As confidence and inflation collapsed after the global financial crisis
of 2008, central banks and governments across the developed world adopted extraordinary policy measures to stave off panic and to bolster growth. Central bank policy rates were slashed to historic lows. The US Fed Funds rate was cut from 5% to 0%. Japan
and Switzerland took policy rates below 0%.
Major central banks then undertook large-scale asset purchases, bringing down long-term yields, expanding their balance sheets and flooding markets
with liquidity. The Fed balance sheet grew from US$ 800B pre-crisis to well over US$ 4 T. The ECB balance sheet rose from EUR 1T pre-crisis, to over EUR 4.5T.
In addition, governments stepped in to spend. The US clocked a federal deficit of 9.8% of GDP
in 2009, from 1.1% of GDP
in 2007. The Euro area fiscal deficit, likewise, moved from 0.7% of GDP
in 2007 to 6.3% of GDP in 2009.
Looking back, on the positive side, global growth has largely returned, without any sign of inflation as yet. On the flip side, much of the excess liquidity has moved into stock markets, emerging markets
and other risky assets, leaving the system still vulnerable.
India’s policy response post-2008: the focus on growth
Post the 2008 crisis, as India’s growth and exports fell sharply, our policymakers stepped in to support growth. The Reserve Bank of India slashed policy interest rates from 7% to an effective low of 3.25%. India’s 10y government bond yield dropped from 9% to 5% by end 2008. Moreover, the central government expanded the fiscal deficit from 2.5% of GDP in FY08 to 6% in FY09, and 6.5% in FY10.
As a result, India’s GDP growth rose to pre-crisis levels in 2010. This brought back portfolio investments, and Rupee, having touched a low of over 50.00 to the US$ in 2009, recovered to 44.00 by mid-2011.
But this is where the script went awry for India. Our recovery came at a severe cost to financial stability – which in turn sparked a fresh crisis.
Fiscal spending alongside low interest rates stoked inflation and imports. After dipping sharply in 2008, India’s WPI
strayed into double-digits beyond 2010. Likewise, our current account deficit (CAD) deteriorated sharply, from 1% of GDP in FY06, to 4.8% of GDP in FY12. Banking balance sheets grew sharply, with increased financing of long-term infrastructure projects.
Eventually, rising twin deficits and inflation took a heavy toll. The Rupee fell from from 44.00 in August 2011 to 68.80 against the US$ in August, 2013. India’s 10y government bond yields rose from 5% in late 2008 to 9% in late 2013. India’s economic growth slumped back to pre-crisis level in FY12 through FY14. In many ways, India’s real economic crisis came not in 2008-2009, but in 2012-2014.
While crude oil prices, political scams and policy paralysis complicated matters, all things considered, we still paid a price for neglecting financial stability in our hunt for growth. With the advantage of hindsight, perhaps we should have compromised on short-term growth, and instead controlled our fiscal deficit, inflation and banking system health better.
India’s policy framework now: the focus on inflation
We have now adopted a flexible inflation-targeting framework. Fortunately for us, global crude oil prices subsided from 2014.
Yet, we did allow risks to financial stability build up.
First, inflation targeting has impacted our external sector. Real interest rates were kept high in a bid to control inflation, even as our macroeconomic context improved. That brought in reversible, carry-seeking currency inflows across FPI in debt, net exporter hedging, unhedged ECB inflows and other speculative flows. Between FY15 and FY18, $120B of such opportunistic flows came into the country.
This caused INR overvaluation. Alongside, from $15B in FY17, our CAD
rose to $49B in FY18, and is now projected above $70B in FY19. This is not only on account of higher crude oil prices. Our exports and manufacturing have struggled, and our imports of electronics and gold have risen. An overvalued rupee also likely contributed to this rising CAD.
We are effectively borrowing expensive, fickle foreign exchange to fund our oil, gold and electronics purchases.
Second, our fiscal position remains unhealthy as well. While overall central fiscal deficit was arguably under control at 3.5% in FY17 and FY18, the quality of the deficit deteriorated. Our revenue deficit rose from 2.0% of GDP in FY17 to 2.6% in FY18, and could slip even more in the election year FY19. Our absolute capital spending reduced from INR 2.90T in FY17 to INR 2.64T in FY18. Our government is effectively borrowing money to pay for current expenditures including subsidies and loan waivers.
Lastly, stressed banking balance sheets remain the soft underbelly of the Indian economy. We continue to kick the can down the road on complete bank recapitalization, resolution of stressed assets, and reform of the banking sector. Relatively high real yields, particularly post demonetization, also added to the banking sector stress.
Oil prices are still well shy of the levels seen in 2012-2014, and yet, our vulnerabilities are already showing up. Inflation control using interest rates is not the lone panacea – we must still consider and balance across all metrics including external balance, internal balance, and health of the banking sector.
Economic policymaking is complex. In our Indian context, each time we try and simplify this by focusing on one metric alone, we risk aggravating overall financial stability.
Post-2008, our over-arching focus on growth allowed the twin deficits and inflation to take hold.
Likewise, inflation targeting using interest rates is no panacea – in fact, it may have actually contributed to the current external imbalance.
We may have no option but to consider financial stability as a whole – across external balance, fiscal health, and health of our financial sector, besides growth and inflation. We also need a coordinated effort from the government and the central bank, to optimize and address financial stability as a whole.
The author is Associate Professor of Finance, SPJIMR. The views expressed are his own.