The power of prices in times of crisis

Business Standard May 18, 2026

When an economy is hit by a shock—whether a war, or a pandemic—it can adjust in two broad ways: through prices or through administrative controls imposed by the State. Market economies rely primarily on prices. Centrally planned systems depend on bureaucratic allocation. The distinction matters because prices allow millions of households and firms to adjust voluntarily, whereas controls require the State to decide who gets what, and at what price. The current disruptions in global energy markets offer a useful illustration of why this difference matters.

Consider a simple example. Suppose an economy normally consumes 100 units of fuel, but a global disruption reduces available supply to 80. Since supply cannot quickly increase, demand must fall to match it. This can happen in only two ways: either the State forces demand down through rationing and controls, or prices rise and people voluntarily reduce consumption until demand matches supply.

The second mechanism is often far more efficient and less disruptive. Let’s understand why.

First, prices perform two critical functions: they convey information and shape incentives. In many ways, the market is like a giant opinion poll—except people back their views with money. Prices aggregate the decisions of millions of consumers, businesses, traders, and investors into a single signal about scarcity or abundance.

When fuel prices rise people respond by driving less, postponing discretionary travel, or shifting to public transport, while businesses cut wasteful energy use or seek alternatives. Producers receive the opposite signal: higher prices encourage them to increase supply, reroute shipments, or find substitutes.

The alternative is for the State to make these decisions. But this raises difficult questions. If cooking gas becomes scarce, should priority go to households or restaurants? Small eateries or luxury hotels? Should fertiliser subsidies go equally to all farmers or mainly to small farmers?

There are no easy answers because no State can fully understand the preferences of millions of households and businesses. Prices solve this coordination problem more effectively by allowing people to adjust their own behaviour as conditions change. This preserves economic freedom and ensures that decisions about what to consume, conserve, or prioritise are made by those directly affected, rather than by a central authority with limited information.

Secondly, State interventions often create unintended consequences. Export bans on agricultural products can depress farm prices and discourage production, while restrictions on gold imports can lead to shortages, black markets, and smuggling. Artificially suppressing prices may feel comforting initially, but the costs eventually appear elsewhere, often through higher taxpayer burden.

Since the West Asia war began, India’s state-owned oil companies have incurred losses of around Rs 1 lakh crore as fuel prices were kept largely unchanged. In effect, consumers face a trade-off: either reduce fuel consumption today in response to higher prices or pay more than Rs 1 lakh crore in taxes at a future date. Most countries have raised fuel prices since the war started including Malaysia, Pakistan, and Philippines where prices have gone up by 50%. India, in contrast, has adjusted the least, allowing fuel prices to go up by only 3%.

Finally, repeated State intervention can create uncertainty because people stop responding to market signals and start trying to anticipate State actions instead. Businesses delay investment decisions because they do not know what new controls, or bans may appear next. This weakens confidence in the broader policy environment.

Over time, mature market economies have learned to trust prices. After Russia invaded Ukraine in 2022, Europe allowed energy prices to rise, which encouraged conservation, reduced demand, and attracted LNG supplies from around the world, helping avoid a deeper shortage. The US has followed a similar approach during the current West Asia conflict. Despite being largely self-sufficient in oil, gasoline prices have risen by about 45 per cent, allowing the market to allocate scarce fuel more efficiently.

This adjustment mechanism is also transparent and reversible. As supply conditions improve, prices naturally fall back, allowing normal economic activity to resume without the State having to dismantle complex controls and restrictions.

India itself has undergone this learning process gradually over the past few decades. There was a time when people expected the State to determine prices of petrol, steel, or airline tickets. Today, most accept that these prices move with market conditions. Yet large shocks such as wars still trigger demands for intervention. Policymakers increasingly need to recognise that markets are better at determining prices than the State. Where prices remain controlled, such as petrol and diesel, a more effective approach may be to announce future price increases in advance, giving households and firms time to adjust.

Prices are not the problem. They are how economies adjust to shocks. The role of policymakers is not to suppress these signals, but to protect the vulnerable in a targeted manner while allowing the price system to continue doing its job.

Union Budget 2025-26: Many small measures but lacks big ideas

Union Budget 2025-26: Many small measures but lacks big ideas, Ideas for India, Feb 5, 2025.

