Why inflation targeting works

Mint, August 16, 2016

The Reserve Bank of India (RBI) officially adopted inflation targeting (IT) as a monetary policy strategy in February 2015. A few days ago, the government notified a consumer inflation target of 4% to be followed till March 2021. Some economists have expressed fresh concerns about the wisdom of adopting IT. These concerns are misplaced. Inflation hurts everyone in the country from households to firms. Even moderately high inflation is bad for growth as is inflation volatility. The primary objective of monetary policy should be to ensure low and stable inflation. IT offers a framework to achieve this objective in a credible and sustainable manner. The adoption of IT by the RBI is a significant step in the right direction. The RBI should stick to this framework and put in place the operating procedure needed to implement IT.

Central banks have the power to print “fiat” money. Unlike money backed by metals such as silver or gold in the pre-World War II era, fiat money gets its value from a legal decree. Every fiat money needs a nominal anchor to tie down the price level. A nominal anchor can take various forms such as money supply, nominal gross domestic product (GDP), value of domestic currency relative to a foreign currency or a price measure such as the consumer price index (CPI). Since the collapse of the gold standard, central banks have tried all kinds of nominal anchors but with limited success. The world has increasingly moved towards inflation targeting where the nominal anchor is the CPI.

IT requires a central bank to adjust its monetary policy instruments in response to the gap between the forecast inflation rate and a pre-announced target rate. Most countries today follow a “flexible IT” framework. This gives the central bank discretion to respond to shocks such as a growth slowdown in the short run and meet the inflation target in the medium run. This is the kind of IT framework that has been adopted by the RBI. The objective is to pin down the value of the rupee to the price of the CPI basket.

IT anchors the inflation expectations of the private sector. It imposes discipline on monetary policy. Before the adoption of IT, monetary policy in India was conducted in an ad hoc manner. The RBI would target multiple indicators ranging from inflation and growth to exchange rate and trade balance. There was no clarity about the primary objective of monetary policy. The lack of accountability, clarity and transparency in monetary policy introduced uncertainty. Uncertainty about the central bank’s monetary policy objective is a risk factor for the economy.

In the absence of a specific mandate to target inflation, monetary policy in India was often used to achieve objectives unrelated to price stability. For example, during 2004-07, in response to a surge in foreign capital inflows, the RBI lowered the nominal interest rate. This was done to prevent the rupee from appreciating. This meant interest rates were kept low at a time when the economy was growing at a very high rate fuelled by a credit boom. A pro-cyclical monetary policy triggered inflationary pressures. CPI inflation began exceeding 5% from February 2006 onward. Post 2008, in response to double-digit inflation, the RBI pursued successive rounds of monetary tightening at a time when growth had begun slowing down. IT acts as a guard against this kind of a discretionary monetary policy.

IT was first adopted by the Reserve Bank of New Zealand in 1989. Since then, the number of countries using IT as a framework to conduct their monetary policy has steadily gone up. As of now, 36 countries, including India, have officially adopted IT (see table). In addition, all 19 countries in the euro zone are bound by the inflation target chosen by the European Central Bank. This takes the total count of IT countries to 55.

Inflation targeting countries

Year of adoption	Country	Target measure
1989	New Zealand	H CPI
1991	Canada	H CPI
1992	United Kingdom	H CPI
1993	Australia	H CPI
1995	Sweden	H CPI
1996	Mauritius	H CPI
1997	Israel, Czech Republic	H CPI
1998	Poland, South Korea	H CPI
1999	Brazil, Chile, Colombia	H CPI
2000	South Africa, Thailand	H CPI
2001	Mexico, Hungary, Iceland, Norway	H CPI
2002	Peru, Philippines	H CPI
2005	Guatemala, Indonesia, Romania	H CPI
2006	Armenia, Turkey	H CPI
2007	Ghana	H CPI
2008	Botswana	H CPI
2009	Serbia, Albania, Georgia	H CPI
2010	Moldova	H CPI
2011	Uganda	Core inflation
2012	USA	PCE**
2013	Japan	H CPI
2015	India	H CPI
*H CPI: Headline consumer price index. **PCE: Personal consumption expenditure. Source: Gill Hammond, 2011, State of the art of inflation targeting-2012, Centre for Central Banking Studies, Bank of England, and respective central bank websites.

