Opinion: Time for economic policy vigilance
External sector risks are getting amplified by the tightening of financial conditions in global markets
The Indian economy is gaining momentum. The annual assessment by the International Monetary Fund (IMF), released on Wednesday, showed that it expects the Indian economy to grow at 7.3% in the current, and 7.5% in the next, fiscal. India is contributing 15% to global growth. Some of the recent structural reforms, such as the implementation of the goods and services tax (GST) and Insolvency and Bankruptcy Code (IBC), along with liberalization of foreign direct investment and improvement in the ease of doing business, will help improve economic activity. The IMF has also highlighted several external and internal risks. Although some of them are well known, they will require careful management.
On the external front, for instance, there are risks such as high crude prices and the tightening of global financial conditions. India’s current account deficit widened to 1.9% of the gross domestic product (GDP) in 2017-18 and is expected to go up to 2.6% of GDP in the current year. The widening of the current account deficit is getting reflected in the depreciation of the rupee, which has fallen over 7% since the beginning of the year. External sector risks are getting amplified by the tightening of financial conditions in global markets. The US Federal Reserve is reducing the size of its balance sheet at a predetermined pace and is also raising policy rates. The Fed is expected to raise rates twice more this year. Further, higher bond issuance by the US government to fund its budget deficit is affecting dollar liquidity in global markets. The rising interest rate has also put pressure on capital flows. Indian markets witnessed capital outflows in excess of $11 billion between April and June.
A slow and gradual weakening of the rupee is not particularly worrisome for India, as it was significantly overvalued in real terms and the Reserve Bank of India (RBI) has sufficient reserves to smoothen volatility in the currency market. The RBI has done well by pre-emptively hiking rates to anchor inflationary expectations, which will also help reduce volatility in the currency market. Gradual depreciation should help contain the current account deficit. The IMF also expects merchandise exports to pick up in the current year. However, faster-than-expected rate hikes by the Fed could escalate volatility in global financial markets and increase the risk for emerging market economies like India. Aside from current external risks, policymakers should also review the way India manages its currency so that a sharp real appreciation is avoided.
On the domestic front, there are risks such as the delay in addressing the twin balance sheet issue and possible revenue shortfall owing to GST implementation issues. The resolution of the twin balance sheet problem is a real challenge. Even though India now has a bankruptcy code in place, these are still early days and the structure will take time to stabilize. The government is working to improve the system. It has been reported that it is now planning to set up special courts under the National Company Law Tribunal, which should help speedy resolution of cases (bit.ly/2Mdb9Oe). Nonetheless, it will still take time, and resolution or liquidation of distressed assets could result in large haircuts for banks. This will possibly increase the capital requirement of public sector banks and the government, with fiscal constraints, may find it difficult to spare resources.
On the fiscal side, while the collection from GST is improving, it is still running below the desired rate of ₹1 trillion per month. A shortfall in revenue will affect Central government finances as it is bound to compensate state governments. Any compression in capital expenditure as a result of revenue shortfall will affect growth. Some analysts are also worried about the possibility of higher- than-budgeted expenditure in an election year. Fiscal slippage at this stage will affect confidence and increase both external and internal risks. Therefore, the government would do well to not allow the fiscal deficit to cross the budgeted mark of 3.3% of GDP.
Further, the IMF has rightly highlighted that even as important reforms have been implemented, more will be needed in areas like land and labour. In this context, it noted: “Labour market reforms could complement the GST in terms of promoting the formal economy and creating fiscal space for needed social and infrastructure spending.” Factor market reforms and greater formalization of the economy will push growth and generate higher tax revenue. A strong fiscal position will also help reduce external vulnerabilities.
However, these reforms may have to wait at least until after the 2019 general election. For now, the government should work on smoothening the IBC and GST and not allow electoral compulsions to affect fiscal management.
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