Home / Opinion / Columns /  Opinion | India’s macroeconomic policy playbook is ripe for a debate

Finance minister Nirmala Sitharaman will present the first budget of the second Narendra Modi government against the backdrop of a sharp economic slowdown. The growth rate in the fourth quarter of fiscal 2019 was 2.2 percentage points lower than the growth rate clocked in the first quarter. The Indian economy has been losing momentum in recent months, and even though it is unlikely that the quarterly rate of economic expansion will substantially come down from here in the current fiscal year, a rapid recovery does not seem to be on the cards either.

A lot of attention is now focused on what the monetary policy committee (MPC) will do this week. The fiscal strategy will be revealed in the Union Budget due to be announced in early July. There seems to be more scope for monetary loosening rather than fiscal expansion right now—even while the problem of monetary policy transmission remains intact. Lending rates have not moved down in tandem with reductions in the policy rate.

The finance minister—and indeed the entire Modi government—will also have to pay attention to economic challenges over the longer term once the excitement over her first budget dies down. I have argued in a new working paper for IDFC Institute that India should take a hard look at the existing macroeconomic playbook.

India has been operating in a 2-4-6-8 macro framework in recent years. These are the respective targets or comfort zones for the current account deficit, retail inflation, the consolidated fiscal deficit on the Union and state governments, and the aspirational growth rate of the Indian economy. A well-functioning macro policy framework should be able to usually meet all four targets simultaneously, while satisfying the famous Tinbergen Rule that the number of policy targets should be equal to the number of policy instruments.

There are two specific issues with the existing 2-4-6-8 macro playbook. First, these four targets have been identified at different points of time by different institutions. There is no common analytical framework.

The estimate for the sustainable current account deficit goes back to the 1993 report of a committee headed by C. Rangarajan, though there have been subsequent updates. The retail inflation target comes from the 2014 report on Indian monetary policy by the committee headed by Urjit Patel. The target for the consolidated fiscal deficit is embedded in the Fiscal Responsibility and Budget Management Act of 2003, and similar fiscal laws passed by state legislatures. The aspirational growth rate can be found in some of the recent strategy papers by NITI Aayog.

A look at the data over the past decade shows that India has rarely been able to meet all four targets simultaneously. In other words, India has found it difficult to grow at 8% a year while keeping the current account deficit at 2%, retail inflation at 4% and the consolidated fiscal definition at 6%. Why is that so? One possible reason why rapid growth with economic stability has been hard to achieve is the nature of the Indian growth process. India has been a mix of East Asia and Latin America—periods of rapid growth supported by high domestic savings and periods of economic instability because of a heavy dependence on consumption. The splendid economic boom in the four years to the North Atlantic Financial Crisis is an example of the former. The economic instability during the four years after the crisis is an example of the latter. There are no prizes for guessing which model India should aspire for.

The Narendra Modi government now has to make a tricky political economy choice. Should it ease some of the economic stability constraints such as the fiscal deficit, the current account deficit and retail inflation in a bid to maintain economic growth at 8%; or continue to prioritize hard-won economic stability while facing the risk of social unrest as lower economic growth fails to provide the adequate number of jobs in formal enterprises; or put in place policy reforms that can help raise potential growth without creating periodic bouts of macroeconomic instability? The third option is the most economically attractive in the medium term but also the least politically attractive in the short term given the ongoing economic slowdown.

This is an opportune moment for a organization such as the NITI Aayog to start a broader discussion among economists about whether the 2-4-6-8 framework needs to be tweaked—and if so, how? India needs at least two more decades of rapid economic growth without economic instability to pull most citizens out of extreme poverty. That is easier said than done. The key is to figure out what policy changes are needed to lift potential growth to well over 8% a year, and what are the levels of inflation, fiscal deficit and current account deficit needed to do this in a sustainable manner.

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