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Open economy challenges may haunt policies ahead as spillovers intensify

A common economic sophism is that fiscal policy can prop up growth even when monetary policy is assigned to bringing inflation under control. In the short run, lifting demand amid supply constraints will only fuel inflation and the twin deficits, with a wider fiscal gap feeding into a wider current account deficit (CAD).

The pandemic has already made debt dynamics unsustainable in several economies. IMF research shows that a one percentage point unanticipated contraction fiscal balance reduces the CAD, on average, by 0.8 percentage point of GDP.

With the four large central banks expanding their balance sheets by about 8x since 2007, demand and inflation have returned with a vengeance. Private wealth and inequities have increased on the back of fiscal support and large central bank liquidity. This has accentuated CAD to unsustainable levels in some countries. Careful countervailing policy action is required. Open economy considerations will rule monetary and fiscal policies, going forward.

Fiscal consolidation

Fiscal policy, and not monetary policy, will determine long-term interest rates in the Indian economy. More of fiscal restraint will be needed to avert interest rate shock.

It is time to move back to the 15th Finance Commission’s fiscal consolidation path envisaged under its baseline macroeconomic assessment. It envisages GFD/GDP ratio at 4 per cent by 2025-26. Union Budget 2021-22 had announced the government’s intention to reduce the GFD (gross fiscal deficit) below 4.5 per cent by 2025-26. In this year’s Budget, the government reiterated the resolve to meet this target. However, this target is consistent with the 15th Finance Commissions’ worse-case scenario of slower than assessed recovery path from the pandemic.

Macroeconomic conditions are evolving better than anticipated. The key metric of nominal GDP growth was 19.5 per cent in 2021-22 against the base case projection of 13.5 per cent by the Finance Commission. This year too it will easily exceed the 9.5 per cent growth assumed by the Commission.

The government, however, will not be able to meet even the slow post-pandemic recovery scenario targets unless it packages next year’s Budget with a clear strategy to downsize government. This seems an uphill task given that not even two state-owned banks have been privatised this year. Opposition should support the needed reforms, but if political consensus is elusive, the government that has a clear mandate, must push reforms that are never painless.

Next year’s Budget will set the course for the economy. Given the impending slowdown, the 15th Finance Commission’s base case GFD/GDP ratio of 5 per cent for 2023-24 looks difficult but the government must make sincere efforts to bring the ratio down to 5.5 per cent.Those who think this is big adjustment, may be reminded of how successfully the Euro area did the same. The region ran a general government deficit (net borrowing) of 6 per cent of GDP for two years after the global financial crisis but even with some improvement in growth, it went on massive fiscal consolidation and ran primary surpluses for five years from 2015 onward. This enabled them to expand the fiscal deficit by 6.4 percentage points in 2020 after the pandemic struck. Such is the power of counter-cyclical fiscal consolidation.

Avoid trilemma

The impossible trinity will increasingly haunt macroeconomic policies in the near future. It is just not possible to maintain independent monetary policy, fixed exchange rate and an open capital account. The trilemma needs to be handled with less than corner solutions. Exchange rate can be managed but not pegged to a level. Markets can enter very choppy waters once financial conditions tighten and target Fed Funds rate peaks at about 5 per cent  next year. Fed had last month hiked by 80 basis points (bps) its guidance on its terminal rate. Dot plots could rise further by another 50 bps if inflation remains intransigent.

Investor risk-aversion can magnify financial and business cycles. Recent work from Chicago University (Pflueger and Rinaldi’s, September 2022) shows that investor habit preferences explain the large response to Federal Funds rate surprises. A surprise increase in the short-term interest rate lowers output and consumption relative to habit, thereby raising risk aversion and amplifying the fall in stocks.

We have witnessed substantial global equity and bond market corrections in the first half this year, but the tightening cycle is far from over and very much likely to continue into next year. This could result in substantial tightening of global financial conditions into the next year. House price bubbles may burst in parts of the world soon with correction already underway in the US, China, the UK, Australia, Korea and many other parts of the world. The end of free money can do a lot to deepen fissures in the world of finance. The rising pressures on Credit Suisse are just tips of the iceberg.

We are already witnessing a clustering of volatility in the exchange rate market. While a section of the market has taken the call that the dollar has peaked, from the rate cycle perspective that looks rather hasty. The JPY-USD rate, which had dipped to as low as 131 in the first half of August on expectations of looser Fed policy, fell to almost 145 on Powell’s Jackson Hole speech later that month and is holding there. Japan intervened in the foreign exchange markets for the first time since 1998 but could not do much. Dollar strength can remain the bugbear for EM (emerging market) currencies till the middle of next calendar year and we must bulwark against such outcomes.

Our buffers have come very handy, but we have used a fair chunk of our ammunition early on, whereas exchange rate should best be treated as an automatic stabiliser while leaning against strong volatile movements. The RBI’s early July capital flow measures have done little to stem the tide.

In this milieu, the RBI will do well to encourage corporates to maintain a good hedge ratio. If the going gets worse, one cannot rule out radical measures, like quasi fiscal dollar borrowing (such as Resurgent India Bonds issued by SBI) or taking the oil companies’ demand out of the market.

