The first fortnight of the year suggests 2016 will be turbulent as policymakers around the world grapple with difficult tradeoffs. Chinese policymakers are attempting to stabilise growth amid severe global trade headwinds and are simultaneously constrained by spillovers that risk undermining the efficacy of key policy instruments. Similarly, strong job growth but weak wage growth in the US is symptomatic of the dilemma the Fed finds itself in as it tries to retain flexibility without losing credibility. These are delicate balancing acts that are bound to result in periodic bouts of turbulence. Amid this storm, the good news is that India remains the emerging market (EM) deemed most resilient to global shocks, underpinned both by good policy (fiscal and monetary) and a lot of good luck (collapse in oil). The depreciation of the rupee over the last week may have jangled some nerves but the fact is that it continues to be among the best performing EM currencies. The current account deficit is tracking at less than 1 per cent of the GDP, compared to nearly 5 per cent at the time of the taper tantrum, dramatically reducing the required capital inflows. The real policy challenge, therefore, is not guarding against a rupee collapse (like in 2013), but ensuring that it doesn’t appear too strong on a trade-weighted basis as other currencies depreciate even faster. India’s worry is not external preparedness but growth risks that have increased in recent months. For all the discussion on exports and reforms, our estimate is that the collapse in oil prices has been the biggest driver of growth, boosting it by more than 1 percentage point in 2015-16 by increasing household purchasing power, improving corporate margins, and creating budgetary space to increase expenditures.
Remember, however, that this is a one-time boost because it’s the change in oil prices — not their level — that creates the growth dividend. To the extent that oil stabilises, India will lose this growth dividend next year. There could be offsets, as a normal monsoon could boost rural demand. But with balance-sheet stress not alleviating, and the export outlook not improving, the growth drag from the terms-of-trade shock rolling off will be hard to overcome. The risks, therefore, of a growth slowdown next year are real — a concern the government’s mid-year review, to its credit, acknowledged. In contrast, most market participants still project a linear acceleration of growth in 2016 and 2017, and any slowdown will come as a sticker-shock to them. The obvious next question will is: Is there space to mount a counter-cyclical policy response? The continued correction of oil has increased the possibility of some more monetary easing this year. But any easing is likely to be relatively modest as progressive inflation targets (5 per cent by 2017 and 4 per cent by 2018) become stiffer, and underlying “core” inflation has stubbornly remained above 5.5 per cent in 2015. More importantly, we shouldn’t suddenly lose our nerve on inflation targeting. It has provided a much-needed anchor to monetary policy, creating credibility, enabling consistency, and anchoring medium-term inflation and rupee expectations. These are priceless virtues to forego. With the space for monetary easing acknowledged to be limited, the debate has unsurprisingly turned to fiscal policy. Amid concerns of a slowdown, should the fiscal-consolidation path be followed and the deficit reduced further from 3.9 to 3.5 per cent of the GDP? On the one hand, doing so would make fiscal policy procyclical (tightening when growth is slowing) and potentially suboptimal, as the mid-year review correctly argues.
But on the other hand, deviating from the fiscal path again is not without risks. First, it could impinge upon hard-earned credibility.
Second, a larger-than-expected borrowing programme could further pressure benchmark G-sec yields, pushing up private-sector borrowing costs and risking some crowding-out of private investment. The recent stickiness of G-sec yields is symptomatic of the fragile equilibrium in that market. A much-needed reversal of financial repression has meant that a larger fraction of bonds are on banks’ “mark-to-market” books, increasing interest rate risk and reducing incremental appetite for bonds, thereby keeping yields sticky. Compounding this will be Uday bonds, which some profitability-constrained public-sector banks may be induced to sell to book profits. This would add to supply and compound the demand-supply mismatch. Against this backdrop, an unpleasant fiscal surprise could further harden yields.
Finally, with nominal GDP growth moderating sharply and approaching the same level as the cost of government borrowing, public-sector debt dynamics have become less favourable. The surest way to protect against adverse dynamics is to reduce the primary deficit as soon as possible. Fiscal consolidation would further dampen growth but relaxation could push up borrowing costs and impinge on credibility — so is fiscal policy caught between a rock and a hard place? Not if authorities prioritise asset sales. Just the sale of Suuti, holdings of which have no strategic imperative, would realise 0.35 per cent of GDP, enough to achieve almost the entire consolidation next year. Then, other sources of revenue or savings could offset the Pay Commission increase. A typical objection to disinvestment is that valuations of government commodity companies have come down. But what if they fall further next year as China continues to slow? And to the extent that these resources are ploughed into public investment, the cost of building infrastructure is also commensurately cheaper when commodities collapse. So there is a price hedge. More importantly, think of disinvestment as an “asset swap” on the government’s balance sheet rather than an “asset sale”. Operationally, too, it may be optimal to sell each asset in dribs and drabs — much like a household’s systematic investment plan — rather than in one go, to hedge against price fluctuations. The key is to realise that asset sales are the only way for the government to protect credibility while avoiding procyclicality. There are no easy policy choices in India. And the lesson from 2013 is: In this global environment, higher growth will be rewarded only if it doesn’t come at the altar of macroeconomic stability.
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