Why this is going to be a tough year for economic policymaking

Global central banks are set to raise interest rates steeply to contain inflation. With supplies disrupted by the Russia-Ukraine war and China’s slowdown, interest rate hikes could tip the global economy into a recession. Higher interest rates will encourage continuing capital outflows, threatening financial stability in developing countries that have borrowed too much in dollars and also posing problems for exchange rates.

All this will affect our growth prospects. A global recession will certainly restrain our exports and therefore our growth. Financial instability is less of a danger because our exposure to foreign borrowing is limited, but exchange rate management could pose problems. The Reserve Bank of India (RBI) will face the difficult choice of either intervening strongly to ‘manage volatility’ at the risk of losing reserves or letting the currency ‘find its own level’.

Some basis for framing the alternative possibilities facing us can be obtained from the World Bank report, Is a Global Recession Imminent, released last week. It uses a global model of the economy and spells out three alternative scenarios for emerging market developing economies (EMDEs).

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Base line scenario: EMDEs accelerate modestly to 4.1 % in 2023 and 4.3 % in 2024, bringing them almost back to pre-pandemic growth by 2024.

Sharp slowdown scenario: EMDEs decelerate to 3.3 % in 2023 and then pick up to only 4.1 % in 2024.

Global recession scenario: In this scenario EMDEs decelerate sharply to 1.8% in 2023 and recover to only 3.4 % by 2024!

Where does India stand in this framework? The finance ministry’s assessment of “robust growth" remains broadly valid for 2022-23. RBI’s original projection of 7.2% may well be revised downward to below 7%, but that still qualifies as robust. But this is largely a reflection of the very high growth of 13.5% in the first quarter, reflecting a low base last year. RBI had projected a substantial deceleration in subsequent quarters, with growth in the last three quarters averaging only 5%.

The World Bank report does not contain projections for India but the International Monetary Fund had projected 6.1 % growth for India in April, and it has been lowering its projections since then. All this suggests that the budget for next year has to be framed around a real growth rate of gross domestic product (GDP) of 6 or 6%+. We can aim at higher growth over the medium term. For example, the target of a $10 trillion economy by 2030 calls for an average growth rate of around 8% and we need not give up on that. But the budget for 2023-24 needs to be based on a realistic target. If growth is set at 6%+ and inflation at 4%, nominal GDP growth of around 10.5% would be realistic. Tax revenues should then be projected on this basis. Any optimistic assumption about tax buoyancy should be linked to identified tax reforms, such as implementing the GST reforms that have been talked about.

The growth of expenditure that can be budgeted then depends on the size of the fiscal deficit. This is clearly a weak spot because the central government’s fiscal deficit has been way off the target we had fixed years ago. The pandemic was a legitimate excuse for this deviation, but now that it is behind us, budget watchers will expect steps to bring the deficit under credible control.

Significant fiscal correction is always achieved over time, and in this context we could aim at bringing the central government deficit down to, say, 3.5% of GDP over a three-year period. This could consist of 0.5 percentage points improvement in 2023-24, followed by 2.5 percentage points over the next two years.

It would help if the finance ministry restored the earlier practice of showing the deficit for the next two years after the budget year. Since 2024 will be an election year, the normal budget will be presented only after the polls, but setting a respectable fiscal target in advance is an important signal.

If the growth projection in the budget is lowered to a realistic 6%+ next year, there will be pressure to raise public investment to give demand a boost to extract higher growth. We do need more public investment, especially in new climate-change areas, but these investments should be accommodated by cutting other unproductive expenditure.

Private investment is a way of raising investment which does not worsen the fiscal deficit. The Finance Minister raised this issue in a recent interaction with Indian business when she asked them why the private sector was not investing, although corporate tax rates had been reduced to levels competitive with other countries. Some large houses have announced some large investments. This is good, but announcements by a few large houses will not correct the underlying problem of a much broader slowdown in private-sector investment, including in the household sector, which includes farm investment and investment in small industry.

This broader slowdown is arguably a reflection of a large fiscal deficit crowding out private investment. The combined deficit of the Centre and states is today close to 11% of GDP, which exceeds the entire financial savings of the household sector. A reduction in this deficit would provide room to finance private sector expansion. The need for this compression is all the greater if tight liquidity conditions in world markets dry up funding for startups, which have relied considerably on non-bank funding from global markets and are an important positive feature of India’s economic situation.

Exports will be a problem area if the world slips into a sharp slowdown. This is a good reason for allowing the rupee to weaken. Exporters have already said that the depreciation we have seen thus far does not help because the currencies of their competitors have depreciated much more. They are seeking other fiscal sops, but a weaker rupee may be a better option.

This must be supported by longer term policies to support exports by improving export related infrastructure and logistics. We should close quickly the various free trade agreements being negotiated. We should also rethink the negative stance taken thus far on the Indo-Pacific Economic Framework’s trade pillar. These steps are necessary if we want our exports to benefit from the global pivot away from China that is taking place. Exports may not respond immediately, but these actions will convey to markets that we are shaping macro economic policy to deal realistically with the new world that is emerging around us.

Confidence is the key ingredient in any strategy to manage crises. We should articulate a balanced strategy that generates confidence based on our macro economic balance plus progress in implementing reforms. Not just announcing, but actually implementing is what matters.

Montek Singh Ahluwalia is former deputy chairman, Planning Commission, and currently distinguished fellow at the Centre for Social and Economic Progress.

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