Budget 2025: Balancing reforms and fiscal consolidation to revive growth

Business Standard January 21, 2025

In less than two weeks, the Finance Minister will present the Union Budget for 2025-26. The budget will be presented against the backdrop of a slowing economy characterised by high levels of fiscal deficit and debt. That means the FM will have to find a way to announce policy initiatives to revive growth while also achieving fiscal discipline. While calls for tax cuts and increased infrastructure spending are loud, this Budget must do a lot more to drive sustained growth.

The two key questions are: What is the diagnosis of the economic slowdown? And what can the Budget do to address it?

Let's tackle the question of slowdown first. The consensus is that the slowdown is temporary, but data suggests otherwise. Barring one quarter, the economy has been slowing steadily since mid-2023, with real GDP growth rate falling from more than 8 percent to under 6 percent in just a year. High-frequency indicators also show that the post-Covid growth momentum is fading, possibly signalling a deeper, structural slowdown.

Before Covid, the economy was already struggling, growing at less than 4 percent in Q4 2019. Post-Covid, many high frequency indicators pointed to the emergence of two different economies within one: an "Old economy" in middle and rural India, and a "New economy" driven by a boom in service exports. The latter was fuelled by the rise of global capability centres (GCCs), mainly US-based, employing high-skilled Indian workers in sectors like Research and Development. The New economy boosted luxury consumption, like SUVs, and sparked a mini-boom in construction. In comparison, the Old economy has been weaker from even before the pandemic, the result of low private sector investment and weak goods exports. Workers in the Old economy have also been getting battered by high food inflation and falling real wages. And now, the New economy is slowing down too, normalizing to a more moderate growth pace. Together, these dynamics are creating a serious demand problem.

How should the Budget address this, while also reducing fiscal deficit? Two things are worth considering.

The Budget should focus on rationalizing expenditure to achieve fiscal consolidation. In February 2023, the FM had set a target to reduce the fiscal deficit to less than 4.5 percent by 2025-26, but this will be challenging in a slowing economy with nominal GDP growth under 10 percent. However, lowering the fiscal deficit is essential for macroeconomic stability, which is key for growth. To achieve fiscal consolidation, the government should reduce revenue expenditure, which includes schemes and transfers, and accounts for nearly 77 percent of total spending. For example, why is it important to provide free food grains to 800 million people annually when there is no pandemic emergency any more?

On the issue of growth, there is a lot of clamour for more government spending on infrastructure. While some infrastructure is needed, it is unclear if this alone will boost GDP growth. For sustained economic growth, a revival in private sector investment is crucial, but public infrastructure spending does not seem to encourage this. Moreover, with much infrastructure already built, the marginal benefits of new roads or highways are diminishing. In short, government infrastructure spending might be a blunt tool for stimulating growth when private sector confidence remains low.

Likewise, tax cuts can boost consumption, but given the limited fiscal space, there is little room for widespread cuts. Moreover, large segments of the Old economy, where falling wages and poor job prospects are hurting demand, aren't even in the tax base. As a result, some tweaks here and there with the tax structure are unlikely to make a significant impact.

To facilitate high, sustained growth, the Budget must revive a key element missing from India’s economic agenda: Reforms. Since the rollout of Goods and Services Tax (GST) in 2017, no major reforms have been introduced. Many say that no new reforms are needed since all the key policy initiatives have already been adopted. But this is not true. There is in fact much that needs to be done.

Given the current economic climate, the Budget could propose liberalizing import tariffs, removing non-tariff barriers where import-dumping is not a concern, scrapping Quality Control Orders that restrict the imports of vital supplies to the manufacturing sector, overhauling the tax system (including residence-based taxation to attract foreign investment), further simplifying the GST, eliminating cesses and surcharges, curbing excessive industrial policy so as to create a level playing field for all firms and incentivising states to do land and labour reforms. Long-overdue regulatory reforms should also be prioritized. The conversation around reforms has faded, but now is the time to bring it back.

This Budget must serve as a blueprint for the government’s long-term economic vision, laying out a comprehensive medium-term strategy to restore private sector confidence. Incremental changes to taxes or spending will not be enough to turn the tide, and the economy will continue to struggle. The time is ideal for a "dream budget" akin to the 1991 reforms that sparked high growth and unlocked significant gains in productivity.

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.

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.

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.

