Photo: Bloomberg
Photo: Bloomberg

Lifting the ‘trend’ rate of growth

It is important that the gains made on the fiscal and monetary fronts over the past two years are not reversed

The policy initiatives of the Narendra Modi government so far have largely focused on repair and reform of ecosystems and improving the macroeconomic fundamentals. If the momentum on these improves, it will do more to raise India’s ‘trend’ or potential rate of growth—or that which does not set off inflationary fires—rather than push up cyclical growth. Global experience suggests raising the trend growth is not only arduous but happens with a lag.

In contrast, aggressive monetary and fiscal policies can have a steroidal, and often short-lived, impact on growth, just like stretching a rubber band. For example, after the global financial crisis, in fiscal 2009, India’s growth slipped more than 2.5 percentage points but then sprung back nearly all the way by fiscal 2011. That rebound had come on the back of both monetary and fiscal stimuli. Not surprisingly, growth declined after the stimulus was withdrawn (when inflation spiked and fiscal distress started building) and government decision-making was paralysed.

Today, the global economy is fraught with risks and fragility, but India stands out in two respects. First, it is among the few countries—and the only large economy—whose 2016 growth prospects have not been scaled down. Second, it has avoided being seduced by monetary and fiscal steroids to support growth and deflect global headwinds and the adverse impact of two consecutive deficient monsoons.

World over, particularly in advanced countries, there is excessive reliance on monetary policy to keep the growth engine firing after the global financial crisis. When interest rates were zero-bound, new unconventional instruments such as quantitative easing and negative interest rates were deployed. With that being not very effective, talk of ‘helicopter money’—wherein a central bank transfers money directly to households to stoke consumption—is gaining currency.

But the truth is, there is no free lunch, and all monetary experiments only add to global risks.

The debate on India’s growth has overwhelmingly focused on the quantum and its veracity and not so much on its quality—which is about whether growth is supported by sound macroeconomic fundamentals that make it more durable.

We believe the quality of India’s growth has improved in the past two years for three reasons:

First, growth this time is not fired by steroids unlike in 2009-11. The fiscal policy, encouraged by low crude oil prices, has been quite prudent. The government’s spending focus is on creation of infrastructure, especially rural roads, irrigation, shipping and railways, while keeping a tight leash on overall spending. This can draw in private investment and over time drive up the economy’s trend rate, and that’s why we believe growth would steadily tick up. Fiscal consolidation will also help keep inflation under check and indirectly benefit the economy by bringing down cost of borrowing for both the government and the private sector.

The government, together with the Reserve Bank of India, has initiated the process of modernizing central banking by adopting an explicit inflation targeting framework and setting up the Monetary Policy Committee, which will engender a low and stable inflation regime. However, food inflation remains a major challenge, and here, the ball is in the government’s court.

Second, growth this time is not supported by excessive credit creation like in China. Domestic credit growth has averaged 9.8% per annum in the past two years compared with a 10.2% nominal gross domestic product (GDP) growth, underscoring sustainability. China is growing faster than what its fundamentals and global economic environment permit. That’s because of excessive credit creation and stimulus from fiscal spending.

And thirdly, India’s growth this time is accompanied by a mix of repair and reform. Over the past two years, steps have been taken by the government to mend the electricity and banking sectors. Measures by the Modi government since taking office in May 2014 have also improved India’s competitiveness and ‘ease of doing business’ rankings. Two key legislation have also been passed— the Insolvency and Bankruptcy Code Bill, 2016, which strives to create an enabling environment for expeditious resolution of bankruptcies with least pain to all stakeholders, and the Aadhaar bill to distribute subsidies, rural wages and pensions through an electronic platform.

But all this is only work half done. Also, the second leg of this journey of quality will involve doing the hard yards on health and education because standards are way below what is required.

What’s pertinent to note is that 2016 will be the mid-point of the five-year term of the Modi regime and election compulsions can soon start dominating policy decisions. The risk with the political cycle kick-starting is that policy attention could shift to ‘performance enhancers’ or cyclical growth, which typically rely on loosening of monetary and fiscal policies.

Steps initiated by the Modi government will remain works-in-progress for some time, and the momentum needs to continue through the political cycle to be truly effective. This year, therefore, will need to be watched for more reforms and, more importantly, relentless implementation of executive and policy actions already announced.

In the context of macroeconomic management, it is important to ensure that the gains made on the fiscal and monetary fronts over the past two years are not reversed. Sure, that would mean only a gradual pick-up in GDP, but it will ensure that India wins the growth marathon by lifting its trend rate.

Dharmakirti Joshi is chief economist at Crisil.

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