There’s a relaxed air about the macroeconomic situation. Satisfaction about economic improvement has risen in general. Much of this owes to fortuitous developments in the past one month: The FIIs are back in the domestic markets, the price of crude oil has steadily trended down, inflation has peaked and under a firm grip, the rupee has held up strongly against the rising dollar and other blows, and despite growth falling short of expectations in the first quarter, many lead indicators signal steady betterment that is expected to progress in the festival season. While pride in exemplary macroeconomic management during Covid-19 and thereafter compared to that by some advanced nations has further uplifted by crossing the size of one of their members, the United Kingdom. There’s an air of comfort all round. The question is if this will last?
Consider the world’s topmost macroeconomic development. After a long period of denial, the US Federal Reserve has realised it has lost credibility because of its misreading of inflation, mistaken judgement and as result, delayed action. That has roused the US central bank into greater aggression as it attempts to regain credibility. Chairman Jerome Powell’s stern message at Jackson hole last month, that borrowing costs would need to rise higher and stay in growth-constraining region to bring down inflation, was only the beginning. Although that has pushed up real interest rates almost 45 bps since then, bond markets are still not listening. Several FOMC members have repeated that significant interest rate increases are sooner required. Yet the battle between the Fed and the market continues—the US yield curve remains inverted, reflecting beliefs the peak rate will remain below 4% and that the Fed will be able to contain inflation without choking growth! This tussle will get uglier as a determined Fed clamps down aggressively to re-establish itself. The real impacts will then be felt. Risk reappraisals in the international financial markets are probable outcomes, with more severe consequences for emerging market economies.
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These are all short-term possibilities that can quickly play out. Should we be asking harder questions of ourselves in this light?
What, for example, does the weekly fall in forex reserves, $8 billion at the most recent count, signify? Does it reflect an external financing shortfall against far larger demand or current account gap? Is RBI, which has unswervingly held up the rupee with heavy intervention to restrict inflation and debt market spill overs, confident of sustaining this strategy in the face of volatile financial shocks, asset price changes, larger deficits in external financing, weaker exports, other uncertainties? What about the liquidity impact of large interventions or additional tightening upon the real economy? Could inflation resurface, say ‘rice- or wheat-flation’, a turnaround in oil prices, other supply shocks? What could happen to the effectiveness of exchange rate management, an important supplement for subduing imported inflation? Could these bedrocks of macroeconomic stability be shaken, dented, or give way if unsustainable? Or is the stability based upon real economic strength?
There are real consequences of financial shocks as asset prices rejig precariously; fault lines get exposed. In such an environment, growth is likely to take a knock on all fronts. Start with the GDP growth deficit in the first quarter. Of the four pillars of demand, the impact of a slowing world economy is already visible; this is set to accentuate with further downfalls in global demand, high inflation and rising real rates, other factors and uncertainties. The second, private consumer spending, is not yet on sure grounds; its largest base at the bottom remains weak, vulnerable sections need income support or the substitute free foodgrains; its prospective uplift ahead and endurance therefrom remains to be tested; with additional drag from falling exports and costlier financing. Private business investment, anticipated to bounce back with force, isn’t likely to get excited with signs of weakening or wavering demand and deteriorating macro conditions, overseas and within.
That leaves the single pillar of government spending to support growth. The weak public finances and lack of fiscal capacity for responding to persisting or widening deficit in demand is well-known. That the sustenance of national debt, nearabout 85% of GDP, depends heavily upon decent growth is equally understood. When things turnaround unfavourably, jeopardising growth and investments, then increased fears prompt investors and markets to redo the math and review the risks. If perceptions change, the special understanding shown by markets and rating agencies during the pandemic can swing in reverse. Fiscal risk reappraisals can surface with alarming speed. Notwithstanding the domestic financing and captive base, India’s fiscal indicators could suddenly flash red, threatening macroeconomic stability. It isn’t evident that relatively better debt positions vis-à-vis another country matters. India wouldn’t be immune to a fiscal review based upon stricter standards that govern EMEs.
The choice between growth and stability is clearly binary. Any additional expenditure for demand support has to reckon with instability risks in a hazardous atmosphere. There’s little doubt that further fiscal expansion is impossible; arranging resources from existing allocations the only course. The enormous market borrowings have become unsustainable; these are imprudent. In an inflation-charged world environment, the RBI will find it hard to house large borrowings at low costs as since 2019-20. Costs have risen—the trough-to-peak change in the 10-year benchmark yield in the last two years is 159 bps, while a corresponding increase in this year was 80 bps that has narrowed to almost 40 bps this month. Yields could rise more as the RBI seeks to restore price stability, from spill overs of US monetary policy, or unavoidable realignments of the exchange rate if continuous pressures test the RBI’s abilities to retain the tight wall between forex and debt markets.
The difficulties of expenditure restraints in hard times are entirely understandable as the choices are tough. The danger is that may incline restricting capex than compromise welfare spending, aggravating growth risks. To believe that comparably higher growth and lower inflation eliminates the risk of any fiscal reappraisal would be folly. Or that a high growth potential ensures stable debt dynamics when potential output is unsure and likely lowered from years of sluggish private investment and then from the pandemic. It would be more reasonable to ask instead if the perceived macroeconomic strengths and stability can withstand the scrutiny of reappraisals in a perilous environment.
The writer is New Delhi-based macroeconomist.