Since the 2008 financial crisis, questions have been raised about the effectiveness of monetary policy to boost demand in developed countries where interest rates are close to zero. Yet, IT has stood the test of time through shocks, including the 2008 crisis. No country has moved away from IT as a framework and newer countries have adopted it after the crisis. What has changed is not the overarching framework of IT but the instruments used to meet the inflation target. Under conventional IT, short-term interest rates are the instruments of monetary policy. In the post-crisis period, several developed countries started using unconventional measures such as quantitative easing to achieve the inflation target. IT has continued to be the framework used to anchor inflation expectations. A broad consensus supported by empirical evidence has emerged that IT is effective in delivering low and stable inflation and anchoring inflation expectations in developed and emerging countries.

The RBI has taken the first step towards stabilizing inflation by formally adopting IT as India’s monetary policy framework. A lot more remains to be done in order for RBI to actually become an inflation-targeting central bank. Equipped with the IT mandate, the RBI needs to focus its efforts on strengthening monetary policy transmission (MPT) and putting in place a comprehensive operating procedure. Unless financial market reforms are undertaken to strengthen MPT, small rate changes will not have any effect on aggregate demand and hence inflation. The RBI should consider bigger changes in the interest rate. Small rate changes of 25 or 50 basis points work well in IT countries that have strong MPT. One basis point is one-hundredth of a percentage point.

The RBI needs to build internal technical capacity to forecast inflation using sophisticated econometric models, improve the quality of publicly available macroeconomic data, publish its forecasts of inflation and related macroeconomic indicators at regular intervals, systematically track the private sector’s inflation expectations, form the monetary policy committee (MPC) that will decide the interest rate, and furnish the MPC with necessary information, including data, and models used to forecast inflation.

IT is a whole new regime in monetary policymaking in India. The policy focus should now be on understanding how the new regime works and how this framework can be used to deliver low and stable inflation on a sustainable basis.

RBI should not regulate asset reconstruction companies

Business Standard, July 2, 2016 (with Pratik Datta)

The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (also known as the Sarfaesi Act) facilitated the creation and regulation of Asset Reconstruction Companies or ARCs which purchase and manage stressed assets. A bill to amend the Sarfaesi Act is currently being reviewed by a Joint Parliamentary Committee (JPC). The amendment proposes to increase the powers of the Reserve Bank of India to regulate ARCs. This is problematic for two reasons. First, recovery of stressed assets by ARCs has failed. The new Insolvency and Bankruptcy Code 2016, or IBC, seeks to correct this. Regulation of ARCs outside the new bankruptcy law is unnecessary. Second, banking and stressed asset management are two separate businesses. The banking regulator has a conflict of interest in regulating the stressed asset management industry and should not be given this responsibility. The JPC in its review should consider these aspects of the proposed amendment.

