India is now grappling with a balance sheet recession that has perhaps put the economy close to deflation. This stunning insight lies at the heart of the excellent second volume of the Economic Survey released by the finance ministry on Friday. The first volume was released in January.
The Survey argues that the problem of over-leveraged private sector balance sheets makes the current economic downturn resemble what countries such as Japan, Spain and China experienced in recent decades.
As the Survey points out: “The Indian boom of the 2000s has not been followed by serious deleveraging. While the slow growth of bank credit in the last two years has been a source of concern, the question may well be not the slowdown but whether there has been enough of it. If deleveraging is a necessary condition for the resumption of rapid growth, perhaps India needs less credit growth — or to be precise more debt resolution and reduction — in the short run".
This is the sort of boom-and-bust cycle that has been analysed by economists such as Irving Fisher in the 1930s and Richard Koo in the 1990s. Further, the finance ministry believes a witches’ brew of economic trends adds deflationary risk to the Indian economy — real exchange rate appreciation, farm loan waivers, increasing financial stress in power and telecom companies, rural distress and the immediate effects of the new goods and services tax (but curiously does not mention demonetisation in this context).
The economists in the finance ministry are clearly hammering away at the deflation risk in the first few pages of the Economic Survey, given the recent debates about whether the Reserve Bank of India is keeping monetary policy too tight.
The Economic Survey makes three points.
First, the central bank has been overestimating inflation in its forecasts. Second, India is in the middle of a structural fall in inflation thanks to the global commodity cycle. Third, standard analytical tools such as the Taylor Rule suggest that policy interest rates are up to 75 basis points (one basis point is one-hundredth of a percentage point) higher than required.
The finance ministry officials also make a peace offering by agreeing that a central bank may need to be hawkish to build credibility in the early years of inflation targeting.
What is to be done?
This is where the Survey treads on water. The standard response to a balance sheet resolution is quick resolution of excess debt plus a fiscal stimulus to domestic demand.
Lower interest rates rarely work since a private sector deep in debt prefers to hold on to the savings from lower interest rates rather than spend on new projects or consumer goods.