Budget 2022-23: Hits and misses

Budget 2022-23: Hits and misses, Ideas for India, February 14, 2022.

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.

Is GDP data a reliable way to measure the health of the economy?

Indian Express, January 4, 2022

The primary yardstick that analysts use to measure the economy’s health is GDP. Economists, technocrats and journalists cite GDP numbers when crafting their narrative about how well the economy is recovering from the pandemic. The Reserve Bank of India and multilateral agencies use GDP statistics to make claims about the future growth path. Yet no one seems to be asking the most important question: How reliable are the Indian GDP data?

The CSO released the current GDP series in 2015, using 2011-12 as its base year. Since then, the new series has been embroiled in controversy. Scholars have pointed to measurement problems, both in the nominal GDP numbers and the real GDP growth rates. Yet none of those problems has been addressed by the CSO, to the best of our knowledge. As a result, the measurement errors still persist.

There are three major reasons why the GDP data, and hence any narrative of economic recovery based on it, are questionable.

First, the growth rate of real GDP is contaminated by the "double deflation problem". Simply put, the CSO calculates real GDP by gathering nominal GDP data in rupees and then deflating this data using various price indices. The nominal data needs to be deflated twice: once for outputs and once for inputs. But the CSO – almost uniquely amongst G20 countries – deflates the nominal data only once. It does not deflate the value of inputs.

To see why this is a problem, consider what happens when the price of imported oil goes down. In that case, input costs will fall and the profits recorded by Indian firms will rise. This increase in profits is merely the result of a fall in input prices, so it needs to be deflated away. After all, GDP is meant to measure the amount of production in the country, which hasn’t changed, at least in the first instance.

But the CSO doesn’t deflate away the increase in profits. Instead, it records a purely nominal increase as a real increase in GDP, thereby overstating growth. Simulations have shown that this effect can be substantial. For further information, see my article here.

Since the cost of inputs is measured by the WPI, a crude measure of the overestimation caused by the absence of "double deflation" is given by the gap between the WPI and the CPI. In the 2014-2017 period, oil prices plunged, causing the WPI to fall sharply relative to the CPI. This meant that real growth was probably overstated.

In the last few months, the exact opposite has been happening. WPI inflation is soaring, reaching 14 percent in November, while CPI inflation has "only" been 5 percent. The rapid increase in the WPI relative to the CPI is imparting an upward bias to the deflator, which increased at the remarkable rate of 8 percent in the second quarter of 2021-22. If this deflator is being overestimated, then real GDP growth rate could be underestimated right now.

A second reason why growth might be underestimated is that the CSO has not updated the sectoral weights. When the CSO calculates GDP, it takes a sample of activity in each sector, then aggregates the figures by using sectoral weights. To make sure that the weights are reasonably accurate, the CSO normally updates them once a decade. It has now been more than 10 years since the weights were changed, and there are no signs of a base year revision. As a result, the sectoral weights are still based on the structure of the economy in 2010-11, when in particular the information technology sector was much smaller. In other words, the fast-growing IT sector is being underweighted, which implies that GDP growth is being underestimated.

But before we jump to conclusions, we need to take into account the third measurement problem – which works in the opposite direction. Measurement of the unorganised sector has always been difficult in India. Once in a while, the CSO undertakes a survey to measure the size of the sector. In the meantime, it simply assumes that the sector has been growing at the same rate as the organised sector. This practice was working well when the two sectors were moving in tandem.

However, starting in 2016 the large unorganised sector has been disproportionately impacted by a series of shocks. First came the demonetisation shock of 2016, which was a severe blow to cash-dependent firms in this sector. Next came the implementation of the Goods and Services Tax (GST) from 2017 onwards, which necessitated a particularly difficult and costly adjustment for unorganised sector enterprises. Then in 2018 came serious problems in the NBFC sector, in turn creating problems for unorganised sector firms, since they were heavily dependent on NBFCs for funding. Finally, the Covid pandemic from 2020 onwards was undoubtedly a much bigger shock for the unorganised sector, compared to the organised sector enterprises.

Despite these severe shocks, the CSO does not seem to have made any adjustments to their methodology for estimating unorganised sector growth. They apparently continue to assume that unorganised sector enterprises have been growing as fast as those in the organised sector. In that case, there would be an upward bias to reported GDP growth.

So, what is the bottom line? Can we say whether the latest GDP numbers overstate or understate growth? The answer is no, because the measurement problems go in different directions. Without more information from the CSO on their methodology we cannot say whether the positive factors outweigh the negative one, or vice versa. But what we can be clear about is that there are serious problems with India’s GDP data. Hence any analysis of recovery or any forecast of future growth of the Indian economy based on this data must be taken with a handful of salt!

