A month ahead of the Union Budget, Reserve Bank of India Governor Raghuram Rajan warned the government Friday against a spending spree to spur economic growth. Citing the example of Brazil, another emerging economy in trouble now, he pointed out that “the enormous costs of becoming an unstable country far outweigh any small growth benefits that can be obtained through aggressive policies”.
Delivering the C D Deshmukh Memorial Lecture in New Delhi, Rajan said: “Unfortunately, the growth multipliers on government spending at this juncture are likely to be much smaller, so more spending will probably hurt debt dynamics. Put differently, it is worth asking if there really are very high-return investments that we are foregoing by staying on the consolidation path.”
He said the country was already grappling with an increase in the aggregate fiscal deficit during the last calendar year, even as a newly implemented power reforms scheme would likely strain finances of state governments further next fiscal.
He also reiterated that the central bank would not change its monetary policy strategy of targeting inflation, saying that doing so would hurt policy credibility.
“As Brazil’s experience suggests, the enormous costs of becoming an unstable country far outweigh any small growth benefits that can be obtained through aggressive policies. We should be very careful about jeopardising our single-most important strength during this period of global turmoil, macroeconomic stability,” Rajan said.
Last year, the government deviated from the fiscal consolidation path, postponing reduction in fiscal deficit target by a year. Finance Minister Arun Jaitley had redrawn the fiscal consolidation roadmap, stretching the time to reach the fiscal deficit figure of 3 per cent of GDP from two years to three years and setting the fiscal deficit target at 3.9 per cent for 2015-16, 3.5 per cent for 2016-17 and 3.0 per cent for 2017-18.
Rajan said that the consolidated fiscal deficit of the Centre and states had risen to 7.2 per cent in 2015 from 7 per cent in the previous year. “So we actually expanded the aggregate deficit in the last calendar year. With UDAY, the scheme to revive state power distribution companies, coming into operation in the next fiscal, it is unlikely that states will be shrinking their deficits, which puts pressure on the Centre to adjust more,” he said.
He said while there is a public discussion whether the fiscal consolidation roadmap should be postponed and instead engage in fiscal expansion to generate growth, it may not hold true for India.
“Of course, the common man does not really care whether we stay on the consolidation path or not. But the bond markets, where we have to finance over Rs 10 lakh crore of deficits plus UDAY state bonds, do care. Deviating from the fiscal consolidation path could push up government bond yields, both because of the greater volume of bonds to be financed and because of the potential loss of government credibility on future consolidation.”
Stating that the fall in inflation has been on account of the “joint work of the government and the RBI, aided to some extent by the fall in international commodity prices”, he said this was “no mean achievement given two successive droughts that would have, in the past, pushed inflation into double digits”. He added though that despite the success on the inflation front, there were voices suggesting weakening the fight against inflation.
“Let me reiterate that macroeconomic stability relies immensely on policy credibility, which is the public belief that policy will depart from the charted course only under extreme necessity, and not because of convenience. If every time there is any minor difficulty, we change the goal posts, we signal to the markets that we have no staying power,” he said.
“Let me, therefore, reiterate that we have absolutely no intent of departing from the inflation framework that has been agreed with the government. We look forward to the government amending the RBI Act to usher in the monetary policy committee, further strengthening the framework.”
Macroeconomic stability, Rajan said, would be the platform on which “we will build the growth that will sustain our country for many years to come, no matter what the world does”.
He also cautioned against raising tariffs to protect domestic industries facing problems. The RBI is scheduled to announce the next bi-monthly monetary policy on February 2.
Rajan began the lecture by stating that though the RBI is in “fine fettle”, the world today is much less comforting as industrial countries were still struggling, with a few exceptions, to grow. “Our fellow BRICS all have deep problems, with confidence about China waxing and waning. Indeed, India appears to be an island of relative calm in an ocean of turmoil,” he said.
Citing the example of Brazil, which is facing double digit inflation, he said it is confronted with financial problems because it tried to grow too fast on the back of substantial stimulus.
“While the Brazilian authorities are working hard to rectify the situation, let us not ignore the lessons their experience suggests. It is possible to grow too fast with substantial stimulus, as we did in 2010 and 2011, only to pay the price in higher inflation, higher deficits, and lower growth in 2013 and 2014.”
“Of course, India is not in the same situation today. Given the inhospitable world economy and two successive droughts, either of which would have thrown the economy into a tailspin in the past, it is to the immense credit of the government that we have over 7 per cent growth, low inflation, and a low current account deficit. But it is at such times that we should not be overambitious,” he said.