So far, ARCs in India have failed in their primary purpose. While gross NPAs have risen to 10 per cent of total advances made by banks, the total value of loans sold to ARCs in the last two years is less than two per cent of the banking system. One reason for this is poor recovery due to an ineffective corporate insolvency resolution framework. The IBC is set to correct this situation and improve the recovery rate. Additionally, foreign investors have recently been allowed to invest in ARCs under the 100 per cent automatic route. This sequence of positive developments is likely to get derailed by the amendment. ARCs do not take deposits. They do not deal with retail consumers. Retail consumers cannot even invest in security receipts issued by ARCs, since they are not listed. There is no consumer protection concern. ARCs are too small to generate systemic risk for the financial system. Micro-prudential risk is also minimal. There is no market failure in the ARC industry that justifies heavy state intervention. From 2002 onward this industry has been repressed due to over-regulation. The proposed amendment makes it worse. The amendment gives unfettered powers to the RBI to remove the chairperson or any director from the board of ARCs on vague grounds like 'public interest', and to issue directions on the fees charged by ARCs and other expenses incurred by them. While the government liberalised foreign direct investment or FDI norms to invite foreign investors to invest in ARCs, the amendment gives arbitrary discretion to the RBI to remove ARC board members without basic natural justice. India has undergone a significant reform in the insolvency resolution space in the form of the IBC. Existing laws need to be in sync with the principle enshrined in the IBC to create a coherent framework for debt recovery and resolution. The IBC accords rights to every key stakeholder in the process without creating a bias among participants. The amendment goes against this principle by giving a special status to ARCs. The usage of the term ARC in India is misleading. Emerging economies like Indonesia, Malaysia and Korea set up government-funded vehicles as a one-off solution to a banking crisis situation, such as after the East Asian crisis of 1997. They are not regulated by the respective banking regulators of these countries. On the other hand, the United States and UK have hedge funds (distressed debt funds) that use private money to buy bad loans from banks. These funds are not regulated by the banking regulators either. In India, the Sarfaesi Act has created a unique situation where the so-called ARCs are non-government vehicles funded by corporate money; they are regulated by the banking regulator and are not a one-off creation. This regulatory architecture is fundamentally flawed. When an ARC buys a loan from a bank, it acquires the right to an assured cash-flow from the borrower. If the borrower defaults, the ARC can recover the due amount from the borrower. The business of stressed asset recovery is disconnected from the business of banking. There is no reason why the banking regulator should regulate the ARC industry in India, when globally it does not. The banking regulator has conflicting interests in regulating ARCs. If the regulator fails in micro-prudential regulation of banks, non-performing assets or NPAs will build up. If these NPAs are sold to independent ARCs at marked to market, the actual magnitude of prudential mismanagement of banks will be evident - a clear sign of the banking regulator's failure. Instead, if the banking regulator could "direct" the ARCs to absorb the NPAs at a higher price than what they are actually worth, the scale of the failure may not be fully evident. Thus, the banking regulator has perverse incentives in regulating ARCs. Further, the amendment is unconstitutional in spirit. It proposes that penalty orders against ARCs by the RBI can be appealed before an Appellate Authority comprising only RBI officers. Effectively, the RBI will be the judge of its own cause! This violates the principle of independence of the judiciary, which is equally applicable in the regulatory context. Regulators are "mini states" and their quasi-judicial functions (including the appellate function) must be insulated from their executive role. In the financial sector, an independent tribunal - the Securities Appellate Tribunal or SAT - hears appeals against orders by Sebi, Irdai and PFRDA. The Justice B N Srikrishna-led Financial Sector Legislative Reforms Commission had recommended that the RBI's orders should also be appealed to SAT. In this backdrop, creation of a parallel mechanism within the RBI to hear appeals against its own orders is a retrograde step and is potentially unconstitutional. The amendment will stifle the development of the struggling ARC industry and hamper the reform process initiated by the IBC and the liberalised FDI norms. The JPC must rectify this, given the unfolding NPA crisis. ARCs should be regulated by Sebi-like private equity funds investing in stressed assets and not by the RBI. This industry needs room to grow, which only light-touch regulation can provide.

Inflation targeting: A long way to go

Mint, June 29, 2016

The Finance Bill, 2016, amended the Reserve Bank of India (RBI) Act, 1934, to define inflation targeting (IT) as the central bank’s primary objective. Passing a law by itself is not sufficient to achieve the objective. Reforms will be needed on two fronts to build institutional capabilities that will add up to a working IT system. These involve (i) changes in the working of the central bank, including, releasing better and more frequent macroeconomic data, analysis and inflation forecasts in a timely manner; constituting the monetary policy committee and putting in place an operating procedure; letting the currency float and liberalizing the capital account; (ii) changes in monetary policy transmission, through financial market reforms.

A central feature of a well-functioning monetary policy is monetary policy transmission (MPT). MPT in India is ineffective. In an ideal world, changes in RBI’s policy repo rate—the rate at which it lends to banks—would affect the entire economy through three channels of transmission. First, banks would change the rates they charge their customers. Second, the bond market would be commensurately affected at all maturities. Third, the exchange rate would change because of the impact of the interest rate change on debt inflows and outflows.

None of these channels works in India. First, India is a bank-dominated economy but the number of banks have not increased noticeably over time. In a decade or so, only two new commercial bank licences were granted in 2015. The landscape is dominated by public sector banks which account for 80% of the deposits but lack competitive energy. Private and foreign banks face a plethora of entry barriers. While RBI has granted licences to payments and small finance banks, these will not move the needle in an otherwise stagnant banking environment.

