With credit multiplier staying weak, it is time to worry if contagion from the financial sector to the real sector is spreading
News on weak domestic economic activities continues. Judging by leading real and financial indicators, it seems certain that Q2FY20 growth would be worse than last quarter’s 5%. Currently, most forecasts hope for a quick turnaround in H2FY20 from a supposedly cyclical slowdown, a popular first line of explanation that economists dish out. RBI’s sharp cut in FY20 growth projection to 6.1% will not hold for long; another downgrade will most likely follow in December, after the release of second-quarter GDP estimates. Even as the forecast error relative to over-optimistic initial growth projection (above 7%) magnifies, the underlying narratives haven’t changed much—the slowdown is still cyclical, but with a much larger output gap!
What if the slowdown is more structural? If so, potential growth should be declining, i.e., weakening trend. The accompanying graphic clearly supports such a view—the Q1FY19 peak, at 7.4%, was 100 bps lower from the preceding peak, Q1FY17 (8.4%). One can quibble about the statistical finesse of this simplistic assessment, but the trend slowdown is unmistakable. The real question is if it has fallen further after the recent growth shock. There was always a question mark on the claim of higher potential growth rate amidst weak private investment, and consistently lower capacity utilisation; its sudden collapse supports the contention that it was pushed by higher government spending, and credit by NBFCs.
For quite some time, RBI has been careful not to make its potential output estimates public, speaking in terms of the output gap. But, its projection of a sharp recovery to 7% in FY21 indicates RBI believes the economy’s potential remains intact! This recalls a recent phase in which most analysts, including us, went horribly wrong on inflation forecasts! RBI, too, kept projecting higher inflation, anticipating a rebound in food inflation that was long dead. Consequently, monetary policy remained overtly tight for too long, lasting several quarters.
In hindsight, one could argue that those policy errors possibly contributed significantly to the subsequent slowdown!
This makes one speculate if RBI, and others, are making similar errors in H2FY20, and FY21 growth forecasts. With inflation projections, the gap in actual and forecast errors kept increasing, but MPC was unwilling to amend, sticking to its structural model built around the ghost of food inflation bounce-back. Now, error between actual and forecast GDP growth keeps amplifying each quarter, but policy makers stick to ‘predominantly cyclical’ description of the slowdown. A widening output gap creates ample space for countercyclical responses; it prompts MPC to ease more, and government to seek fiscal stimulus opportunities, largely off-budget.
Ordinarily, any countercyclical response to structural slowing would invite higher inflation, and related uncertainties. But, many believe there is an extraordinary phase of weak inflation; this could absorb any potential fallout of countercyclical policy error.
The risk is worth taking, they reason; bigger policy rate cut, and some on-budget fiscal expansion could quickly close the output gap. Such thinking would appeal to a government looking for a quick turnaround, but underlying risks could multiply manifold and blow-up in the medium term. Inflation may have been tamed, but inflationary expectations are still very high!
One shouldn’t forget the post-2008 experience, when UPA-II fired many countercyclical measures, raising demand through unflinching credit expansion and fiscal boost, which created a mirage of higher trend growth while real potential remained well below. What followed was an inflation spiral, growth crash, and external account pressures. Adherence to cyclical accounts could be laying the ground for repeating historical mistakes.
Some argue that even if this is a structural slowdown, the real rate remains too high; there is enough space for further easing. We, alongside this newspaper, consistently advocated such a view for several years. But, that time has now passed: Monetary policy has lost its mojo. Even with MPC further lowering the repo rate and RBI forcing banks to immediately transmit through external benchmarking, little is going to change on the ground. Just see the recent policy rate cycle: the MPC eased 160 bps from June 2018 to August 2019, when the credit channel remained completely blocked.
The “Flow of Financial Resources to the Commercial Sector” graphic in Monetary Policy Report, October 2019 that has invited much attention shows how RBI’s obsession with inflation targeting (IT), another structural reform in Modi 1.0, has gone haywire.
IT advocates constantly assured that once macroeconomic stability is durable, growth dividend would follow via lower cost of capital, and stable bond market. What happened? One can understand bank lending rates not falling much because of high NPAs and their slow redressal, but why did treasury yield not crash in line with falling inflation?
Focus has now shifted to the Centre’s off-budget spending, and quasi-sovereign borrowings by public sector undertakings, viz. public sector borrowing requirement (PSBR). Eagerness to play by letter, not spirit of the Fiscal Responsibility and Budget Management (FRBM) Act is at the centre of the blame game. If governments, Centre and states (about whose off-budget borrowings, little is known), were to capture most financial savings, crowding-out is no more “psychological”. It is real, and embedded in high bond yields. Rising debt, and falling tax revenues have virtually shifted the economy’s lever to the bond market! More OMOs, liquidity management tweaks through additional tools (e.g. forex swap) are only temporary reprieves.
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Opinion that the current fiscal logjam can be navigated by scaling up divestment is not a great strategy either. With financial savings dwindling, where is the scope for further raising PSBR? More asset sales will only squeeze private corporate savings directly for public capex; this is currently happening through PSBR, but indirectly, through bank borrowings and bonds. This may please fiscal hawks, but macroeconomic gains would be marginal. The government may have the satisfaction of building more roads and railways, flaunt more statistics, but the economy’s potential will not raise much unless private investment is back in the game!
This should make it abundantly clear to votaries of the cyclical prognosis that fiscal space is more or less closed. Policymakers must accept that the FY16-FY18 growth acceleration increasing PSBRs and fuelling credit through NBFCs was never sustainable. That the NBFC credit cycle busted even before public banks’ balance sheets were adequately repaired shouldn’t have surprised anyone. With credit multiplier staying weak, they should worry if financial contagion is spreading to the real sector.
Forcing credit through “Loan Melas” is not the way forward. This will further erode credibility of PSBs. The focus must shift to structural reforms. To the government’s credit, it implemented several key reforms, small and big. Unfortunately, textbook reforms like inflation targeting, IBC, RERA, and GST have not yielded expected growth dividend.
More structural reforms are welcome, but we must know why current ones underperformed? Likewise, more roads and railways have been built, yet these haven’t added to the potential; at least, not so far. It is a mystery why consumer and business sentiments nosedived after re-electing a popular government; one bad budget couldn’t have pulled down confidence so much. It is time to introspect if we are misdiagnosing the problem over and over again!
(The author is New Delhi based macroeconomist. Views are personal)