Opinion | Testing times for Indian policymakers
As the country heads into a long spell of elections, the government will be under constant pressure to reduce taxes on petroleum products
This is a difficult time to be a policymaker in India. The complexities of economic management continue to deepen. On Thursday, for instance, the rupee fell to a fresh low, stock prices were once again in a deep correction mode and bond yields went up. Then came the kicker: the Union government announced excise duty reduction of ₹1.5 per litre on petrol and diesel and asked state governments to reduce value-added tax on them. Oil marketing companies too will absorb a hit of ₹1 per litre. This is not going to make things any easier—quite the reverse.
The cut will affect government finances and complicate matters for financial markets. As the country heads into a long spell of elections, the government will be under constant pressure to reduce taxes on petroleum products, and markets will now factor in this possibility in asset prices. Meanwhile, rising crude prices are likely to push India’s current account deficit (CAD) further, putting more pressure on the currency.
But the problem is not limited to a potential rise in the CAD; financing is likely to get more difficult in the evolving global economic environment. The yield on 10-year US government bonds touched a multi-year high this week. The US Federal Reserve is on course to raise interest rates once more this year, followed by three hikes next year. Global money managers are likely to shift more towards US assets with the given economic outlook and higher yields. Capital flows to dollar assets would not only affect global liquidity but will also push the greenback up. This will put more pressure on currencies of emerging market countries like India with widening CADs.
It has been reported that in order to combat this pressure and boost foreign exchange inflow, the government is considering a special deposit plan for non-resident Indians (NRI). This option could be tricky in the given circumstances due to a number of reasons. First, it should be seen as the last option and not an easy one to bring in foreign exchange. It is likely that if the option is used more often, from a policy standpoint, it will have diminishing returns. It will also be seen as a commentary on India’s policy management, which has not been able to find a durable way out of the recurring balance of payments problem.
Second, the tightening in global financial conditions will continue in the foreseeable future. The Fed is on course to raise interest rates by two percentage points between now and the end of 2019. Interest rates in the US will go up along with the ongoing reduction in the size of the Fed’s balance sheet. Further, the European Central Bank (ECB) is likely to end its quantitative easing programme by the end of the year. Therefore, in terms of financing, the global economy is witnessing a structural shift with the withdrawal of crisis-era policy accommodation. Raising NRI funds as was done in 2013 will not solve the problem.
Third, raising foreign currency deposits from NRIs will not be easy. With tightening financial conditions, funds are likely to come at a much higher cost. Also, repayment might add to the problem because of pressure on capital flows. Therefore, it is important for policymakers to carefully consider the costs and benefits of a decision like this. The NRI money will, at best, provide only temporary relief.
Unfortunately, with the given outlook for crude prices and financing conditions, there are no easy answers to India’s problems. By cutting tax on petrol and diesel, the government has further complicated the issue. The next policy test will be for the monetary policy committee of the RBI, which will announce its decision on policy rates later today. This newspaper has argued in favour of a rate hike. With the reduction in tax on petrol and diesel, the case has been strengthened. It will also be important to see how the committee now addresses wider financial stability concerns.
Policy management on the part of the government was always going to be more difficult. Aside from oil prices, issues such as distress in the farm sector will put pressure on government finances. A slippage at this stage will disproportionately increase financial stability risks. It is, therefore, important that the government keep its finances under tight control. While the government has reiterated that it will maintain the fiscal deficit target, markets will now view this claim with greater scepticism.
The need at this stage is to quickly move forward with reforms—such as removing impediments in the factor market—that will improve investor confidence and push the growth potential of the Indian economy. It is critical for policymakers to not take short-term decisions that can backfire.
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