The relatively smaller number of banks in the economy thwarts competition among the existing banks, who do not feel the necessity to pass on the rate changes to the final consumers. This renders the bank lending channel of transmission ineffective.

Secondly, bond market development has been an important failure of financial sector reforms. In advanced countries such as the US, the bond market is an important transmission channel through which changes in monetary policy affect the yield curve. In India, we do not observe this channel. In the absence of a large and liquid bond market, the burden of MPT falls squarely on the banks. For the bond market to develop, reforms are needed to facilitate the bond-currency-derivatives nexus.

Third, in an open economy with flexible exchange rate and monetary independence, when the central bank changes the policy rate, capital flows in or out of the economy, depending on the direction of the policy rate change. This leads to movements in the economy’s exchange rate. This is the third channel of transmission through which sectors linked to currency movements such as tradables feel the impact of a monetary policy change.

In India, there exist several restrictions on the movement of capital flows. Compared to other emerging economies, India still enjoys a limited degree of integration with international financial markets. So, any change in RBI’s policy rate does not necessarily result in concomitant changes in capital flows. Also, in India, any movement in the currency is actively managed by RBI through market interventions. These reduce the effectiveness of the exchange rate channel of transmission as corroborated by evidence found in our recent paper (Monetary Transmission in Developing Countries: Evidence from India by Prachi Mishra, Peter Montiel and Rajeswari Sengupta). In the absence of an open capital account and flexible exchange rate, the third channel of MPT is rendered ineffective.

In an ideal world, through these MPT channels, the effect of a rate change would be passed on to a large share of the population connected to the formal financial system. In other words, for MPT to be effective, financial inclusion is also important. In India, when RBI changes the policy rate, the impact is felt by a small fraction of the population which has access to the formal financial sector. Only 52% of those aged 15 years and above have accounts at a financial institution in India as of 2014. This is low when compared to 98% in Australia, 78% in China, 96% in Singapore, 98% in the UK and 93% in the US. As a result, a small share of Indian population bears a disproportionate burden of the impact of a monetary policy change.

In the absence of a powerful MPT, the only way a monetary policy change can affect the economy is if it is large in magnitude. For example, when C. Rangarajan was RBI governor from 1992 to 1997, he pursued aggressive monetary contraction in the mid-1990s amidst an inflation crisis. In response, consumer price index inflation went down from 10% to 4% in two years. In those days, because MPT was weak, a large change in monetary policy was needed to combat inflation. Little has changed since then.

Thus, there are three paths that can be followed in the context of MPT: (i) Adopt structural reforms to de-clog the channels of transmission. This entails improving financial inclusion, fostering a competitive environment for banks, improving the functioning of the bond market, liberalizing the capital account and letting the currency float; (ii) Administer big changes in the policy rate; (iii) Do nothing on the first and deliver only small changes in the policy rate. This is least painful and perhaps easiest to implement in the short run, but does not create any real impact on the economy.

The government has done its bit by amending the RBI Act to incorporate IT as an objective. RBI now needs to undertake a series of actions in order to actually become an inflation-targeting central bank.

Analysis of the recent proposed SARFAESI amendments : are these consistent with the Insolvency and Bankruptcy Code?

Analysis of the recent proposed SARFAESI amendments : are these consistent with the Insolvency and Bankruptcy Code? The Leap Blog, May 29, 2016 (with Richa Roy).

Real GDP is growing at 5%, not 7.1%

Mint, March 14, 2016

Are our gross domestic product (GDP) numbers credible? Many commentators have expressed their doubts. But no one has yet identified problems with the Central Statistical Organisation’s (CSO) methodology. This is because they have been looking in the wrong place. The problem is not, as many have suspected, in the nominal numbers. It lies in the system for constructing the deflators. This methodology is flawed, yielding exaggerated estimates of the speed at which the economy is growing. As a result, policy decisions such as the Union budget are taken on the basis of a “broken speedometer”.

No one is talking about the deflators, but they are important. That is because the real numbers are derived by taking nominal data on the economy and deflating them by price indices. So, if inflation is understated, then real growth is going to be overstated. And this is what has been happening.

In the latest data released by the CSO we focus on the gross value added (GVA) numbers. This measure is conceptually similar to the old GDP at factor prices. In nominal terms, GVA increased by 7.9% in the third quarter (October-December) of the fiscal year 2015-16, below its usual level of 10-15%. This increase translated into a 7.1% real growth, because the deflator reportedly increased by only 0.7%.

