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Tuesday, January 21, 2020

The budget’s dilemma

Fiscal tightening will accentuate growth slowdown, fiscal stimulus will hurt monetary transmission. There is a third way.

Written by Sajjid Z. Chinoy | Published: July 3, 2019 1:53:58 am
budget, budget 2019, budget 2019 date, union budget 2019, Reserve Bank of India, RBI, non-banking finance companies, Nirmala sitharaman, commercial banks, NBFC, NBFC crisis, budget news, budget 2019 news Difficult circumstances require bold and imaginative responses.(Illustration: Suvajit Dey)

This week’s Budget is likely to pose the first dilemma for the new administration. To understand why, however, one must fully appreciate the current macroeconomic context. Activity has been losing momentum for the last three quarters. To be sure, some transient pressures (pre-election uncertainty, one-off regulatory changes in the auto sector) will fade. But even controlling for this, underlying growth momentum is confronting several headwinds.

First, the NBFC slowdown is acute and likely to endure. Policymakers are correct in not rushing towards a special liquidity-window for NBFCs and stoking moral hazard. Instead, the root of the problem is on the asset side. Asymmetric information about asset quality, the inability to separate the good and bad apples, and the resultant “trust deficit” has meant NBFCs are being starved of funding. Market discipline is important and there should be no bailout, but absent some sort of asset quality review (AQR), the logjam will linger and constitute a funding supply-shock to housing, SMEs, and consumption. Aren’t banks picking up the slack? Only partially, given the imperfect substitutability of these lending models, capital constraints and their own misgivings about NBFC asset quality.

Importantly, when credit gets re-routed back to banks from the less-regulated NBFCs, monetary conditions tighten because of the greater regulatory pre-emption (SLR, CRR) that commercial banks are subject to. As demand for bank credit has picked up — partially on account of this substitution away from NBFCs — banks are understandably reluctant to cut rates, because the funding substitution away from NBFCs to banks is subjection to higher regulatory pre-emption. This will impede monetary transmission in an easing cycle.

NBFC stress apart, rural consumption has slowed as the agrarian distress — manifested in a continuously declining terms of trade — hurts rural purchasing power and consumption. The monsoon is off to a poor start and this could further raise rural anxiety and induce precautionary savings. Finally, the global environment provides little comfort. While the US and China may have reached a temporary détente, the two sides seem very far apart on reaching a sustainable deal. The upshot: Expect episodic global shocks, sustained business anxiety and depressed global capex. Unsurprisingly, output gaps are opening up around the world, and India is no exception, manifested most starkly in the annualised momentum of core inflation slowing to 2.5 per cent in 2019 from almost 6 per cent in 2018.

The counter-cyclical dharma of policy would suggest policy must ease to close output gaps, and monetary policy has started in earnest with 75 bps of rate cuts. Markets are expecting more easing, but the real question is how effective will monetary policy be in the current environment? Given the aforementioned substitution of credit from NBFCs to banks, and the significant premium that the government’s small-savings schemes command over bank deposits, banks are understandably reluctant to cut deposit — and therefore lending —rates. Similarly, financial conditions in the NBFC sector remain tight, because credit risk premia have risen and many NBFCs are being quantitatively rationed out of the market. Finally, even as bond yields have softened over the last six months, the yield curve remains uncomfortably steep, and credit risk premia have risen for lower-rated firms in the corporate bond space.

What, then, should the budget do? Slowing growth and limited transmission of monetary policy would argue for a fiscal stimulus. After all, economic theory would argue for fiscal policy to be counter-cyclical, right?

But the reality is quite different. Part of the reason monetary policy is not transmitting more fully is because of a fiscal overhang. With total public sector borrowing almost 9 per cent of GDP, the public sector is eating up virtually all household financial savings. This has contributed to the steepening of the yield curve (with the 10-year yield stubbornly remaining 120 bps over the policy rate despite a slowing economy and rate cutting cycle), pushed up corporate bond spreads given the growing size of quasi-sovereign-issuance, and kept small savings rates high to attract sufficient flows to finance off-balance sheet borrowing. Against this backdrop, if the fiscal deficit meaningfully expands, yields will inevitably harden and further undermine monetary transmission, thereby making any fiscal expansion, at least partially, counter-productive. What, then, should the budget do? Is there a way to impart a fiscal stimulus without widening the deficit?

There is. Last year, the government achieved about 0.5 per cent of GDP in asset sales. What if the government stuck to its deficit target of 3.4 per cent of GDP, but aggressively targeted asset sales of 1 per cent of GDP, both through a combination of strategic disinvestment and re-cycling existing infrastructure assets? This would ensure that even as the deficit is the same as last year, fiscal policy effective becomes expansionary. How so? This is because revenues raised through asset sales are not contractionary likes taxes and duties. Instead, they are an exchange of assets between the public and private sector. Therefore, if the deficit is the same as last year (3.4 per cent of GDP), but asset sales are 0.5 per cent of GDP higher, the effective fiscal impulse is a positive 0.5 per cent of GDP. This would be tantamount to a fiscal expansion (for the purposes of growth), while keeping the headline deficit exactly the same (for the purposes of bond markets).

It’s important, however, that these asset sales are used for higher public investment — thereby making this a de-facto “asset swap” on the public sector’s balance sheet. What we shouldn’t be doing is selling assets to finance current expenditure or make up for shortfalls in tax revenues. This would be tantamount to selling the family silver to pay the monthly credit card bill.

All told, aggressive asset sales will allow a growth stimulus (thereby making fiscal policy effectively counter-cyclical) without widening the deficit. The latter will calm bond markets and allow better transmission of monetary policy to further help growth. Both fiscal and monetary policy will be working in tandem.

Difficult circumstances require bold and imaginative responses. The government’s historic mandate allows it to think big and out of the box. An aggressive asset swap programme in the first budget of a second term would not only help address current cyclical concerns but send an unambiguous signal of intent about the next five years.

The writer is chief India economist at J P Morgan

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