The Reserve Bank of India (RBI) has made no bones about its view that monetary policy in India has been constrained by the central government’s policies. It has, in numerous policy statements, called for a change in both the quantity and the quality of the fiscal deficit. Its recent publication, titled Report on Currency and Finance, elaborates on the rather strained relationship between RBI and the government.
The central bank has for long been saying that government inaction in addressing supply-side bottlenecks has been a major cause of inflation. The report drives home that point. It says that in 16 of the last 20 years, the weighted contribution of the fuel and food groups to overall wholesale-price inflation has exceeded their combined weight in the index. This is proof that inflation in these categories is not temporary but structural in nature, the result of inadequate supply.
The ham-handed response of the government has been to suppress structural inflation by subsidies and administered prices, rather than do the hard work required to increase supply. The upshot is a higher fiscal deficit, which in turn leads to higher inflation.
Naturally, these policies ultimately become unsustainable and administered prices finally have to be raised. What happens then? Here’s what the staff at the RBI’s department of economic and policy research, the authors of the report, think will be the current impact on inflation: “At the current juncture, if prices are adjusted in one go to remove total under-recovery of the oil marketing companies and prices of coal and electricity are adjusted upwards by a moderate 10% each, the direct impact would increase wholesale price index (WPI) by 4%.” Since the WPI is currently at 6.6%, that implies actual inflation would be around 10.6%.
It doesn’t stop there. Higher inflation in turn leads to a higher fiscal deficit. That is because government expenditure increases with inflation. Project costs escalate, wages are indexed to rising prices and expenditure on subsidies too is highly sensitive to inflation. But, shouldn’t government revenues too increase? Not to the same extent. Empirical studies show the long-term impact of inflation on state expenditure is much larger than on revenue. Thus, inflation widens the fiscal deficit, which in turn leads to higher prices and a vicious circle is unleashed.
The report also points out that in India, governments have not taken advantage of high growth to reduce government spending. On the contrary, fiscal policy has been pro-cyclical. Ideally, governments should borrow during bad times and repay debt during good times. But, instead the opposite has happened, even though, as the report’s authors underline, “such behaviour defies common wisdom.”
High fiscal deficits financed through market borrowings push up interest rates and crowd out private investment. And to the extent that higher subsidies have been offset by lower capital expenditure by the government, it prevents increased supply. This reduces the economy’s potential output and constrains monetary easing.
But surely with the government’s new roadmap to fiscal consolidation, all this is now water under the bridge? Well, the report is less than euphoric about it. Here’s what it has to say: “The roadmap does not sufficiently address the issue of quality of fiscal consolidation. There has been over-dependence on non-durable resources of revenue, inadequate pruning of subsidies and undesirable reduction in capital spending as part of this fiscal consolidation strategy.”
What then should the government do? The report feels expenditure rules should be added to the fiscal deficit targets and the definition of deficit should be broadened to cover quasi-fiscal activities. Including the losses of state power utilities would be one example. Perhaps we should target a “public sector borrowing requirement” instead of a fiscal deficit. There’s also the need to reduce dependence on the statutory liquidity ratio, which ensures captive financing for government bonds. RBI officials have said they are considering reducing the held-to-maturity limit in debt for banks, which, as the report says, leads to crowding out of private credit.
At the same time, there’s no doubt the government has moved to lower its fiscal deficit. The 2013-14 budget also envisages a shift from revenue to capital expenditure. Yet, plenty of supply-side problems persist and there is little that can be done about them in the short run. What does this imply for monetary policy?
Clues can be found from a recent speech by RBI governor D. Subbarao, in which he reiterates that much of our inflation is driven by supply constraints and accepting higher inflation “entails the moral hazard of policy inaction in dealing with supply constraints”. Simply put, the central bank must, through a tight money policy, force the government to address the structural constraints that keep inflation high. It should presumably do so until inflation becomes more normal. Now, what is normal? The normal rate of inflation, says Subbarao in the speech, is within a range of 4.4% to 5.7%, the mid-point being around 5%.
In short, interest rates can certainly be lowered as long as there is an output gap without fanning inflation, but supply constraints, exacerbated by government policies, have brought down the potential output of the economy. These constraints will severely limit the extent of monetary easing the central bank can undertake.
Manas Chakravarty looks at trends and issues in the financial markets. Your comments are welcome at firstname.lastname@example.org.