India had flirted with an incipient economic crisis a few months before Narendra Modi was swept to power two years ago. Its weak public finances made it one of the most fragile economies in the world. The fiscal deficit was too large for comfort. The current account deficit was at a record high. Inflation was in double digits. All this was a result of the fiscal irresponsibility of the second Manmohan Singh government, combined with the delay by the Reserve Bank of India (RBI) in increasing interest rates to combat inflation.
Much has changed since then. India is now a far more stable economy. The fiscal deficit is down. The current account gap is easily financed through stable capital flows. Consumer price inflation has halved. The main risk to the Indian economy now comes not from weak public finances, but stressed business balance sheets. The excess leverage in large companies mirrors the growing bad loans at banks.
The improvement in macro fundamentals over the past two years is partly a result of the dramatic collapse in global oil prices. However, there is more to the story than a positive terms-of-trade shock alone. It is to the credit of the Indian policy establishment over two governments—especially the trio of P. Chidambaram, Arun Jaitley and Raghuram Rajan—that it learned the harsh lessons of July 2013. Just take a look at the deepening economic and political crisis in Brazil to understand what may have been in case hard decisions had not been taken in the aftermath of the rupee scare.
The Modi government has done a good job in bringing down the fiscal deficit, as well as not falling for the attractive belief that higher growth can be bought at the cost of a little inflation. It now needs to create a new institutional framework that promotes macro stability rather than keeping it dependent on the government of the day.
The underlying problem in the long term is that the Indian political economy has a distinct deficit bias and inflation bias. That is the main reason why India continues to be an outlier compared with other emerging markets: its fiscal deficit and inflation are far higher than its emerging market peers even now. One of the key challenges for the Modi government will be to craft a new institutional framework that drastically reduces this natural tendency to run unsustainable fiscal deficits as well as keep inflation high.
Three initiatives are worth paying attention to in this context.
First, the Modi government has done well to sign a formal monetary policy agreement with RBI. The pivot of this agreement is a formal inflation target. The central bank should have operational freedom to pursue this nominal anchor of monetary policy. A new monetary policy committee will also be put in place soon, though hopefully it will not be packed with government nominees.
This shift is perhaps the most important change in Indian monetary policy since the abolition of ad hoc treasury bills in 1997 ended the automatic monetization of fiscal deficits. More needs to be done to reduce the fiscal dominance over monetary policy.
Second, even the finance minister has stayed committed to the goal of reducing the fiscal deficit. Too much should not depend on the personal commitment of a finance minister. The bipartisan Fiscal Responsibility and Budget Management Act of 2003 had brought in a fiscal rule that would impose legal limits on deficits. It also further reduced the possibility of deficit monetization by preventing RBI from participating in primary auctions of government bonds.
Fiscal rules have suffered a setback the world over after the 2008 financial crisis. The Modi government has now appointed a committee headed by veteran bureaucrat N.K. Singh to design a new fiscal law for India. It is to be seen if the new law suggests a new framework such as cyclically adjusted fiscal deficit targets, which sound good in theory but are difficult to implement in practice unless there is a much better understanding of Indian business cycles.
Third, the Modi government has appointed an Expenditure Reforms Commission to take a hard look at what the Indian government spends on. An overhaul of public spending—be it through direct benefit transfers or a commitment to focus on only merit subsidies—could delink spending patterns from the politics of the day. An earlier expenditure commission had been set up in 2000 with a formal brief “to find a solution to the problem of high rate of growth of non-developmental expenditure by the government and to begin the process of downsizing the government in a systematic way”.
What is common in these three initiatives is that they constitute a shift from discretionary to more rule-based macroeconomic policy. Such a shift is essential because the Indian political system has clear incentives to pursue policies that endanger economic stability as well as encourage rent seeking.
The Modi government has done credible work in the past two years in terms of building a new framework of rules for the conduct of macroeconomic policy. That is one way it can cement a lasting legacy on Indian economic policy.
Niranjan Rajadhyaksha is executive editor, Mint.