Could India’s inflation be so low? In effect, the CSO is saying that despite India’s booming economy, producer inflation is lower than that of the recession-wracked economies of the West, or even that of Japan, which has been wrestling with deflation since the 1990s (see adjoining chart.) This is not plausible.

How could the CSO have come to such a conclusion? The answer is that in a number of sectors, it has proxied the deflator by using the wholesale price index (WPI). This approach is problematic. For one thing, the WPI and the GVA deflator can move in different directions. To see this, we need to look at value added from the income side. Firms’ value added is paid out to the factors of production, namely labour, land and capital. The biggest share of this income goes to labour, which means that wages form the bulk of the deflator. We do not have good data on wages, but we know that they have been going up. Yet, the WPI has been going down—by 1.5% in the third quarter.

Next, we turn to value added from the production side. When commodity prices decline, the commodity-heavy WPI will decline, as we have just seen. But the GVA deflator will need to increase. This may sound strange, but the reasoning is straightforward. Plunging commodity prices boost firms’ profits, increasing their value added, which is what the nominal GVA measures. But since ‘real’ GVA is measured at constant prices, this increase in nominal GVA needs to be deflated away. Hence, the deflator needs to rise.

In other words, by relying heavily on the WPI, the CSO has been led astray from the true deflator. As a result, the growth estimates have also strayed from reality. Over the past year, the dynamos of the economy—investment and exports—have remained mired in a slump. Yet, according to the CSO, the economy, excluding agriculture and government, expanded by 9.6% in the third quarter. This growth was powered by two sectors—trade and finance—that reportedly grew by around 10%, and one—manufacturing—that grew by 12.6%. In other words, the CSO is telling us that good times are back. But this is not consistent with what we see all around us.

If the WPI is such a poor proxy for the deflator, what numbers should be used in its place? There is no single answer. For the service sectors, one could look at the consumer price index (CPI) for services such as health and education. For manufacturing, one could take the CPI for clothing/footwear and miscellaneous household goods. All of these indices are running at 5-5.75%.

So, let us be conservative and use 5% as the deflator for finance and manufacturing. In that case, financial real GVA would show a growth rate of 2.6% as opposed to the reported 9.9%.

For the manufacturing sector, only 70% of the estimated GVA is derived by deflating the nominal numbers from the corporate sector, while the remaining 30% is based on the Index of Industrial Production. Accordingly, one needs to take 70% of the nominal GVA, deflate it by 5%, then add back the remainder. In that case, real growth of manufacturing GVA comes to 7.7% as opposed to the reported 12.6%.

With these adjustments for finance and manufacturing, keeping the numbers for the other sectors unchanged, we get a real GDP growth rate for the third quarter of 5%. In other words, the economy is struggling, not racing ahead. Now, that seems consistent with what we are seeing.

Where Is The Strategy To Solve The Investment And Banking Crises?

Swarajya, February 29, 2016

The 2016-17 Budget was presented by the finance minister against the backdrop of an economy that is facing two important macro problems—a crisis of investment and a crisis in the corporate and banking sectors. Other than the GDP numbers, all other statistics point towards an economy that is in trouble. The need of the hour was a July 1991 Dream Budget that would recognize the problems in the economy and outline a strategy to address them. The Budget presented today did not live up to these expectations and may go one step further in discouraging investment. Apart from a few good elements, this is not the Budget that would deliver the much-needed boost to private sector optimism in a modern market economy.

A few announcements in the Budget speech, mostly in the field of financial sector reforms, deserve mention. Setting up a resolution corporation for financial firms is a welcome step. This was recommended by the Financial Sector Legislative Reforms Commission (FSLRC) and is part of the Indian Financial Code. This, along with the Insolvency and Bankruptcy Code, when enacted, will reform the current insolvency resolution system, paving the way for faster restructuring of viable firms and exit of the unviable ones.

The amendment of the RBI Act to establish a Monetary Policy Committee (MPC) is important in context of the Monetary Policy Framework Agreement that was signed earlier last year and to achieve the inflation-targeting objective in a transparent and accountable manner. However, the devil lies in the details of the MPC. It remains to be seen what the composition and organization of the Committee will be. The setting up of the Financial Data Management Centre (FDMC) for data integration in the financial sector was also recommended by the FSLRC and is an important step.