Thinking about financial sector reforms in India

Thinking about financial sector reforms in India, Ideas for India, November 15, 2021.

The difficult art of smooth landing

(with Harsh Vardhan), MoneyControl October 19, 2021

The October 8 monetary policy statement sent a mixed signal about the Reserve Bank of India (RBI)'s approach towards liquidity management. While the RBI seemed concerned about the surplus liquidity in the financial system, it was not clear what it plans to do about it. The communication highlighted the conundrum that the RBI faces regarding management of excess liquidity.

Since the start of the COVID-19 pandemic, the RBI has injected massive amounts of liquidity into the system through various schemes, including for the first time, pre-committed to buy government securities (G-Secs) under the G-Sec Acquisition Programme (GSAP). As of now, the surplus liquidity in the system is around Rs 13 trillion.

The RBI should be worried about how to absorb the excess liquidity due to three main reasons — all related to inflation. In September, CPI (consumer price index) inflation was 4.35 percent, which was close to the target of the 4 percent. If inflation remains low, then liquidity can remain easy for a longer period.

However, scenarios with rising inflation seem quite plausible now.

First, inflation in India has not yet been conquered. Core inflation (i.e. non-food, non-fuel inflation) was 6 percent in September, and has been persistently high and sticky for months (see graph below). Core inflation has been stubborn despite the negative impact of the pandemic on aggregate demand, and very low credit growth. As India comes out of the pandemic, the aggregate demand will only increase, thereby putting further pressure on inflation.

Second, the economy is facing an acute energy crisis with coal shortages, and rising global crude oil prices. The price crude oil has increased 122 percent, from $37 per barrel in June 2020 to $81 in October 2021. High fuel prices will feed back into overall inflation. Further, worsening coal shortages will aggravate supply side constraints, and push up the price of electricity, thereby pushing up inflation. We are yet to feel the full impact of this energy crisis.

Third, there is a big risk that we are entering a new phase of global inflation. As the advanced economies recover from the pandemic, and simultaneously experience prolonged supply bottlenecks in an environment of easy money, the era of low inflation seems to be over. If that is indeed the case, India cannot remain insulated.

If inflation pressures keep rising, at some point the RBI will need to withdraw the excess liquidity. While it is relatively easy for a central bank to infuse abundant liquidity, it is significantly harder to come out of it.

On October 8, RBI Governor Shaktikanta Das announced that the RBI will be conducting 14-day variable reverse repo rate (VRRR) auctions on a fortnightly basis. This means that the RBI will be absorbing some amount of the excess liquidity from the financial system on a short-term basis for 14-days at a rate decided in the auctions. This strategy will move liquidity from an overnight window (in case of absorption at the reverse repo rate) to a longer 14-day window. However, it is not clear from the RBI’s statement, what is their plan going forward to take out the liquidity structurally, and permanently, from the system. The VRRR alone is not sufficient to normalise the liquidity situation.

The RBI has suspended its GSAP programme for now. Technically it could conduct a reverse GSAP i.e. it could sell the G-Secs in order to bring the liquidity levels down. This can run into two problems.

First, banks would typically be the ones to buy, but banks are already holding much more than the minimum statutory requirement of holding G-Secs (i.e. the SLR norms). Further, as commercial credit picks up with normalising economy, such actions may crowd out private credit. Banks, focused on maintaining their spreads i.e. the difference between what they pay the depositors, and what they earn on their loans and investments will be reluctant to excessively invest in G-Secs — the lowest yielding investments, as it hurts profitability.

Second, any attempt by the RBI to reduce liquidity will inevitably lead to high G-Sec yields, and push up effective interest rates in the economy. This in turn will worsen the government’s budgetary position given that it is already struggling to finance an unprecedented level of debt.

The natural solution in the short term could be a compromise: withdraw some liquidity but not a whole lot. However, if inflation continues to rise, the RBI will be left with very little choice. If it does not act promptly, then, to normalise the liquidity situation, inflation would get worse, which in turn will force the RBI to raise rates; and if it does try to absorb the excess liquidity, interest rates will go up.

In other words, the very objective of the RBI’s liquidity injection policy of keeping interest rates down, may not be met beyond a few more months.

Understanding the dynamics of the rupee-dollar exchange rate

Understanding the dynamics of the rupee-dollar exchange rate, Ideas for India, October 11, 2021.