The dramatic slowdown over the past few quarters in India has logically brought to fore the role of countercyclical policy. Within this, the role of monetary versus fiscal policy often gets debated. We will focus on fiscal policy, which sees high conviction views. On one hand, the argument goes that government should go ‘all out’ never mind the fiscal, given the current state of the economy. On the other, caution is expressed given the ‘effective’ public deficit as opposed to the actual printed one.

It is quite likely that India’s growth as denoted by real GVA (gross value added) will print around 5% for FY20. If so, this will be the slowest expansion since FY09. Thus, there is little doubt that there is a role for countercyclical discretionary policy as well. Given the more ‘blunt’ nature of monetary policy, there is no doubt that at a concept level, there is a role for more aggressive fiscal policy. However, it is important to understand this in a real world context and assess possible unintended consequences.

What not to worry about

There are some noteworthy points that need mentioning. The most important one is that we are in the midst of this slowdown, where core inflation has now fallen to 3.5% despite a higher aggregate deficit. This is critical to understand since clearly the fiscal hasn’t been noticeably expansionary given economic context or else we would not have slowed so much. Rather, public deficit has expanded as private investments have been subdued, courtesy our famous ‘twin deficit’ problem. Thus net stimulus has been well contained, especially accounting for the last pay commission cycle. This, then, is not the problem to worry about with respect to our fiscal.

What to worry about

The clear problem with respect to our deficit is our domestic ability to finance it. The ratio of public sector deficit with the net financial savings of households, which is a proxy for resources available to finance this deficit has been steadily climbing over the past few years and now stands close to its highest in recent history (at least the last 19 years). There are a few important takeaways here.

One, while there is nothing wrong ideologically to launch a countercyclical fiscal stimulus, the fact remains that we have run out of savings to finance this. All other things remaining constant, this will further accentuate crowding out and further impede transmission of rates. Two, comparing with 2008, public sector deficit more than doubled from 5.2% of GDP in FY08 to 11% in FY10. This represents the magnitude of the government response to that slowdown. Importantly, even after this expansion, public sector deficit as a percentage of net household financial savings was less adverse then that it is today as total savings were much higher than what they are now. The above shows the futility of pushing at the fiscal string. Not only does it risk further crowding out, but the magnitude of incremental response can never match up, given the constraints on financing.

Our effective public deficit is high and sticky. However, this isn’t necessarily a problem of excesses since the current slowdown is despite this deficit. Furthermore, inflation has largely behaved well during this period. The problem is more of financing, at least in the near term. While the deficit has been sticky, household’s net financial savings have been falling. The way out is to aggressively court offshore capital for now so that the constraints posed by domestic financing get alleviated. Overtime, as domestic resources rise, the incremental burden can shift back to domestic financing. This needs to be clearly implemented.

Suyash Choudhary is head, fixed income, IDFC Mutual Fund

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