Finally, adhering to the fiscal deficit target of 3.5 percent of GDP and reducing the revenue deficit target from 2.8 percent to 2.5 percent is prudent and may call for some cheer. But the manner in which it is sought to being achieved may be called into question. One needs to look closely at the numbers to assess the quality of this proposed fiscal deficit reduction. The calculations are based on a GDP growth rate of 7.6 percent. While the new GDP data show that India is doing very well, the new GDP data has its own share of problems and so far no step has been taken to correct these. If we assume that the new GDP data is hiding the true health of the economy, which in reality is a lot worse, then the tax buoyancy that the Budget speech refers to may be exaggerated.

Leaving this aside, there is also the question of windfall gains received by the government for the last several quarters on account of the fall in oil and commodity prices. This could have been used to further reduce oil-related subsidies and achieve a primary surplus. The Budget speech made no mention of such a plan. Instead, it announced the imposition of a series of cesses, a rise in tax on dividends, tax on long-term capital gains and a tripling of the Securities Transactions Tax (STT) on Options. At a time when encouraging investment is the need of the hour, measures such as these would send wrong signals to the private sector.

As the dust settles, it will be important to closely look at the revenue and expenditure calculations. Given that implementation of the recommendations of the 7th Pay Commission amount to roughly 0.6 percent of GDP and a deficit reduction of 0.4 percent of GDP is targeted, revenue measures adding up to roughly one percent of GDP are needed. That is indeed a big number and it is doubtful that all the tax measures announced in the Budget speech would add up to this. This calculation does not even take into account the expenditure on account of the Defense OROP programme. The Budget speech did not lay out any roadmap for gradual disinvestment of shares in public sector enterprises either.

The Budget speech was silent on how the government plans to tackle the two pressing problems that the economy is facing—investment crisis and banking crisis. It lacked the vision required to encourage domestic and foreign investment and to revive the economy. Two steps that could have helped in boosting investment optimism are a reduction in the corporate income tax and a proposal to table a bill in the Parliament to remove retrospective taxation. Not only were these missing in the speech, the tax on dividend was increased, a step that would discourage private investment.

The banking sector is buried under a mounting pile of bad debts amounting to Rs. 8 lakh crore. The FM announced a recapitalisation of Rs. 25,000 crore and the possibility of consolidation of public sector unit (PSU) banks. Given the magnitude of the crisis, Rs. 25,000 crore does not even scratch the surface. Even if one were to overlook this, allocation of any amount needs to be placed in context of a broader strategy to resolve the problem. There needs to be a forward guidance on how the bad debts can be resolved such that the banks can start lending again and the corporate sector can start investing again.

The Budget speech was an opportunity to announce a full blown strategy of how to fix the fundamental problems in the banking system that caused the crisis to begin with, what kind of deeper banking reforms will be undertaken so that a similar crisis is not repeated in future and how banking regulation will be modified to ensure that the RBI is better equipped to either prevent or deal with such a crisis the next time around.

But the Budget speech did not give a sense of the strategy the government will pursue to clean up the mess in the banking system. In absence of this, recapitalisation is merely going to postpone the problem. It will lead to moral hazard among the PSU banks as it will act as an implicit insurance against any loss that the banks suffer owing to NPAs.

India today is a modern market economy where people, especially the youth, are looking for jobs and opportunities and this calls for boosting investment and enhancing growth. This is what the government promised on their campaign trail. They have not delivered on this objective in the last two years and this year’s Budget does not promise a strategy of achieving it either.

The Budget Track Record

Swarajya, February 11, 2016

The Union Budget is a document that describes how much revenue the government expects to earn from what sources, and how much it plans to spend in what categories. Over time, it has become a statement of the work plan of the government for the coming year. It has become a document that spells out the economic vision of the government.

The Narendra Modi-led government has so far presented two Union Budgets. The government was expected to lay out a strategy to solve the pressing problems of the economy and deliver on the promises of growth revival and job creation made on the campaign trail. The Budgets announced by the government in July 2014 and February 2015 had some good elements but, by and large, did not live up to expectations. In recent times, the economic performance has been sluggish. An overall sense of despondency has replaced the initial exuberance that prevailed when the government took over in 2014. Expectations are high for the February 2016 Budget. There are gaps created by the last two Budgets that need to be addressed and a new strategy adopted to turn around the economy.

