One way to read the new monetary policy announced by Reserve Bank of India (RBI) governor D. Subbarao on Tuesday is to see it as a return to normality.
The unprecedented financial crisis that hit the world economy about a year ago led to close coordination between governments and central banks since the interests of both lay in preventing an economic and financial collapse. Now, as economies get back on the recovery path, it is likely that the policies of finance ministries and central banks will start to diverge once again, with the former being more concerned about economic growth and the latter worrying more about accelerating prices in the months ahead.
We see some evidence of that in the new monetary policy announced by the Indian central bank. There is a strong signal that growing inflationary pressure is now Subbarao’s biggest worry and a clear articulation of the fact that “there can be no two views about the need to make a responsible, credible and time-bound fiscal adjustment”.
The immediate potential risks posed by a high fiscal deficit are well known: a downgrade of Indian debt in the global money market, a catalyst for further inflation, upward pressure on interest rates and crowding out of private investment in case it picks up before the government gets in own finances in order.
But recent data also point to the longer term consequences of a high fiscal deficit on the country’s growth path.
There are many ways to explain the growth acceleration that India saw after 2003: the impact of earlier reforms, benefits of a global boom and a surge in productivity, for example. But the core underlying explanation is that the savings rate shot up from 23.5% of national income in 2001-02 to 37.7% in 2007-08 (quick estimate), largely because of the improvement in the government’s finances. A stubbornly high fiscal deficit could pull down the savings rate again, limit resources available for investment and harm economic recovery. This is a fear that has been voiced in this column earlier as well.
The Prime Minister’s economic advisory council said in its October assessment of the Indian economy: “The spurt in growth over the past several years…was driven primarily by an increase in investment, especially private corporate investment… The increase in the level of investment activity was matched by an improvement in the savings rate, and the latter was brought about in large measure through fiscal consolidation and a reduction in the negative savings of government.”
The economists who advise the Prime Minister estimate that the savings rate in 2008-09 was down to 33.9% and will marginally improve to 34.5% in 2009-10. The latest median forecasts of professional forecasters surveyed by the central bank tell a similar story. They expect the savings rate to be at 33.6% against the 35% they had forecast three months ago.
The finance minister has time and again stressed the need to cut the fiscal deficit once the economy stabilizes. The question is, how soon and effectively this can be done. There is nothing in recent history to suggest that the Indian government can cut its fiscal deficit ratio by more than 3 percentage points in a year or two.
Getting back to the high-growth path that the economy veered away from after the global downturn—and to battle which the fiscal deficit had to be pushed up in the first place—will eventually require better public finances and hence a higher savings rate to support an investment surge.
There is one other option, however. An economy can sustain its investment rate above its savings rate by borrowing capital from global investors: or, in other words, through a higher current account deficit. But that could be a risky path to tread in case the world is hit with another financial tsunami or has to suffer a double-dip recession.
As Subbarao mentioned in his Tuesday announcement: “India is one of the few large emerging economies with twin deficits—fiscal and current account deficits.” He added: “Our current account deficit is modest, and may even be benign given the investment requirements of the economy.”
A lot of the debate on the high fiscal deficit and the need to exit expansionary policies has been focused on the immediate implications. But the longer term risk is to the ability of the Indian economy to sustain the sort of investment rates that are needed to take its growth back to poverty-busting rates of around 9%.
RBI has clearly begun to exit from the extraordinary monetary expansion that it introduced to fight a credit squeeze and growth deceleration in the last three months of 2008. The government, too, will have to start showing that it has a credible plan to roll back its fiscal expansion.
Niranjan Rajadhyaksha is managing editor of Mint. Your comments are welcome at firstname.lastname@example.org