3 potential problems for India's economy

Times of India, March 21, 2023

If 2022 was the year of “heightened global uncertainty”, this year is proving to be no different. Until last week, the US financial system seemed resilient to the aggressive interest rate hikes of the Federal Reserve. That perception has now been shattered. With the collapse of as many as three banks, including the Silicon Valley Bank (SVB) which was the 16th largest bank in the country, cracks have started showing in the US banking system, triggering fears of a possible financial contagion. The macroeconomic repercussions will be felt far away in India, even if our banking system does not immediately face the same kind of problems. How might the US situation play out, and what does it imply for the Indian economy?

The genesis of the SVB episode can be traced to the decisions of the US Federal Reserve during the pandemic period. The Fed lowered interest rates close to zero and injected vast amounts of liquidity. Banks consequently received large volumes of deposits and, invested them in treasury bonds. This meant that many banks, like SVB, whose loans books are much smaller in comparison to their deposits, became dependent on the treasury bonds for earning returns.

This became a problem when the Fed started aggressively raising rates in 2022 in its fight against inflation. As interest rates go up, bond prices fall. As a result, SVB began incurring losses on its bond portfolio. Sensing problems, depositors began withdrawing money from SVB—a classic case of a bank run, which led to its eventual collapse.

The problem, however, is far broader than just SVB. Any bank which has a smaller loan book, a bigger deposit base, and a large portfolio of treasury bonds now faces similar risk. In fact, US banks are currently sitting on an estimated $600 billion in potential losses owing to the erosion of their bond portfolios, on a capital base of $2 trillion. In other words, interest rate risk has eroded about 30 percent of the capital base. Within this aggregate, the distribution varies considerably, with midsize banks facing significantly higher capital erosion, which is why they have been facing runs in recent days.

This has put the Fed on the horns of a dilemma. If it sticks to its current strategy of raising interest rates to curtail inflation, bond losses will only increase, putting more stress on vulnerable banks. Alternatively, the Fed could pause or even start reducing rates, thereby relieving the stress on the banks, but at the cost of worsening the inflation problem. In other words, the important question for the US economy now is: will growing concerns of financial stability deter the Fed from pursuing its goal of price stability?

Irrespective of what the Fed decides, there will still be difficulties for India.

In particular, investors will remain very cautious, and will continue to doubt the financial stability of the midsize US banks – as we have seen over the past week. Things may get even more complicated if there are bank failures in the European Union. EU banks are vulnerable to similar risks given that the ECB has been tightening monetary policy as well. Already, fears of a contagion were running high when Credit Suisse, one of the systemically important banks at a global level, began witnessing rapid fall in its share prices last week. This eventually led to a takeover of the bank by rival UBS, a move orchestrated to calm the financial markets.

Any further bank failure could trigger a system-wide panic, and push depositors away from smaller banks to bigger, more diversified banks thereby precipitating more bank-runs. The resultant uncertainty would lead to heightened risk aversion.

In such an environment of risk aversion, there is typically a flight to safety. This will have important implications for India. There will be a surge in demand for “safe” assets such as gold etc., while the currencies of emerging economies like the Indian rupee will come under pressure as foreign investors flee these markets. The rupee has depreciated a fair bit in the last one year and, this trend may continue.

In addition, risk aversion is likely to dampen sentiments in the US, at a time when concerns about an impending slowdown have already persisted for a while. This may lead to a decline in credit growth and hence consumption, given that a large part of the US consumption is credit-fueled. Simply put, financial market turmoil might cause people to hold back spending. If this takes too severe a shape, then the US economy could fall into a recession, thereby hampering India’s growth prospects through the exports channel. Exports bailed out the Indian economy during the pandemic, but they have now stopped growing and, the situation is likely to worsen if the US goes into a recession.

Finally, if the Fed abandons its fight against inflation, this too will be problematic for India because we end up importing high inflation from the countries we trade with. This would aggravate domestic inflation, at a time when it is already running at 6.5 percent, well above the Reserve Bank of India’s 4 percent target.

The Indian economy has experienced a stuttering recovery from the pandemic. Its medium- term growth outlook remains weak, because private investment continues to be sluggish, exports are declining, consumption demand is lackluster and, the fiscal situation is overstretched. Now, the shockwaves from the banking crisis in the developed world are likely to create further headwinds for India’s growth.

We should consequently gear up for another year of volatility, amidst growing global uncertainty.

