Getting the right blend: how the Budget can complement monetary policy

Getting the right blend: how the Budget can complement monetary policy

Getting the right blend of policies challenges economic management at the best of times. When the settings are at crisis levels, the retreat to normalization is a tightrope walk. Distributing fiscal-monetary tightening on the way to full recovery means weighing deficit cuts against interest rate hikes—a delicate coordination of macro policies. The sequencing gets more complex when deficits are large, inflation is headed towards double digits and the growth pickup needs sustenance.

India is at the point where synchronizing monetary and fiscal policies is imperative to lift growth rates beyond 8% next year. The Budget—framed in this context—will set the mixture of macro policies for 2010-11. With medium-term growth predicated upon domestic demand, the fiscal-monetary interplay has to be trained upon reviving investment. Of the 6.8% gross domestic product (GDP) growth in 2009-10, domestic demand adds 5.2 percentage points. Of this, 3.4 percentage points is due to consumption, which displays a sustained rebound from April-June 2008.

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The decomposition shows that the contribution of investment to output growth has fallen to 1.8 percentage points, in contrast to the average 4 percentage points it added annually over 2004-07. The share of imports in gross investment—at 69.8%— is at 2004-05 levels. Though gross investment growth is expected to accelerate by 4% this year—after a 1.7% contraction in 2008-09—this is a quarter of the strong capital expansion underpinning the 8.5-9% growth rates of 2004-07. If output growth in 2010-11 has to be lifted to 8%-plus, a strong investment recovery is key.

A modest fiscal adjustment now will assist monetary policy attain the growth objective. The rebound in industrial growth and a 7.2% GDP growth forecast for 2009-10 show it is time to shift gears. Retrenchment from an ultra-loose fiscal stance will lower interest rates and support investment demand. In the year to January, the 10-year government bond yield zoomed 237 basis points as investors demanded a higher premium to offset increased solvency risk. Inflation concerns have pushed yields up by a further 20 basis points. Markets now expect the yields to reach 8%.

Bringing down the long-term bond yields involves fiscal adjustment and/or monetary action. Lowering interest rates through fiscal discipline is the logical starting point in view of the large fiscal deficit (6.8% of GDP), the existing stock of debt (close to 80% of GDP) and the costs of debt financing. Much of the yield premia reflect these risks: Public finances spoil India’s stable macroeconomic position. A negative confidence shift affects its credit rating, marring growth prospects. An effort at consolidation would boost investor confidence; this will lower bond yields. It will also offset the drag on demand from lower government spending and increased taxes.

An alternative policy combination—large deficit and higher interest rates—implies costlier debt. Pushing down bond yields through market intervention constrains monetary policy and sends out wrong signals to market participants.

Three, tightening the fiscal belt now means lesser monetary tightening later. As the business cycle returns to trend and demand tugs at prices, the need to increase rates lessen. Budgetary tightening through reversal of some excise duty cuts will help restrain inflation by containing demand in segments with near full capacities.

Last, this mix of policies will help manage capital inflows. Lowered yields and lesser interest rate hikes translate into a smaller wedge between domestic and foreign interest rates. This will moderate interest differential-driven inflows of short-term foreign capital. A tighter Budget will also counter exchange rate appreciation and offset the impact of a strengthening currency upon exports.

Macroeconomic coordination is thus vital for growth. The Budget can complement monetary policy in three ways. In the near term, it can help unwind stimulus packages through a modest retrenchment. Two, it can aim at budgetary consolidation in the medium term through cyclical improvement in revenue, expenditure reduction and disinvestment. Three, it can implement structural reforms—direct tax rationalization, goods and services tax introduction on the revenue side; subsidy reform on the expenditure side—to bridge the budgetary gap in the long run.

Renu Kohli was until recently with the International Monetary Fund. Comments are welcome at