Meanwhile, the open economy considerations call for continuing with rate hikes for the rest of the fiscal year and then holding them till the expected severe global slowdown starts biting Indian growth. It is best to stay focused on maintaining macro-financial stability and not overly worry about growth at this stage. Such is the nature of policy trade-offs.

(Concluded)

The writer is IEPF Chair Professor at NCAER. He was formerly RBI’s Executive Director and an MPC member. Views are personal.

Opinion: Mridul Saggar:

Amid high inflation and exchange rate pressures, rate hikes and tight liquidity are the best bet.

The RBI has been broadly getting its act right amid difficult circumstances. In my assessment, it has traversed about three-fourths of the amplitude of the current rate hiking cycle, but the economy is stronger than before.

It belies the misconception that if RBI starts hiking rates, the nascent recovery from the pandemic would be nipped in the bud. The RBI has demonstrated its ability to act on both sides of the business cycle. It may have been trifle slow to start normalising but has almost made up for that.

After completing my term at the MPC, I had publicly stated that the terminal rate in this tightening cycle could be 6.5 per cent, though RBI could turn data dependent after raising policy rate to 6.0 per cent. The cycle is broadly evolving along those lines. It is heartening to see RBI shed its panache for forward guidance that was constraining policy flexibility. Even so, the third successive 50 bps rate hike at end-September after an initial 40 bps did not surprise or disrupt the market.

Forward guidance may have served a useful role in the early period of the pandemic but has long over-lived its utility. If RBI had in this end-September policy gone on to hint anything on terminal (maximum) policy rate in this cycle or the time till which it would continue to hike rates, it would have only tied itself in knots at the time when global uncertainty is extremely high, and agility of response is needed to maintain macro- financial stability.

Rate hike appropriate

In my view, the MPC has got the rate hike quantum right. Turning to smaller rate hikes would have been premature at this stage and would have misguided markets besides adversely impacting central bank credibility. The economy is rather strong and inflation is still well above the target.

The RBI has more work to do to do bring down inflation within the target range to soft- land the economy first and then move it very close to the point target of 4 per cent in a two-year period so that gains from inflation targeting in anchoring expectations are not lost and higher growth over medium-to long-run is realised on the back of a stable environment.

The one dissent in the MPC on the quantum of rate hike is, therefore, not very material. While one does anticipate some slowing down of the economy ahead, four things need to be kept in consideration.

First, the RBI has some catch-up move left as real deposit rates are still negative and can further feed into widening current account deficit (CAD) that is mirrored by saving- investment gap. Unless the economy slows down markedly in coming quarters, the CAD/GDP ratio is likely to be about 3.4 per cent this year, perceptibly higher than indications of below 3.0 per cent CAD from the central bank. The central bank may be talking of bringing down the currency pressures, but even at 3.0 per cent the CAD is not sustainable and, therefore, the rate hikes are helpful.

Second, the RBI need not match the Fed’s rate hike quantum 1:1 as inflation is a bigger problem in the US vis-a-vis the inflation target. Yet, if the RBI holds rates at this level, it could entrench high inflation.

Third, a hesitation to raise rates would contribute to financial fragilities with asset mispricing. Fourth, it is important to understand that monetary policy can’t work without any growth sacrifice, even though from a political economy perspective, central banks find it hard to state this in their communication.

The quantum of the end-September rate hike can go a long way in delivering the goal to disinflate the economy — as monetary transmission gains traction with the large rate hike occurring for the first time after the system has moved away from large liquidity surpluses.

Banks have been unduly reluctant to lift deposit rates while pass-through has been more on the lending side mainly because of the large surplus liquidity. Their net interest margins have been protected at the expense of savers. Against a 140 bps rate hikes since May this year before the latest hike, the weighted average lending rate against the outstanding rupee loans rose by 41 bps, while the weighted average term deposit rates on outstanding domestic rupee deposits increased by just 26 bps.

Considering the RBI’s projected average inflation rate of 6.7 per cent, the weighted average real rate on the lending side works out to 2.43 per cent (1.63 per cent for fresh rupee loans which has risen by 82 bps in this hiking cycle), while that on the deposit side remains at (-)1.41per cent (see chart).

Liquidity management

While the RBI in its post policy communication sought to talk down the liquidity fears by explaining that liquidity is not too tight, the fact is that sans government balances system liquidity that sets the money market rates is temporarily in balance. Yet, durable liquidity surplus that includes government cash balance was ₹3.69 lakh crore on the eve of the latest policy.

Once festival currency leakages and more foreign exchange interventions take place, the durable system liquidity could tighten further and may hover at less than ₹1 lakh crore. Should the central bank worry too much about these tighter liquidity levels? Why should it when, in fact, it will force banks to raise deposit rates and accelerate transmission to positive real rates at which monetary policy can be deemed neutral and not yet tight in a true sense?

At a time when we face double whammy of high inflation and spillovers of exchange rate pressures, even marginally deficit liquidity conditions will be justified as it will ameliorate both these pressures.