SVB crisis has brought the trade-off between price stability and financial stability back into focus

(with Harsh Vardhan), MoneyControl, March 17, 2023

Just as it seemed the world had come to terms with a certain level of uncertainty that was triggered last year by the US Fed tightening monetary policy, the Russia-Ukraine war and the Covid resurgence in China, a new source of uncertainty sprang up over the last few days—financial stability concerns in the US economy as manifested through the collapse of the Silicon Valley Bank (SVB). The shock reverberated through the US stock market with shares of several banks plunging. Some European banks have begun experiencing steep losses in share prices as well. For India, the relevant questions are: can something like this happen here, and what lessons can we learn from this saga?

Several analysts and commentators in India have written extensively about this episode. The general consensus seems to be that, thanks to the business model of Indian banks, the regulatory oversight of the RBI, relatively gradual monetary tightening in India compared to the US, and careful management of the yield curve by the RBI, an event like this is unlikely to occur in Indian banking.

While that may be true, this episode nonetheless offers some important lessons for Indian banking and its regulation.

Market risk in banks: This episode is a rare one where a bank collapsed due to market risk and not credit risk i.e. not due to a rise in non-performing loans, something we have witnessed frequently in India. The total marked to market losses that US banks are currently sitting on owing to the fall in the value of the government bonds in their portfolios, are estimated to be $600 billion on a capital base of $2 trillion, thereby implying that market risk has eroded about 30% of the capital base of US banks. Generally, In India we do not pay adequate attention to market risk in banks. But banks are steadily increasing their holding of bonds (see here: https://www.moneycontrol.com/news/opinion/why-banks-are-buying-more-bonds-6139661.html) which enhances their exposure to market risk. It is high time we started looking at this risk carefully.

Swift resolution: It was remarkable to see the speed with which the authorities acted to resolve the SVB crisis. Within a matter of days, the Fed and the FDIC (Federal Deposit Insurance Corporation) stepped in, evaluated the situation, and reopened the bank under a modified name. The bank is now being auctioned off and will be sold shortly. FDIC also publicly announced that they would bail out all the depositors.

Quick action is critical in the resolution of financial entities to restore public confidence, and prevent a contagion. It requires clearly laid-out laws, and protocols and also institutions empowered to implement them. Else, each resolution is dealt with on a sui generis basis and could lead to inefficient outcomes as is often the case in India. While we now have a bankruptcy law for non-financial companies, we do not yet have a well-defined law for resolution of financial entities. It is also important to note that the FDIC followed the expected pecking order of loss absorptions – they wiped out equity holders, followed by bond holders and saved the depositors. Contrast this with the Yes Bank resolution in India where AT1 bond-holders were written down before equity.

Moral hazard: One action taken by the FDIC however may offer lesson of what not to do. They announced that they would bail out not only the 7% secured depositors, but also the uninsured depositors.

In case of a bank failure, deposit insurance is meant to safeguard the deposits of small investors. Large depositors whose deposits are beyond the threshold stipulated in the deposit insurance schemes ($2,50,000 in the case of SVB) are expected to be “informed” depositors who should take into account the robustness of the bank before making a deposit. Such depositors are expected to bear the risk of the bank defaulting. Bailing out these depositors as if they were insured, creates a “moral hazard” problem. It creates expectations among the uninsured depositors of similar institutions that they too will be bailed out if such a situation arises. It generates an illusion of implicit government guarantee for all depositors.

Age of social media: As the depositors started shifting out of the bank, SVB had to sell some of its bonds to repay them, but in doing so it incurred losses since the bonds had lost value with rising interest rates. The size of this loss and the potential for future losses in relation to its capital doomed the bank and created the perfect recipe for a “bank run”. Once panic spread in social media about the bank’s stability, this ensured that the run happened very quickly, before the bank or the authorities had any time to react. Some commentators have rightly called it a “Twitter” driven collapse. This exposes the vulnerability of banks to such attacks in the era of social media.

Over and above these lessons for Indian banking, this episode has once again brought to focus the old issue of the trade-off between price stability and financial stability, and how should central banks deal with this. The roots of the SVB collapse lie in the policy decisions taken during the pandemic, when the US Fed first injected abundant liquidity into the system, and then aggressively raised interest rates to fight inflation.

The crucial question therefore is: should a monetary authority (for example, the Fed or the RBI) take financial stability into account when setting its monetary policy or be guided by the mandated objectives of inflation control and economic growth? The SVB episode is likely to reignite the debate on this issue.