A downturn began in the Indian economy in 2012. GDP growth fell to a seven-year low of 5.3 per cent. Inflation was stubbornly high at 7 per cent, creating a situation of stagflation. Investment demand was sluggish, and the scope for increasing government expenditure was limited by the fiscal deficit of 5.9 per cent. It was against this background that the new government took charge in May 2014. In the months leading up to the election, the Bharatiya Janata Party made all the right promises. It won the election with a majority in the Lok Sabha—the first majority government in 30 years. With this win, came hope and optimism that the government would unveil a game plan to initiate structural changes in the economy.

July 2014 presented the new government with an opportunity to deliver a Budget that would reshape the economy, the way the P. V. Narasimha Rao-led minority Congress government had done in 1991. That government, elected in June 1991, had even less time to prepare for the interim Budget that Manmohan Singh presented on July 24, 1991. The situation back then was also direr. In comparison, the interim Budget of 2014 announced many small measures but did not spell out an economic vision of the government.

The government announced initiatives such as the development of 100 Smart Cities, a national-level Skill India programme, the Digital India programme, and the Swachh Bharat Abhiyan project. Arun Jaitley’s Budget speech mentioned the keenness of the government to revive growth, restore vibrancy in the economy, boost the manufacturing and infrastructure sectors, promote financial stability and introduce fiscal prudence. These are all good aspirations but what is needed is a long-term strategy to achieve these goals. There needs to be a deeper diagnosis of the problems in the economy, and addressing the underlying institutional bottlenecks by amending laws and constructing State capacity.

The good elements of the Budget were the increase in foreign direct investment (FDI) cap in the defence and insurance sectors to 49 per cent from 25 per cent, aimed at improving the investment climate and the announcement that a monetary policy framework would be put into place. The latter initiative is important because, for decades, India lacked a framework to deliver low and stable inflation.

On the fiscal front, there should have been a detailed roadmap to roll out the Goods and Services Tax (GST). For long in India, poorly designed and executed tax policy and tax administration have resulted in a low tax-to-GDP ratio and have been inimical to growth. With a 35 percent tax rate on corporate income, India has one of the highest tax rates among similar countries. What was needed in the Budget was a strategy to reform the tax policy and the tax administration. Overall, the 2014 interim Budget left much to be desired.

The 2015 Budget was the first full year Budget to be presented by the new government. The fall in global crude oil prices meant that the government was in a position to utilize the resultant windfall to cut back on subsidies. The government should be given credit for accepting the recommendations of the 14th Finance Commission to increase the share of the states in the central taxes to 42 percent. This meant that going forward, the states would be responsible for their own expenditures. This provided the government with an opportunity to bring about fundamental changes in the machinery of central expenditures. All of these could have been used to facilitate fiscal consolidation.

The previous Finance Minister, P. Chidambaram, had committed to a certain fiscal adjustment path. The 2015 Budget, however, announced the extension of the timeline to achieve the fiscal deficit target of 3 percent by one more year to 2017-18. This was unfortunate. The government could have instead announced systematic disinvestment measures to free up resources for capital expenditures and public investments while remaining on the committed trajectory of fiscal consolidation.

While subsidies on petroleum products were cut back in 2014-15, there was a lot more room to reduce expenses by pruning subsidies. The primary focus of the Budget should have been to boost GDP growth and achieve primary surplus so as to bring down the debt-to-GDP ratio. The budgeted primary surplus instead was -0.7 per cent and non-interest expenditures were budgeted to go up only by 4.06 per cent.

There was no plan in the 2015 Budget to implement tax reforms. The Direct Taxes Code that seeks to consolidate all direct taxes and is designed to make the tax regime more stable was dropped from the Budget. This was a new low. It is one thing to remain silent on new initiatives. But it is worse when the government announces a work plan to not do reform.