Will this cause a destabilising interest rate spike? Not unless the government walks off the fiscal consolidation path as electoral cycle considerations come to fore. The government has so far done well to exercise restraint even while taking supply-side measures to reduce inflationary pressures.

(to be concluded)

The author is IEPF Chair Professor at NCAER. He was formerly RBI’s Executive Director and an MPC member. Views are personal.

Dominance of banking by PSBs has also been a hurdle in the way of improving the regulatory regime, which, in turn, hampers the modernisation and, therefore, healthy growth of the sector. This is because RBI has limited regulatory jurisdiction over PSBs. Indeed, this fact has at times provided RBI an easy cover for its own flaws.

Our July 2022 paper, ‘Privatisation of Public Sector Banks in India: Why, How and How Far?’, presented at the India Policy Forum of the National Council of Applied Economic Research (NCAER), has led to a lively debate on the subject. We appreciate the subsequent advocacy of public sector bank (PSB) privatisation by others such as the former Reserve Bank of India (RBI) governor Duvvuri Subbarao as well as constructive commentary from experts holding a differing view.

But we cannot help noting that the majority among the critics relied on the usual tactic of asking rhetorical questions such as:

Can private banks deliver on social objectives?

Haven’t there been big frauds in the private banks too?

Did India not escape a major fallout from the global financial crisis due to the robustness of PSBs?

Private Banking

Such whataboutery amounts to nothing more than obfuscating the bottom-line issue: when all costs and benefits are considered, is the balance in favour of maintaining the status quo, or privatisation of some or all PSBs? Policies may have some downsides. And, yet, we should adopt them whenever the upside unambiguously outweighs the downside.

In assessing the benefits of PSB privatisation, the first point to recognise is the criticality of a well-functioning banking sector for sustained rapid growth in a developing country. Banks must perform the function of mobilising the savings of savers and allocating them to the most productive investment projects. Failures at either end – mobilisation and allocation – can cost the economy heavily in terms of growth forgone.

Today, with GDP at $3 trillion, even the loss of one-percentage-point growth due to a poorly functioning banking sector would amount to losing $30 billion or more in extra GDP every year. The difference between growing at 7% versus 8% is a GDP of $5.9 trillion versus $6.5 trillion in 10 years’ time. The extra income from 1% additional growth each year can give the government far more resources to pursue social goals than any potential shortfall arising out of its ownership of fewer than the current 12 PSBs.

Evidence points to PSBs as having done a significantly poorer job than private banks when it comes to mobilising as well as allocating the savings to productive investments. On the mobilisation front, they have rapidly lost the share in total deposits to private banks. On the allocation front, they have accounted for disproportionately large share of loans that had to be written off in recent years. These non-performing loans (NPLs) cost the economy dearly in terms of growth, not only because the investments failed to translate into output but also because credit growth by the poorly performing banks came to a near standstill.

On top of that, the taxpayer had to foot the bill for the rescue of the banks. GoI had to spend a massive $57.45 billion to recapitalise the PSBs between 2010-11 and 2020-21. Each of the 12 PSBs required a significant sum out of these recapitalisation funds. Market valuations of some of these PSBs remain below the amount of taxpayer funds infused into them.

In comparison, among private banks, only Yes Bank required a rescue. And even that was accomplished without using taxpayer money. Moreover, its market valuation quickly rose above the value of resources devoted to the rescue. Also notable is the fact that during the NPL crisis of the last decade, credit by private banks continued to grow at a rate significantly higher than that by PSBs.

Holding to Account

Dominance of banking by PSBs has also been a hurdle in the way of improving the regulatory regime, which, in turn, hampers the modernisation and, therefore, healthy growth of the sector. This is because RBI has limited regulatory jurisdiction over PSBs. Indeed, this fact has at times provided RBI an easy cover for its own flaws in regulating the banking sector as a whole.

GoI is not only the owner of PSBs but also their policymaker and regulator. This is contrary to the principles of good governance. The staff of these banks remains subject to oversight by vigilance agencies that seriously undermines their ability to take even normal risk in lending. With salaries of senior staff capped by government rules, PSBs remain handicapped in hiring high-calibre managers and technical staff. At the same time, near-iron-clad job guarantee has resulted in resistance to productivity-enhancing change at all levels.

Any benefits of PSBs must be evaluated against these costs. It must also be asked whether the delivery of those benefits requires as many as 12 PSBs. For example, private banks have been as effective at delivering on priority-sector lending as PSBs over the last four decades. Even if there are goals on which PSBs can potentially deliver more effectively, one must evaluate the benefits of achieving those goals against costs.

We must also ask whether such goals cannot be achieved by retaining just one or two banks in the public sector. Will the nation not be better served if the government owned one or two banks and managed them effectively, instead of shelling out crores of taxpayer money every 5-10 years on keeping several of them afloat, and undermining the modernisation of the banking sector?

IEPF Chair Professor Dr Mridul Saggar speaks to Latha Venkatesh, CNBC TV18 on “RBI’s Monetary Policy Announcement in the CNBC Indianomics program, 30 September 2022. Watch the Video