Budget 2023-24: Fiscally conservative but lacking economic strategy

Budget 2023-24: Fiscally conservative but lacking economic strategy, Ideas for India, February 27, 2023.

An uncertain fiscal math

Indian Express, February 2, 2023

It is helpful to think of the Union Budget as satisfying two important objectives--growth, and stability. Depending on the state of the economy and availability of fiscal resources, electoral compulsions etc, a given Budget is either more growth-oriented or stability-oriented. Which category does the Union Budget of 2023-24 fall into?

The Union Budget is an annual statement of the government’s income and expenditure. From that standpoint, this Budget was a critical one, for two main reasons. First, for several years the government has been struggling to spend within its means and the fiscal deficit had been increasing. In the pre-pandemic year of 2019-10, the fiscal deficit of the central government alone was more than 4.5 percent of GDP, much higher than the 3 percent medium term target set by the Fiscal Responsibility and Budget Management (FRBM) Act. During the pandemic period, the deficit shot up first to 9.2 percent of GDP in 2020-21, and then to 6.9 percent in 2021-22. Such high levels of fiscal deficit raise concerns about macroeconomic stability, and can be detrimental to the economy’s growth. Hence all eyes were on the Budget this time to see whether the government would continue on the path of fiscal consolidation that it had embarked upon in 2022-23.

Secondly, this was the last full-year budget before the country goes into general elections in 2024. There was a general apprehension that the government would throw caution in the wind, and use the budget to announce populist schemes for specific electoral constituencies.

Instead, the Budget was a relatively conservative one. It refrained from populist measures, and projected a fiscal deficit of 5.9 percent for 2023-24, implying a 0.5 percent reduction from this year’s deficit. From this perspective, it sounds like a stability-oriented budget.

The important question to ask is, how credible is the fiscal consolidation path? Three points are worth noting in this context.

First, the Budget adhered to the fiscal deficit target of 6.4 percent for 2022-23. This was facilitated by the government’s conservative estimates of nominal GDP growth and gross tax revenues for 2022-23. As the economy normalised from the pandemic, both nominal GDP growth and tax revenues exceeded the government’s expectations. In particular, GST (goods and services tax) revenue was boosted by two main factors: an increase in sales of luxury goods which carry higher tax rates, and a big jump in imports. Both these maybe considered one-off shocks. Nominal GDP also received a boost from rising inflation. In 2023-24, as the economy slows down owing to global headwinds and weak domestic demand, and as inflation cools off, it is plausible that tax revenue growth will be lower than the Budget estimate, and nominal GDP growth will be less than the estimated 10.5 percent.

Secondly, while total non-debt revenue for 2023-24 is projected to be around Rs 27 lakh crore, tax revenue is projected to be around Rs 23 lakh crore. This implies that Rs 4 lakh crore must come from non-tax sources. This seems ambitious. For example, the Budget has set a disinvestment target of Rs 51,000 crore. Given that the disinvestment receipts in 2022-23 are unlikely to be anywhere close to the target, it is not clear how the target for 2023-24 can be achieved, especially in a year when economic growth is predicted to slow down, both domestically as well as globally.

Third, given the decline in global commodity prices, the government will incur some savings in 2023-24 on account of its subsidy bill. And some more savings have been budgeted on account of reduction in current expenditure. Using this savings to bring down the fiscal deficit would have made sense. But the Budget has also announced a steep increase in capital expenditure. This raises questions about the credibility of the fiscal math. Moreover it also raises questions about what fraction of the expenditure burden is being passed on to the states. It is important to note that ultimately what matters from a macro stability perspective is the consolidated fiscal deficit of both the centre and the states.

On the growth front, the Budget announced a 33 percent increase in capital expenditure. The objective, like last time, is to “crowd-in” private investment. While many would applaud this sustained capex push, it is problematic for two reasons.

First, it maybe argued that the increased capex spending by the government since last year has not resulted in the desired “crowding-in” of private sector investment which continues to be sluggish.

Second, and more importantly, the capex increase conveys a worrisome message. The government clearly feels compelled to do the heavy lifting of investing and boosting demand in the economy because the private sector is not investing in capacity expansion. This is deeply concerning because for an emerging economy like India to grow at 5-6 percent, and more importantly, to create the jobs required to absorb the millions of young people entering into the labour force every year, it is imperative that the private sector starts investing on a large scale.

