It is but natural that India and China have taken the lead in exiting from the extraordinary stimulus that governments around the world put in place after the collapse of global economic activity in the fourth quarter of 2008 and the first quarter of 2009. The two Asian powers have managed to get their economies back on track before other major economies, and there are fears that continuing with loose fiscal and monetary policies will lead to asset and credit bubbles, especially in China.
Illustration: Jayachandran / Mint
Both India and China have begun their exit policies with monetary rather than fiscal tightening, increasing the statutory minimum of cash that banks will have to hold, moves that will raise the cost of money at the short end of the yield curve. The Reserve Bank of India (RBI) raised the cash reserve ratio by 75 basis points last week and a rate hike seems due within the next three months, given the robust economic recovery and the sharp rise in inflation.
But this is a game for two: The ball is now in the court of the government, as it prepares to announce the new Union Budget on 26 February. “The reversal of monetary accommodation cannot be effective unless there is a rollback of government borrowing,” RBI governor D. Subbarao said in his Friday monetary policy statement. Finance minister Pranab Mukherjee is well aware of the challenge, going by his many recent statements on the need to get public finances back in shape in the medium term. Bringing indirect taxes—which were cut in early 2008 to stimulate domestic demand—back to normal in the coming Budget is one clear way forward.
The finance minister will most likely announce a path of fiscal sanity at the end of this month, based on the recommendations of the 13th Finance Commission headed by Vijay Kelkar. But he will also have to make serious and credible moves right away to convince the bond and equity markets that the fiscal deficit will indeed shrink.
The issue here is not just coordination between the finance ministry and the central bank on the stimulus exit. One way to think about the stimulus is the shift of risks from the private sector to the government sector, the most well-known indicator of this being the sharp rise in public debt. The risk was shifted from a risk-wary private sector to the government. This process will have to be reversed if India is to steer clear of yet another fiscal trap.
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