In contrast, the financial sector reforms that were announced may be considered the redeeming features of the 2015 Budget. The announcements included merging the commodity futures with the Securities and Exchange Board of India (SEBI), setting up the statutory Public Debt Management Agency (PDMA), shifting the government bond market regulation from the Reserve Bank of India (RBI) to SEBI, shifting regulation-making power on equity flows related capital controls to the government, setting up the Gujarat International Finance Tec-city (GIFT), and formalizing inflation targeting as a monetary policy strategy through the signing of the Monetary Policy Framework Agreement (MPFA).

Another good element of the Budget was the announcement that a comprehensive Bankruptcy Code would be introduced in 2015-16 in order to facilitate efficient exit of failed firms. The 2015 Budget also mentioned that the Indian Financial Code (IFC)—the most comprehensive and game-changing piece of legislation on financial sector reforms in the history of the Indian economy — was going to be introduced “sooner rather than later”. All of these were steps in the right direction.

Looking back on the implementation, however, several of the announcements made in the 2015 Budget have either been shelved or implemented in a half-hearted manner or continue to be in limbo. The GST is still a far cry from becoming a reality. Discussions to introduce the IFC in Parliament seem to have lost momentum. Establishment of the PDMA and shifting of bond market regulation from the RBI to SEBI have both been rolled back.

One area of reform that has been discussed widely in policy circles in recent times is infrastructure reform. The Budgets of the BJP government did not unleash the wave of public investments in infrastructure needed to revive the economy. The overall outlay allocated to infrastructure projects in the 2015 Budget amounted to less than 0.4 per cent of GDP. The Finance Minister proposed reviving the public-private partnership (PPP) model of infrastructure development. To make this work, deeper institutional reforms are required to sustain private sector participation in infrastructure. This, in turn, needs amendment of laws, establishing well-performing regulators and building adequate State capacity to ensure high quality execution.

On corporate and individual insolvency reforms, the Bankruptcy Law Reforms Committee (BLRC) submitted its report and a draft bill proposing a comprehensive Insolvency and Bankruptcy Code (IBC) in November 2015. The bill was introduced in Parliament in December and was referred to a Joint Parliamentary Committee that is supposed to submit its report around the next Budget session.

Implementing big structural reforms should be a measured process that includes perfecting laws, and creating good institutions. Just as legislative delays exacerbated by political logjam can be damaging for the economy, rushing to pass a bill without perfecting it and without a full implementation plan can also hamper outcomes.

The business cycle downturn that began in 2012 has not ended. Economic performance continues to be bleak. For the 2016 Budget, the government needs a completely new strategy that involves thinking about the full picture, getting clarity on where we want to be by 2019, what is the vision for the economy as a whole, and what steps need to be adopted to achieve this goal.

India’s fiscal situation has worsened over the last few years. At present, the interest rate paid by the government is higher than the nominal growth rate which means that the debt to GDP ratio is now on an upward trajectory. One important component of the next Budget should be steps to achieve fiscal correction in order to restore fiscal stability and debt sustainability.

While increasing fiscal deficit at a time like this would not be prudent, a push for infrastructure reforms is needed. This calls for a strategy to boost public expenditure especially on infrastructure, by using revenues from public disinvestments and subsidy reductions.

There also needs to be a strategy for reforming the tax policy and the tax administration.

Even after taking into account the rollbacks post the 2015 Budget, by January 2016, it appears that a lot of the work in the financial sector has lost momentum. The next Budget should revitalise this process if the financing needs of the infrastructure sector are to be met. There also needs to be a roadmap to introduce the IFC in Parliament.

The economy today is experiencing a balance sheet crisis of the firms and the banks. The government should review the idea of opening up the economy to new private and foreign banks in order to relax the credit crunch that the real sector has been facing.

The need of the hour is big thinking on the scale of the 1991 Budget and bold ambition underlying a slew of policy initiatives. Budget 2016 needs to deliver on strong fiscal, financial and monetary institutions that are needed for India to emerge as a mature, market economy.

While it is relatively easy to enumerate a list of agenda items for the Budget, the announcements in the Budget speech are only a part of the overall strategy. This has to be followed up with a full implementation plan to turn the Budget speech into concrete actionable points that can be delivered over the next financial year. Short of that, merely a good Budget speech will be akin to engaging in “isomorphic mimicry” where the reform process gains legitimacy through announcement of policy initiatives without actually obtaining the desired outcomes.