Stimulus to pump-prime economy? Think again, reforms can do better

A sharp deceleration in India’s growth has triggered a discussion on the possible policy responses to address the problem. There is unanimity in favour of monetary stimulus from RBI. However, opinion is divided on fiscal stimulus.

The growth slowdown is, indeed, sharp and worse than expected. March quarter growth rate at 5.8 per cent was a 20-quarter low and FY19 growth rate at 6.8 per cent was a five-year low.

There are no signs of a pickup in private investment and the global environment is fast turning unfavourable. Stimulus is, indeed, necessary, but in what form and how much are the questions that need to be answered first?

The Monetary Policy Committee (MPC) of RBI has to be appreciated for coming up with the right policy at the right time. The 25 bp rate cut in last review along with a change in stance to ‘accommodative’ from ‘neutral’ was eminently desirable. The 6-0 vote in favour of the rate cut and change in stance made the policy all the more dovish. RBI Governor’s statement that “the policy reflects the resolve of the MPC to act decisively and in time” was a reassuring message for the market.

The scaling down of the GDP growth projection for FY20 to 7 per cent and inflation target for FY20 to 3.4 to 3.7 per cent means the policy would remain accommodative for some time. Given the benign inflation, MPC may cut interest rates by 25 bp twice this year, provided Brent crude prices won’t surge beyond $70.

No room for fiscal stimulus

However, the prospects for a fiscal stimulus are bleak. The shortfall in tax collections in FY19, as per revised estimates, at Rs 1.6 lakh crore indicates that the fiscs are more expansionary than what the Budget had indicated. Even though the government has technically succeeded in containing fiscal deficit at 3.4 per cent, the fact remains that this was achieved through off-Budget borrowings by public sector entities like the FCI.

Therefore, a more realistic indicator of the deficit would be the combined fiscal deficits of the Centre and states at 7 per cent and public sector borrowing requirement (PSBR) at 8.5 per cent. And, the government debt-to-GDP ratio is inching up to 70 per cent. This is hardly the macro backdrop appropriate for a fiscal stimulus.

Keynesians who argue for pump-priming by government should ponder over the externalities of a fiscal stimulus. One of the reasons why monetary transmission has been poor is that banks find it difficult to bring down the cost of funds by cutting deposit rates. At a time when deposit growth is lagging credit growth, banks cannot afford to cut deposit rates, particularly when small savings offer higher rates. Higher small savings rates, while enabling government to finance fiscal deficit, are diverting savings away from banks.

In brief, higher fiscal deficit not only crowds out private investment, but also negatively impacts credit growth in the economy. In such a scenario, further fiscal stimulus will do more harm to growth than good.

Also, higher fiscal deficits and accumulated debt will add to the government’s interest burden pre-empting the resources for capital expenditure. In FY19, interest payments accounted for 37.3 per cent of GoI’s revenue receipts.

The PM Kisan Scheme is expected to cost around Rs 87,000 crore in 2019-20. Other welfare programmes promised in BJP’s election manifesto would also need huge resources. Growth alone can generate the revenue buoyancy needed to fund these programmes.

The government’s focus should be on implementing structural reforms – in land and labour – which can raise India’s potential growth rate.

We need a blitzkrieg of reforms to reignite the animal spirits. It was the Structural Adjustment Program initiated in 1991 that pushed the Indian economy to a high growth rate trajectory that enabled us to achieve 6.8 per cent growth in last 26 years and made India the second fastest growing large economy in the world.

We need similar structural reforms now to raise our potential growth rate. Foremost on the agenda should be labour and land reforms to raise our factor productivity: With the right kind of labour market reforms, India can create a large number of jobs in manufacturing, particularly in areas from where China is moving out due to higher wages of a middle income economy.

Land reforms to enable land acquisition for infrastructure and non-farm uses can’t brook further delay. “Politics”, as Bismarck famously said, “is the art of the possible’. NDA 2.0, and Prime Minister Modi in particular, are uniquely placed to practise this art to promote India’s growth and development.