Now is not the time for stimulus

As India struggles to find its way out of a massive economic contraction resulting from a severe lockdown, there are two fundamental questions policymakers face. 

Do we need to stick to the fiscal stimulus of around 2 per cent delivered thus far? And do we stick to the inflation targeting framework that requires inflation to be contained below 6 per cent? The answer to the second question dictates the answer to the first.

Finance ministry officials have said that the government intends to adhere to the enhanced government borrowing target for the fiscal of Rs 12 trillion announced some time ago. This rules out any further fiscal stimulus for now. 

Given the expected shortfall in revenues, adhering to the target not only precludes any additional stimulus, it could mean a reduction in government spending budgeted for FY 2020-21. SBI Research estimates that sticking to the expenditure targets in the Budget will mean a fiscal deficit of Rs 17.4 trillion. Limiting government borrowings for the year to  Rs 12 trillion will require a surge in tax revenues in the coming months of an order that is unlikely. Reduction in government expenditure appears inevitable unless the government is willing to relax its borrowing limit.

Critics say India’s fiscal stimulus is niggardly in comparison to that of several other economies. Ever since the onset of the pandemic, leading economists have urged a fiscal stimulus of up to 5 per cent of gross domestic product (GDP). Yet, the government’s contrarian call in settling for a modest fiscal deficit is now beginning to look as sensible as it was bold at the time. 

First, even if fiscal stimulus is limited to 2 per cent of GDP, the combined fiscal deficit of the Centre and the states will be 11-12 per cent of GDP. True, this is lower than the level of 16.5 per cent of GDP that the IMF’s World Economic Outlook (June 2020) estimates for the advanced economies. But the rating agencies treat the advanced economies very differently from an emerging market such as India. Any further deterioration in the fiscal deficit raises the real possibility of a rating downgrade and a destabilising outflow of foreign capital. In the real world, rating agencies can’t be ignored. 

Secondly, it is not clear that a stronger fiscal stimulus at the onset of the pandemic would have made a material difference to GDP growth. Many commentators believe India’s measly stimulus resulted in GDP contracting by 23.9 per cent in the second quarter of financial year 2020. 

But countries that used a bigger stimulus have not seen vastly superior outcomes. The UK delivered a stimulus of 5.9 per cent of GDP and saw the economy contract by 22 per cent. The US had a stimulus package of 14.7 per cent of GDP and yet its economy contracted by 9.1 per cent. Advanced economies as a whole are projected to shrink by 8 per cent in 2020, not very different from the 9 per cent shrinkage projected for India.

Why has fiscal stimulus not made a material difference to economic outcomes? One explanation is that increasing aggregate demand cannot impact growth significantly when supply is disrupted by the inability of people to show up for work. Increased public investment in infrastructure remains notional unless the lockdown is eased sufficiently for public works to be carried out. 

Cash transfers tend to get saved, not spent, as people see the income shock they have suffered as permanent and the cash transfer to them as transient. The government’s decision to use the stimulus to help those most vulnerable instead of trying to shore up firms across the board thus seems appropriate. 

illustration: Binay Sinha
For supporting firms, the government has opted for a combination of lower interest rates, liquidity support in the initial months followed by loan restructuring to support solvency. Economic pundits have decried the policy of letting the central bank do the heavy lifting. Now that we know how fiscal stimuli have generally panned out, this again appears to have been the right call.

With the exit from the lockdown on, we can contemplate further fiscal stimulus. There is a way to increase the fiscal stimulus without increasing public debt and facing the risk of a rating downgrade. That is to monetise the deficit, meaning, get the RBI to subscribe to government bonds. The snag is that any monetisation of the deficit would mean an increase in money supply. 

This would not be an issue under the deflationary conditions present in the West. Conditions in India are very different. With CPI inflation at 6.7 per cent in August and averaging 6.6 per cent in the current fiscal, monetisation of the deficit could mean violating the upper limit of 6 per cent for inflation in the inflation targeting framework. We would need to revisit the inflation target or, perhaps, introduce an “escape clause” for inflation targeting similar to the one we have for the fiscal deficit target. Rating agencies and foreign investors are bound to view such a move as a drift towards irresponsible macro-policy. 

It follows that the government can contemplate another bout of fiscal stimulus only when the inflation rate falls to below 6 per cent. Once that happens, the government may resort to monetisation of the deficit. Direct monetisation, that is, the RBI buying government bonds in the primary market is preferable to indirect monetisation, that is, the RBI buying bonds in the secondary market. The impact on money supply and inflation is the same in the two cases. However, in the first course, unlike in the second, public debt does not rise. 

The most stringent lockdown with the weakest fiscal stimulus. For critics, is a damning comment on the government’s response to the pandemic. The merits of the lockdown may be debated. But fiscal stimulus remains weak not because there is an aversion to fiscal stimulus per se but because any further stimulus will mean a breach of the inflation target. 

The finance minister has said that she is open to another stimulus but that she will choose the timing. Once inflation falls below 6 per cent, the time will be right for injecting a further stimulus through monetisation of the deficit. 

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