perfectly legitimate international transactions. This is similar to the demonetisation episode when the entire country was inconvenienced in order to punish a few.

More fundamentally, the Indian economy has benefitted enormously from the liberalisation reforms of the early 1990s. During the last three decades, Indians have undertaken vast amounts of cross-border transactions. A significant percentage of Indians today live in a globalised world where they can easily travel to other countries for leisure or education or business purposes. We need to further encourage free flow of people and money across borders to be able to enjoy the fruits of globalisation. The ability to spend using credit or debit cards anywhere in the world is a critical element of this process. By making these purchases costlier, the recent TCS rule disrupts the financial freedom that a growing number of Indians have come to enjoy over the years, both at an individual level as well as from a business perspective.

Second, it seems ironic that these announcements were made when the country is trying to internationalise its currency, for example by using it to trade with other countries. An important pre-requisite for a currency to become international is people having confidence in it. Frequent withdrawal of currency notes without any prior warnings or increasing the cost of using the currency in other countries dent the credibility of the rupee and move India farther away from the goal of making it an international currency.

Finally, both these announcements come at a time when the Indian economy is struggling to find its feet. Forecasts by major organisations show that the economy is going to slow down in 2023-24. Much of the growth witnessed in the last year was due to the release of pent-up demand once the pandemic related mobility restrictions were fully removed. By now, that pent-up demand is exhausted. The two main engines of growth have also not been performing well. Non-oil goods exports contracted on a year on year basis in the quarter ending March 31, 2023, and private sector investment continues to be sluggish. At such a juncture, it is important for the government to create an environment in which the private sector feels confident to start investing again. Instead, the surprise withdrawal of the 2000 rupee notes bringing back memories of the 2016 demonetisation and the abrupt TCS announcement, undermine confidence in the policy framework. This kind of uncertainty discourages private investment even further.

In order to revive rapid economic growth, it is essential to ensure policy stability and predictability. The two announcements of last week are likely to create the opposite effect. This kind of sudden announcements act as a reminder that the government without any warning can introduce rules that may disrupt investment plans and hamper economic freedom. A proliferation of rules and regulations in this manner may seem non-events at first brush but cause long-term damage to the economy.

Is the RBI’s commitment to inflation targeting credible?

Is the RBI’s commitment to inflation targeting credible?, Ideas for India, May 24, 2023.