The repair and recovery in emerging market (EM) economies that started in early 2016, widened GDP growth differential with developed market (DM) economies for the first time since 2010. This widening of growth differential brought with it a resurgence in capital inflows, rising asset prices, and firming exchange rates after a gap of over five years. Those of us who have been covering these markets not only heaved a sigh of relief but even dared to imagine that perhaps this recovery could sustain for a while.
Then in November two events changed all this: first, the surprise US election result and second, the demonetisation in India. The reaction to the US elections has been a dramatic reassessment of the US fiscal and trade policies whose immediate impact was a sharp rise in long-term interest rates and in the dollar. This generalised tightening of global financial conditions resulted in substantial capital outflows from EMs, including India, and depreciated currencies over the last two months. More important, neither the US interest rate cycle nor the appreciation of the US dollar has peaked, such that it has made it very difficult for EM central banks to ease rates to support growth in their economies, fearing that any such easing would lead to further capital outflows. And in the last few weeks as the new administration has ticked-off one promise after another made in its 100-day agenda, the likelihood of border-adjusted taxes and increased import tariffs imposed by the US and possible retaliatory measures taken by other countries loom large on the horizon. If any of these actions are taken, it could easily lead to very large exchange rate adjustments, redirection of global trade flows, FDI, and supply chains. Countries, like Mexico and China, will be in the direct firing line but other EM economies, including India, will not be spared given the extensive supply-chain linkages.
In India’s case, the uncertainties surrounding the impact of demonetisation have added to the global concerns. While the dominant narrative is that, the demonetisation will only have a transient demand shock for the next few quarters and things will thereafter return to normal, there is a risk that parts of India’s domestic supply chains that go through the informal economy may have been disrupted. And that the cost structure of the formal sector is too high for it to replace the broken supply chains. Consequently, inflation and imports could rise when demand recovers, which, in turn, could widen the current account deficit exerting further downward pressure on the currency over and above that from possible US tax and trade policy changes.
But none of these risks made it in yesterday’s budget. One can understand why the government would underplay the risks from demonetisation, but what about the global risks? Instead, the FY18 budget was grounded on a forecast of benign growth, inflation, and external conditions. And consistent with such a narrative, the budget targeted a deficit of 3.2% of GDP. I could quibble that if there wasn’t any downside to India’s economy, then why not stick to the planned 3% of GDP target. But I won’t. Even at 3.2% of GDP, it is still a commendable consolidation.
If there is nothing really worrisome about the economy, then there is no need to make dramatic changes to specific policies. In keeping with this logic, the budget proposes incremental changes to capital spending, privatisation, MNREGA allocation, housing support, income and corporate taxes. Support from the government for PSU bank recapitalisation has been inadequate for long and the allocation in this budget remained symbolic as well. One important outcome in the current year’s budget has been that capital spending was larger than budgeted, while current spending lower, which should warm the hearts of those who believe that capital spending is good and current spending bad. I have never been convinced of this argument as empirical evidence suggests that the outcome is often the opposite. The elimination of the FIPB removes an irritating bureaucratic hurdle, while the limit on cash transactions adds another.
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So, if nothing else, the budget was consistent with the government’s envisioned baseline of how the Indian and global economy would evolve in FY18. One understands that a budget has to be based on a baseline scenario, but the lack of any discussion on global and domestic risks that are widely seen as large and material was glaring by its absence. If nothing else, the government’s assessment of such risks would have helped to allay these concerns and provide some comfort that it was aware of them and ready to take counter measures if needed. Without such an assurance, one can only pray that the world indeed turns out to be as benign as anticipated in the budget. Otherwise, policies could well have to be altered dramatically before this year is over.
Views are personal