Budget 2020 India: As the Fy18 period shows, a large fiscal push to revive growth may end up hurting rather than helping a recovery.
By Pranjul Bhandari
Union budget 2020 India: We look at the possible macroeconomic foundation of the slowdown, and whether there are any lessons for the upcoming budget.
It is useful to divide the slowdown into FY18 and 2019. After falling for five years, India’s investment rate began to rise in FY18, driven largely by higher public sector spending. This had three key implications: (1) because savings did not rise in tandem, the savings (S) minus investment (I) differential fell, and the current account balance (C) worsened in line with the ‘C=S-I’ macroeconomic identity; (2) graphically, the downward sloping ‘I’ curve moved right (see graphic), and for the given upward sloping ‘S’ curve, economy-wide interest rates rose; (3) while the objective of higher investment was to spur a recovery, growth fell instead. Investment may have risen, but the fall in net exports (C) that it triggered offset the rise, leading to lower GDP growth.
Challenges in 2019 proved a bit different—marked by strong risk aversion in India’s banks as uncertainties around asset quality grew. Credit growth weakened and the rate transmission was impaired, leading to: (1) the vertical financial intermediation curve moving left in our S & I graph, as banks became unwilling to intermediate efficiently. The new intermediation curve became a binding constraint, intersecting the I curve at a higher interest rate than before. Alongside this, funds available for investment shrank; (2) the silver lining is that S-I rose, and the current account balance improved; (3) but, RBI may not have wanted the rupee to appreciate during a downturn and began to buy dollars. Risk aversion at banks may have ended up placing more of the country’s domestic savings abroad. There are two important takeaways for budget 2020: one, as the FY18 period shows, a large fiscal push to revive growth may end up hurting rather than helping a recovery; and two, the experience in 2019 suggests steps that lower risk aversion at banks should be a national policy priority. The slowdown in 2019 has been a much talked about phenomenon, but the fact it is not standalone has received less focus. 2019 is the the third year of growth slowdown. These sub-periods have some things in common: economic growth was lower than in the previous year; and interest rates remained elevated. In fact, all the key interest rate spreads were higher than their long-term average, and rising, during this period. And, yet the two periods were distinctly different, with different lessons for reviving growth.
The hallmark of 2017 and 2018 was a rise in investment. Details show a big push by the public sector. The contribution of public investment to GDP growth rose from 0.1ppt in 2016 to 0.8 ppt in 2017. This spending spree was not costless. Public sector borrowing rose from 7.5% of GDP in 2016 to 8.4% in 2018, and there were three not-so-desirable outcomes:
i) Worsening of the C: The rise in savings was not in step with the investment spurt. Consequently, the savings S-I differential, fell. When domestic savings proved insufficient, the reliance on external funding rose. The CAD widened rapidly from 0.6% in 2016 to 2.1% in 2018.
ii) Upward pressure on interest rates: The fall in S-I had implications for economy-wide interest rates. Think about it as an upwards sloping S curve and a downward sloping IR curve. As the I curve moves out (to the right) due to a push in public investment, rates rise for similar savings behaviour. No surprise then that almost all interest rate spreads in India began to rise around that time.
iii) Lower growth: While the idea behind higher investment was to spur growth, growth fell instead. GDP on the expenditure side is C+I+G+X-M. A closer look reveals that while I (and G) rose, (X-M) fell. Because domestic savings did not rise enough to fund the investment spree, it was accompanied by a wider CAD.
It is tempting to assume that fiscal policy should be pro-cyclical, i.e., fiscal deficit must widen during slowdowns. However, a widening at a time when domestic savings are not enough can put upwards pressure on rates, and pressure net exports, taking away from growth. While some slippage is inevitable this year because revenues have fallen, and it is not possible nor prudent to cut some expenses, a growth revival policy based on a large fiscal push could backfire.
A balance here may be to stick to the new FRBM rule, which allows a fiscal slippage of 0.5%, not more. Any higher government spending would be better paid for by disinvestment, rather than by running a higher fiscal deficit.
RBI cut rates by 135bps, but this barely got transmitted. Economy wide interest rate spreads widened over the year. Something else was going wrong.
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Following the NBFC fallout in late-2018, there was much uncertainty about the balance sheet. India’s banks had been an important lender to NBFCs, and suddenly they were not sure about the quality of loans. The sharp fall in GDP growth also raised worries about the NPL cycle. In its latest review, RBI also raised concerns that after declining in early 2018, NPLs could rise again.
India’s banks became increasingly uncertain of their asset base and thus extremely risk-averse. Credit growth slowed and the spreads kept widening.
What risk aversion means for macro?
i) Higher rates and lower investible funds: We go back to S-I curves. They intersect at point e0, which determines the investment levels and interest rates. Now let’s introduce a financial intermediation curve (see graphic), which determines whether the country’s banks are functioning normally. Think about it as a vertical line crossing at e0. The rise in aversion in 2019 meant the intermediation curve moved left. Banks were now only willing to intermediate partially. The new intermediation curve intersected the investment curve at a higher i1. And, the funds available for investment shrank.
ii) Improving CA balance: At the i1, savers may want to save more (all else unchanged). In this situation, the S-I gap improves (increases). And given the S-I-C identity, so does the CA balance. What is the mechanism here?
As investment falls, imports fall as well, improving trade balance. Indeed, CAD has shrunk from 2.1% in 2018 to an expected 1.2% in 2019.
iii) …but domestic savings are getting placed abroad: There is another angle to the risk aversion fallout. Think of the intermediation curve as allocating domestic savings between domestic investment and funds placed abroad. So, risk aversion at banks can lower domestic investment, placing more of a country’s domestic savings abroad.
Budget 2020 presents an opportunity to reduce banks’ risk aversion through a host of policies, including (1) strengthening the IBC, (2) untangling stalled investment (3) reducing the weight of government mandates on PSBs, (4) a regulatory overhaul of shadow banks , and (5) increasing the pace of strategic disinvestments and public asset recycling to lower fiscal pressures that weigh on India’s banks (e.g. a sharp sell-off in the 10-year G-sec rate can impinge on bank profitability given their large holding of G-secs).
Co-authored with Aayushi Chaudhary, Economist, HSBC
Edited excerpts from HSBC’s Lessons from India’s three-year growth itch (January 16, 2019)
Bhandari is Chief India economist, HSBC.Views are personal