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Home >Opinion >Views >Opinion | Fiscal wheels must also roll in order to make monetary policy effective

The Reserve Bank of India (RBI), through four successive repo rate reductions in this calendar year, has reduced it by 110 basis points to 5.4%. So far, the economy has been slow to respond to these incremental monetary stimuli. Quarterly growth data, as well as high frequency indicators, show a continuing slowdown, which is mainly driven by sluggish demand, due to both external and domestic factors. Sectors that are bearing the brunt of this slowdown include the employment-intensive real estate and automobile sectors. There is substantial excess capacity in the manufacturing sector. With unutilized capacity, temporary and casual employees are being laid off and wage hikes are being postponed, reducing levels of aggregate disposable income, which is further reducing demand, particularly for consumer durables. Unless capacity utilization improves, investment demand from the private sector is not likely to improve. Repo rate reductions only provide enabling conditions to reduce the cost of borrowing. To be effective, adequate transmission needs to take place.

Further, demand for investment and consumer durables has to increase, which is a function of income, much more than the cost of borrowing. To uplift investment sentiments, adequate momentum has to be generated at the fiscal side.

However, given revenue constraints and legislative limits on government borrowing, suitable countercyclical fiscal measures have not yet been taken. It is a bit worrying that public sector investment has been showing signs of stagnation for some time. The central government’s capital expenditure to gross domestic product (GDP) has stagnated at 1.6% for 2018-19, and 2019-20 as budgeted. The state government’s capital expenditure to GDP has also been stagnating at close to 2% of GDP for some time. The public sector as a whole has an investment rate of close to 7%. Without a demand push from the public sector, monetary policy alone would not be effective.

In this context, the central government has to take a lead. In federal fiscal systems, countercyclical policy is primarily the responsibility of the central government. Given the Fiscal Responsibility and Budget Management Act, 2003 (FRBMA), there is a limit to which the Centre’s fiscal deficit can be stretched beyond the operational limit of 3% of GDP. However, a one-year departure from the budgeted fiscal deficit of 3.3% of GDP for 2019-20 may be justified at the current juncture, provided it is ensured that the entire additional borrowing above the budgeted level is spent on capital expenditure.

It is empirically well established that increases in government capital expenditures have much larger multiplier effects, as compared to increases in government revenue expenditures.

The Centre’s efforts should be supplemented by bringing the state governments and the central and state public enterprises on board, persuading them to undertake additional investment spending focused on infrastructure.

With the entire public sector participating in this augmentation of spending, investment from the private sector can take off, first uplifting the infrastructure and construction sectors, and later spreading out to other sectors through the multiplier effects.

Once a virtuous cycle is triggered with increased public sector investment, particularly focused on the employment-intensive infrastructure and construction sectors, private disposable incomes would increase, reversing the ongoing demand slow down. At that point, the banking sector should find its risk-taking appetite improve. As the magnitude of private borrowing grows, transmission would improve.

Accompanied by a fiscal stimulus, there may be scope for further repo rate cut in the course of the fiscal year. Another reduction of 40 basis points would take the repo rate down to 5% by the end of 2019-20. This is comparable to the level of 4.75%, which was brought about in April 2009, in response to the global economic crisis. At that time, both fiscal and monetary instruments were used.

In order to protect savings, particularly of small investors, some additional margin may continue to be provided to the depositors in small savings and other similar instruments. Together, the joint impact of the fiscal and monetary stimuli, is expected to uplift the country’s growth from its present low level (5.8% in Q4 of 2018-19) to levels comfortably above 7% and, eventually, closer to 8.5-9%. Sustaining growth at these levels is required if India were to become a $5-trillion economy by the end of FY25.

D.K. Srivastava is chief policy adviser at EY India. The views expressed here are personal.

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