The other important driver of growth is exports. While the Budget did announce several customs duty reductions, these were primarily aimed at reversing the inverted duty structure (i.e. higher duties on imported inputs but lower duties on imported finished goods), and it also announced several customs duty increases. The Budget also does not contain any major steps to roll back the protectionist policies the government has been implementing over the last few years.

In summary, only time will tell what impact the “growth” measures announced in the Budget will have on the economy, and while the Budget seems to have ticked the right boxes on “stability”, it lacks clarity on how this stability will be achieved.

Food subsidy for thought

Times of India, January 2, 2023

The government has recently announced that it will discontinue the free-food scheme that it started during the Covid-19 pandemic and will instead distribute foodgrains for free under the Public Distribution System (PDS). According to some analysts, this is good news because it will reduce the government’s food subsidy bill. However when looked at closely, this announcement could raise questions about the fiscal conservativeness of the government and also about the direction of agricultural policy.

Let’s try to unravel these issues.

During the pandemic, the government’s fiscal deficit understandably soared, as revenues fell and the need for spending increased. But even after the economy has recovered from the pandemic, the fiscal deficit remains large. The deficit of the centre and states put together is likely to be around 10 percent this year, the highest among G20 countries. The deficit of the centre alone is budgeted to be 6.4 percent of GDP.

Such a high fiscal deficit is not sustainable. Hence, economists expect the Union Budget, to be presented by the Finance Minister on February 1, 2023, to establish a clear glide path of consolidation, which would ensure that the deficit is brought down over the medium term.

How does the recent announcement fit into this picture?

To answer this question, some background is necessary. In March 2020, the government launched the PM-GKAY (PM Garib Kalyan Anna Yojana) free food scheme as a Covid-relief measure. The scheme provided 5 kg of free foodgrains (wheat or rice) per person, per month to all families holding a ration card, around 80 crore people. The scheme was meant to run from April to November 2020 but was extended multiple times and most recently to December 2022. While being well-intentioned and appropriate as an emergency measure, this scheme imposed a serious fiscal burden on successive Union Budgets.

Accordingly, on December 23, the government announced that it will discontinue the PM-GKAY scheme. Instead, it would provide free foodgrains through the existing PDS system for a period of one year, starting from January 1, 2023. This policy action will supposedly generate savings for the government on account of a reduced food subsidy bill. Hence, at first glance, it seems that the announcement achieves the right objectives – help the poor and reduce subsidy burden. But does it, really?

The food subsidy will undoubtedly fall next year, compared to this year, but that is not the right comparison. This is because PM-GKAY was meant to be a temporary relief provision to help people tide over the pandemic. So, the post-health emergency plan needs to be compared to the pre-pandemic situation. Evaluated against that base, the announcement implies that food subsidy will go up since (a) the selling prices of PDS grains have been reduced to zero, and (b) the quantities provided have been increased. In other words, the scheme will increase the fiscal burden when compared with the pre-pandemic base.

The medium-term implications could be significant. In the past, there was always the possibility that the government could reduce the budget deficit by raising the prices at which foodgrains were distributed through the PDS. But now that the government has made grains free, it will be difficult to start charging the households again. In other words, this announcement commits the government to a scheme that arguably makes it more difficult to achieve medium-term fiscal consolidation targets.

This announcement is likely to have repercussions for the overall agricultural policy as well. The government will now be even more constrained than before as far as raising the Minimum Support Price (MSP) is concerned. If it raises the MSP, its budget will get squeezed further because it will procure the grains at a higher price and then distribute them for free. Yet if it does not raise the MSP, farmers’ income from selling to the government will fall in real terms.

In that case, the farmers may decide to sell to the free market rather than the government. But then, the government will face a shortage of foodgrain stock and will not be able to fulfil its commitment. In other words, over and above fiscal issues, this announcement may have opened a Pandora’s Box.

Some may argue that this is nonetheless a good measure, since the government is giving more help to poor people. But the new programme is aimed at 80 crore beneficiaries: is more than half the country’s population poor? Put another way, why is it necessary to provide free foodgrains tomorrow to people who could afford to pay for them yesterday, when the country is becoming more prosperous every day?

