Photo: Mint
Photo: Mint

Opinion | The ‘frown curve’ that could determine a government’s fate

How the NDA fares might depend on the balance it has struck between populism and prudence

As India gears up for general elections, a key question is whether good economics is also good politics. Empirical evidence over the past two decades appears mixed. Consider the following: The Bharatiya Janata Party (BJP)-led National Democratic Alliance (NDA) fought the polls of 2004 having achieved stable low inflation and favourable external sector dynamics. But deteriorating rural terms of trade was one of the factors that resulted in its electoral defeat. The first term of the Congress-led United Progressive Alliance (UPA) government marked a reversal in rural fortunes, and the alliance was re-elected in 2009. However, as rural reflation and fiscal excesses triggered inflation, real rural incomes declined, and, along with corruption scandals, led to the UPA being voted out of office in 2014.

That brings us to the “frown curve": The past two decades suggest an inverted-U (a frown) relationship between the degree of populism and electoral success. Both too much populism and too much prudence could result in electoral defeat. As economic populism increases, there is a short-run increase in political popularity up to a “Goldilocks point", where a stable macroeconomic climate just about accommodates populist excesses. Eventually, as populism becomes endemic and sticky, it starts to erode macro fundamentals, and on the margins, popularity among voters as well. Push the cart a little further and imbalances lead to a fall off the confidence cliff into an economic slowdown. Having frittered away most policy space already, there is little wriggle room left for stabilization. Once this spreads to job and real income losses, voter sentiment rapidly starts deteriorating.

We are arguably quite far from such an apocalypse, in part thanks to stable macro policies and fundamentals over the past few years. Yet, today’s macro backdrop is slightly similar to that of 2004. Banks had large non-performing assets during 1999-2004, as they have had from 2014 until now. The BJP kept minimum support prices (MSPs) and food inflation low then, as now. Rural income growth was slow then, as is now. It should, therefore, come as no surprise that the broader direction of macro policy is moving towards less prudence.

The interim budget in February was expansionary, with the government announcing a direct income support scheme for small and marginal farmers worth 0.46% of gross domestic product (GDP) cumulatively. This follows the government’s decision to raise MSPs to at least 1.5 times the cost of production in 2018. Concessions on income tax and other social welfare commitments, such as on healthcare and pensions for the unorganized sector, have been announced over the last year. In doing so, the central government’s fiscal deficit continues to remain in the 3.4-3.5% of GDP range since 2016-17, and its ambitious revenue targets for 2019-20 suggest that even a target of 3.4% cuts the cloth too short for the coat.

Will these policy changes work? In the short term, the efficacy of the recent policy easing will be partly lost owing to transmission lags and implementation hurdles. As for the farm package, not all states have land records in digital form; and those that do, do not necessarily have accurate data or bank accounts linked to these. The government’s spending targets of 20,000 crore in 2018-19 and 75,000 crore in 2019-20 for the farm package will be undershot marginally.

Similarly, the impact of the Reserve Bank of India’s rate cut will likely be delayed and uneven. The credit-deposit ratio rose to near 78% in January, from 74.5% a year ago, and the incremental credit-deposit ratio remained above 100% (six-month change) for most of 2018. Banks that have the capacity to lend are essentially making retail loans and/or financing shadow banks. The elevated credit-deposit ratio and tight liquidity will delay transmission of policy rate cuts.

Meanwhile, parts of the real economy that had relied heavily on shadow banks in the past are now facing a credit crunch, especially commercial real estate and micro, small and medium enterprises. Non-banking financial companies and housing financiers have become increasingly relevant due to sluggish credit from capital-strapped public sector banks in recent years. They are estimated to account for 30-40% of incremental lending in recent years. This suggests the slowdown in GDP growth to 6.6% year-on-year in the third quarter of 2018-19 from 7% in the second quarter is not the bottom. We expect a further moderation to 6.0-6.5% in the first half of calendar 2019. However, in the medium term, as rural reflationary policies remain a policy priority, irrespective of the government in power, they will likely succeed in lifting rural demand. This in turn is likely to trigger higher inflation as a consumption-led recovery takes hold. This move towards policies that are less prudent should also be politically beneficial. Going by our “frown" curve, this mix will be viable as long as one remains on the safer side of the “Goldilocks point". Populism beyond that inflection point may eventually outweigh its benefits.

The trick, as in everything else in life, is in finding the right balance.

Sonal Varma and Aurodeep Nandi are chief India economist and India economist at Nomura, respectively.