There has been an enormous amount of writing on the Indian economy in the past few day. Most of it recommends the simple policy option of aggressive rate cuts to boost demand. But while rate cuts are welcome, they might not suffice in the current context.
First, the current slowdown is mostly consumption led, a by-product of the slow income growth in recent times (rural and urban wages have grown by 1-2 per cent in real terms). However, even though private final consumption expenditure (PFCE) has declined by Rs 1.5 lakh crore in Q1 FY20, it is still higher by Rs 1.65 lakh crore over the same period last year. Thus, while we should be worried, we must not be overtly despondent and write obituaries of the India’s growth story just yet. Unfortunately, the markets are currently soaking in trepidation, anticipating an uncertain future that the data still does not suggest.
What could be an ideal policy option in the current context? The high inflation and high interest rates in the 1970s generated a revolution in macroeconomic thinking, policy and institutions. The theory of real business cycles, propounding the ineffectiveness of any policy response and the subsequent theory of market imperfections, opened a new vista in economics literature of how to deal with growth conundrums. In similar vein, the low inflation, interest rate and stagnation of the last decade in the developed economies deserves an equal response.
What could be that response? The contemporary issue for macroeconomists is to kickstart aggregate demand. We believe that monetary policy can only act to some extent — we have been in an era of low interest rates for a decade but that has done little to boost aggregate demand, but increase household debt (household debt in the US has increased from $12.5 trillion in Q1FY08 to $13.9 trillion in Q2FY19). Rather, fiscal policy needs to be the major focus thrust, especially given what low or negative interest rates mean for the sustainability of deficits.
Let us fast forward to the Indian context. The total financial liabilities of households have jumped by a massive 58 per cent in FY18 to Rs 7.4 lakh crores (there was a 22 per cent jump in FY17) and may have also jumped in FY19. In fact, while household leverage has jumped two times in the last five years, disposable income has jumped by only 1.5 times, thereby putting pressure on savings. Even though the jump is not as much as in FY07 (when it jumped by 2.3 times over FY05), such a large jump is a matter of concern. The good thing is that gross household financial savings have jumped by a sharp 1.5 times over the same period (though it could be largely because of remonetisation).
Given such a large jump in household leverage, monetary policy is unlikely to retain the effectiveness through large rate cuts in the current scenario. Only a counter cyclical fiscal response might address the core of the current problem. But, before we discuss that, let us for a moment digress to some of the common market fallacies for the reasons behind the decline in household savings.
First, since FY12, gross savings (as a percentage of GDP) have declined from 34.6 per cent to 30.5 per cent in FY18. This decline was entirely due to the decline in household savings (by 6.4 percentage points). Interestingly, most of this decline is in physical savings of households, with only a marginal decline in financial savings.
Second, the decline in household savings is because of a change in definition. Unincorporated entities, which were a part of the household sector, now get counted as corporate savings. This is visible in the data since FY12 when private corporate savings jumped by 2.1 per cent.
Third, the decline in household savings also has to do with high real interest rates. Our empirical analysis suggests that the long-run effect of real interest rates on the savings rate is negative and is statistically significant at 1 per cent level.
Coming back to the policy options, data on household savings clearly suggests that the benefits of a fiscal push could be significant in the current context. First, the argument of huge government borrowings eating up a significant part of household financial savings only tells a part of the story. Incremental claims of government borrowings on households increased by only Rs 60,000 crore for the two-year period ended FY17.
During the same period, the move to incentivise household savings by increasing the ceiling of section 80C resulted in an incremental Rs 1.8 lakh crore of household savings flowing into tax saving instruments. Our estimates show that the savings incentivisation multiplier is at least five times higher than the revenue foregone by the government through such tax incentives.
Capital gains tax can be abolished. The total assets under management (equity) of mutual funds jumped by only two per cent since January 2018, while they had risen by 68 per cent between November 2016 and January 2018. Such measures are stunting household savings in shares and debentures.
Apart from such a push to savings, what could be the other fiscal policy options to spur consumption? To this end, the government must address the demand weakness by frontloading expenditure through the PM-KISAN and MGNREGA. Any attempt to cut back on expenditure, to balance the fiscal deficit at this time, will be severely detrimental to consumption growth. Another option is to continue aggressively with asset sales, pursue capital expenditure and use the additional fiscal space for infrastructure spending.
A consequence of an increase in spending that the government could be wary of is on the bond markets. In this context, the RBI could front-load a large rate cut in the October policy, while keeping liquidity in surplus mode. The government should also go ahead with the sovereign bond issuance. It could partly hedge its borrowings and decide to not bring back the dollar proceeds, instead keeping it at any of designated scheduled commercial banks (ASCBs) outside the country for import payments. This will take care of the problems of sterilisation and hedging.
The government could also introduce a performance linked compensation scheme for the banking sector employees as well as provide them operational flexibility to hire directly from the market. The wage agreement has been delayed for a long time and a quick announcement before the festive season would help improve sentiment significantly. Setting up a development finance institution could be another policy option.
This article first appeared in the September 16 print edition under the title ‘Banish the gloom’. The author is Group Chief Economic Advisor, State Bank of India. Views are personal