The main task of the approaching Union Budget is to present a credible plan for reducing the fiscal deficit over the medium term. This will be difficult, since most of the major items in the centre’s budget – interest payments, wages, defence, and such like – cannot effectively be reduced. Until recently, the largest scope for reduction lay in steadily narrowing the food subsidy, the largest component of discretionary current expenditure. But with the recent announcement merging the PM-GKAY into the PDS this option may have been foreclosed.

While this may make for good politics, it reflects questionable economics.

RBI’s dilemma: Let prices rise or interest rates?

Times of India, February 8, 2022

One of the striking features of the Union Budget was the high borrowing requirement. The government plans to borrow Rs 15 lakh crore in 2022-23, to finance a higher-than-anticipated fiscal deficit of 6.4 percent of GDP. This decision will complicate the policy choices for the Reserve Bank of India.

During the two years of the pandemic, when the government’s borrowing requirements increased manifold owing to high fiscal deficits, the RBI stepped in to make it cheaper for the government to borrow. It lowered the short-term policy repo rate to a mere 4 percent in March 2020. Then, through a series of unconventional actions, it bought immense quantities of government bonds and injected vast amounts of liquidity into banks, to encourage them to buy bonds as well. As a result of these actions, the rate on 10-year government securities fell to 6 percent, even as inflation kept increasing.

The increase in inflation was fairly modest, considering the extent of the RBI’s actions. In ordinary circumstances, a large increase in liquidity would encourage banks to open the credit taps, allowing firms and households to step up their spending, which would then cause inflation to soar. But during the heightened uncertainty of the pandemic, banks were reluctant to lend, households were disinclined to spend, and firms were hesitant to embark on investment projects. As a result, spending was contained. CPI inflation reached the upper limit of the RBI’s target band, but did not spin out of control.

This situation made life easy for the official sector. The government could run large deficits and the RBI a stimulative policy, without worrying about the consequences for inflation. Even better, the advanced countries were pursuing similar policies. This in turn encouraged capital to flow to emerging markets, providing India with additional liquidity and reinforcing the RBI's strategic objectives.

However, in recent months, the global macroeconomic environment has changed quite significantly. After years of price stability, developed countries are experiencing a serious bout of inflation. Inflation has jumped to 5 percent in Europe and 7 percent in the US, the highest in four decades. This change has two implications for India.

First, for the first time in decades, India is now faced with a serious case of "imported inflation". Prices are rising rapidly on all the goods India imports, from oil to investment goods to vital industrial inputs. Even food prices have increased by 20 percent year-on-year as measured by the FAO Food Price Index.

Second, as a result of this global inflation, developed country central banks are getting ready to increase interest rates and withdraw the additional liquidity they had pumped into the system during the last two years. As a result, their policy has begun to diverge from the RBI’s accommodative stance, prompting capital to flow out of India in copious amounts over the past two months. This has weakened the rupee and pushed up domestic bond rates.

With foreigners fleeing the Indian market, domestic institutions panicked when they found out about the Budget borrowing plan, because it meant that they might have to shoulder the entire burden of absorbing the Rs 15 lakh crore that the government is planning to issue. In addition, they would also need to buy whatever amount of government securities the foreign investors are planning to sell in the coming months. Unsurprisingly, the 10-year rate has shot up to 6.9 percent in a matter of days.

This brings us to the RBI. Given the changed global environment and the government’s big borrowing plan, the RBI is faced with two difficult policy options, each with associated risks.

It could resume buying government securities in order to keep interest rates in check. The problem is that buying bonds will inject even more liquidity into the system, at a time when price pressures are intensifying. This could potentially jeopardize the RBI’s objective, since CPI inflation is already running close to its legally mandated limit.

Alternatively the RBI could wind back liquidity and raise the policy repo rate. This would be consistent with its inflation targeting objective, and bring its stance in line with that of the developed countries, thereby reducing the risk of further capital outflows. But it would also push up bond rates, making it costlier for the government and the private sector to borrow.

Both options have their costs. But between the two, the RBI should worry first and foremost about the costs to society of high inflation. Inflation is a tax that falls heaviest on the poorest, the most vulnerable segment of the society. And once inflation starts rising, it becomes very difficult and costly to bring it down, as we learned from our painful experience during 2013-14, when short-term interest rates reached 12 percent. As for bond rates, ultimately they need to be determined by demand and supply, without interference from the central bank, as this is the only way to ensure that they reflect the real cost of capital.

It will be interesting to see which way the RBI goes.

