By Preeta George & Jaya Bhargavi
It has been more than a year since the pandemic started in Wuhan, which triggered the current global economic crisis. Most advanced economies have used expansionary monetary policy, of course, with synergic fiscal stimulus, as their preferred tool to tackle this situation. Benign inflation in these advanced economies and even in few emerging economies such as Brazil has not put any binding constraint on monetary policy to support the economy.
India has a slightly different story to tell. In the context of the recent recession, policymakers had sensed the slowdown in mid-2019 through forward-looking surveys. The pandemic-lockdown has further deteriorated the conditions, leading to the sharpest economic contraction in recent times.
RBI worked in tandem with the government to support the economy through unconventional monetary tools and conducted appropriate market operations to support additional government borrowings in non-disruptive ways. The effort augmented system level liquidity and provided some cushions.
Nevertheless, support through conventional tools, i.e., policy rates, was limited. The monetary policy committee has maintained its accommodative stance, reducing policy repo rate only by 115 bps to 4% as inflation, primarily due to high food inflation, has been consistently passed the upper tolerance threshold (barring 3-4 occasions) since October 2019. Recent influx of foreign capital, in the form of portfolio investment, has further constrained RBI’s flexibility in managing monetary policy in conventional ways.
In India, inflation is mostly driven by existing structural deficiencies. This can be addressed only through an optimal investment in infrastructure and other fixed assets. The Centre, along with state-level counterparts, allocates funds for infrastructure, in the annual budget, through capital spending. According to Economic Surveys, capital expenditure in Union budgets was below 2% of GDP (barring two occasions) between 2008 and 2019. The gross fixed capital formation (GFCF) has varied from 25-35% since 1995. Compare this with South Korea’s GFCF, which has been in the range of 30-40 % of GDP (except for four or five occasions when it was slightly less than 30%) for 32 years, till 2010. Even in the last decade, its GFCF has been in the range of 25-30%. A recent report by Arthur D Little finds that the global average logistics cost is around 8% of GDP, whereas, in India, it is 14%, primarily due to high direct and indirect costs. Remember, it is a cost, not a value add. Hence, it puts upward pressure on inflation, especially on perishable items, including food, which requires time-bound transportation from producers to consumers.
The government has allocated funds equivalent to 2.5% of GDP for capital spending in the latest Union budget. The change is significant. It will definitely catalyse further investment in fixed assets and ease supply-side constraints in the medium-term. It will reduce supply-side inflationary pressures, thus providing greater flexibility for monetary measures by RBI.
Although the government has focussed on capital spending, it has been inadequate. More needs to be done. There will always be a discussion on the amount of capital spending or the optimal level of GFCF.
There is no confusion that more funds, as a percentage of GDP, are required to improve the current state of infrastructure in order to ease the supply-side bottlenecks for achieving non-inflationary economic growth. Hence, the increased allocation in the latest union budget, is a step forward in the right direction to enhance synergy between fiscal and monetary policies.
George is professor, economics, and Bhargavi is resource person, Bhavan’s SPJIMR. Views are personal