Opinion | Time for the orchestrated use of three different economic levers

A nuanced combination of lower interest rates, fiscal expansion and a cheaper rupee could help India’s economy recover

There are three main mental models that can be used to understand moments of economic stress. These are worth reiterating a week after the government said that the Indian economy had lost momentum for a sixth quarter in a row and economic growth in the second quarter of the current fiscal year was the lowest in 26 quarters.

The first mental model tells us that governments that have gone on a fiscal splurge rapidly expand money supply to earn the seigniorage necessary to fund an unsustainable fiscal deficit. There is neither enough tax collections nor domestic savings to bridge the widening gap in public finances. The rapid expansion in money supply then leads to high inflation. Macroeconomic stress is thus rooted in an unsustainable fiscal policy, though the proximate cause is high inflation from monetary expansion. This has broad parallels with what went wrong in many Latin American countries in the 1980s and perhaps 1990 India as well.

The second mental model relates to the way the exchange rate is managed. Open economies that either formally or informally maintain fixed exchange rates, in effect, lose control over their monetary policy. A central bank dealing with a wave of excess global capital inflows will have to let its money supply expand once it has hit the limits of sterilized intervention. Otherwise, it has to squeeze money supply, and push up interest rates, to maintain an exchange rate peg when there are speculative attacks on the currency. The former is akin to what happened in many Asian economies in the 1990s, while the latter describes the difficulty that the UK had to face when it tried to remain within the European Exchange Rate Mechanism (ERM) in 1992.

The third mental model differs from the other two by being focused on the finances of the private sector rather than the government sector, more specifically the stressed balance sheets of financiers as well as borrowers. There are two forces at work once the reality of excess leverage hits. First, companies and households use their cash flows to repay debt rather than spend. Second, lenders do not have the confidence to make fresh loans when their balance sheets are already groaning under the weight of bad decisions taken earlier. A balance sheet recession could be triggered by a drop in asset prices or some other factor. The classic case of a balance sheet recession is Japan after its asset bubble burst in 1992.

These three mental models need not be exclusive of each other and real world examples of economic stress may have elements of all three. These frameworks could be useful in analysing the sharp slowdown in Indian economic growth over the past six quarters. They also provide clues about what can be done, as each type of economic stress requires a different policy response. Getting the diagnosis right is thus important.

The most startling fact about the Indian economy over the past few quarters is the collapse in nominal economic growth to its lowest level in two decades. The latest quarterly nominal growth rate is lower than the incremental cost of government borrowing, a flashing amber light for a country such as India that also has a primary government deficit. India is not necessarily headed into an internal debt trap and nominal growth is likely to recover. However, this is an early warning that should not be ignored.

A deep interest rate reduction should be a first line of defence. The Reserve Bank of India’s (RBI’s) monetary policy committee should sharply reduce its assumption of the equilibrium real rate of interest in the economy, and thus move towards a zero real policy rate in the coming months, though a minor uptick in headline inflation is expected. RBI had helped bring down the yield on the benchmark government bond from 12.2% in November 1998 to 5.1% in December 2003, during a similar period of weak domestic demand. Among other things, this measure helped the government reduce its cost of borrowing and also provided banks with a buffer as the value of their bond portfolios went up.

However, lower interest rates will not suffice. They can just be used by the private sector to further deleverage. The key will be to get banks, companies and households to change their behaviour, or reignite animal spirits. Central banks are generally more successful when they have to control the country’s monetary levers while demand for credit is higher than the comfort level, and less successful when they have to use the same levers while demand for credit is very weak.

Fiscal policy will have a role to play in getting aggregate demand back on track. The example of the 2009 stimulus shows that the failure to pull back in time can lead to balance of payments problems down the line, so using fiscal policy aggressively is not without its risks. Also, bond yields will jump unless the government can credibly signal that its fiscal expansion is merely a temporary response rather than a new trajectory. Remember that total government borrowing is already soaking up most of the domestic financial savings of households.

A lower exchange rate can help reflate the economy too, but will also impose costs on firms that have large unhedged dollar borrowings. How to depreciate the exchange rate without being denounced as a “currency manipulator" is also a tricky question. The coordinated use of monetary, fiscal and exchange rate levers will thus be a nuanced act.

*Niranjan Rajadhyaksha is a member of the academic board of the Meghnad Desai Academy of Economics

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