Why it’s not time to cut taxes

Indian Express, January 31, 2022

With the Union Budget round the corner, many people hope that taxes will be cut to boost private spending and growth. While ordinarily this might be a good idea, there are four main reasons why tax cuts are not prudent now.

First, the strong revenue performance during 2021-22 gives a misleading impression of the government’s fiscal position. Revenues this year have benefitted from some exceptional factors: (i) strong profit growth in the private corporate sector, led mostly by the large firms; (ii) robust collections from the Goods and Services Tax (GST); and (iii) rapid GDP growth. The crucial question to ask is what might happen to these factors in 2022-23. And here we run into some difficulties.

It is risky to assume that corporate profit will continue to grow rapidly going forward. This is because we do not yet fully understand what led to the growth in 2021-22. If we look at the data of listed non-financial, non-oil firms in the private sector, we find that by June 2021, their profit margins were higher than the pre-pandemic period. This could have been the result of an increase in their market share, given that the smaller firms bore the brunt of the pandemic. The larger firms also took emergency measures to cut costs. It is not obvious that as the pandemic recedes, the same trend will continue in 2022-23. If it does not, then corporate tax growth would not be as high as in 2021-22.

In addition, GST growth is likely to slow down. In 2021-22, average monthly collections increased to Rs 1.2 trillion from Rs 0.94 trillion in 2020-21. This increase was mostly on account of resumption of economic activity. GST on imports also played a big role, fuelled by an import boom and higher tariffs. It is unlikely that we will witness a similar import boom next year.

As the recovery period ends and the economy normalizes, GDP growth will slow down too. The main engine of growth for an emerging economy like India is private sector investment, which still shows no signs of acceleration, even as the broader economy recovers. Another engine of growth is exports. While India experienced an export boom in 2021-22, as the developed countries normalise their macro-policies, the global exports boom will diminish, and this will impact India as well. Hence it is not certain where a high GDP growth will come from in the next fiscal year.

All these factors lead to uncertainty about tax revenues.

Second, the fiscal deficit, targeted at 6.8 percent of GDP for 2021-22, continues to be very high. There is little room to cut spending, since demands for social spending such as on NREGA remain high, interest payments continue to be a big component of expenditure, and there is mounting pressure on the government to increase capital expenditure. There is consequently no room to provide tax relief without imposing further pressure on the deficit. Nor is it a good idea to allow the deficit to increase. Government’s total debt has already reached 90 percent of GDP, the highest ever, and there is significant pressure on the bond yields to go up, which would make it costlier for everyone to borrow.

Third, the pandemic has caused supply shortages the world over. In India too we have been experiencing supply chain bottlenecks. In a supply-constrained environment, any attempt to boost demand by increasing households’ after-tax income would lead to inflation. This is exactly what has been happening in the US and other developed economies. In India, CPI inflation has been running at 5-6 percent, close to the upper limit of the RBI’s target band. And already there are pressures for inflation to go up, coming from rising oil and commodity prices. Tax cuts and the resultant increase in spending might push inflation beyond the limit, forcing the RBI into an uncomfortable choice: raise interest rates sharply at a time when the recovery is beginning or allow inflation to tax the country’s poor.

Finally, globally we are entering into a period of macroeconomic uncertainty. The US economy is experiencing its highest inflation in 40 years. The US Fed will consequently raise interest rates this year. When the developed world pulls back their expansionary policies, it is important for emerging economies like India to display strong macroeconomic fundamentals, and for the government to come across as credible.

One of the key reasons India was badly affected by the Taper Tantrum episode of 2013 was because it was doing poorly on macro fundamentals. In a way, the situation now is not very different. Once again, we are running a high fiscal deficit and the real interest rate is negative because inflation is higher than the policy rate. True, inflation is lower than it was in 2013, but the government debt ratio is substantially higher. Hence, the government needs to be somewhat careful about its fiscal math.

With state elections coming up, it might be tempting for the government to slash taxes and win votes. But given its own fiscal limitations and the uncertainty surrounding India’s growth and inflation trajectories in the next fiscal year, this would not be a prudent call.

Sudden Rise of the Floaters

Sudden Rise of the Floaters, The Leap Blog, August 9, 2021.

Indian economy & Covid-19: Risk aversion may be higher in 2nd wave

Indian economy & Covid-19: Risk aversion may be higher in 2nd wave , Trade Promotion Council of India Blog, May 26, 2021.