By Sonal Varma and Aurodeep Nandi
With general elections scheduled for April and signs of the tide turning against the ruling BJP, the drumroll of populist policies has intensified over the past six months. While strong macro-fundamentals can accommodate these populist excesses in the short-run, they risk creating imbalances in the medium-term, with implicit prioritisation of consumption over investment. In addition, stimulus during times of economic calm often comes at the cost of crucial policy space needed in the future when the downturn becomes entrenched. Consider the following: the BJP -led National Democratic Alliance (NDA)’s rule during 1999-04 was marked by stable macros of low inflation and favourable external sector dynamics.
However, deteriorating rural terms of trade was one factor that resulted in its electoral defeat in the 2004 elections. The first term of the Congress-led UPA government during 2004-09 marked a reversal in rural fortunes and a return of the UPA government in 2009—likely due to the ‘just right’ mix of prudence and populism. However, as rural reflation and fiscal excesses triggered inflation, real rural incomes declined and, along with corruption scandals, ousted the UPA in 2014. The macro backdrop today seems eerily similar to 2004. Banks had large NPAs during 1999- 04, as they have had during 2014-till now. The BJP MSP and food inflation low then, as now. Rural income growth was low then, as it is now.
At a national level, the experience of the last two decades suggests an inverted-U (a frown) relationship between the degree of populism (defining this predominantly as rural reflationary policies) and the electoral success. Too much populism as well as too little populism (too much prudence) have both resulted in an electoral defeat. The trick is finding the right balance between prudence and populism. Policies around rural India have played a big role in deciding the electoral outcome, as rural India accounts for ~70% of the total population.
The broad direction of macro policies in India is moving towards more accommodation. The triggers are both political and economic. On the fiscal front, the Central government’s fiscal deficit has remained in the 3.4-3.5% of GDP range since FY17 (year ending March). To appease the farm sector, the government announced an income support programme for landholding farmers, which carries the bearings of a perpetual scheme, rather than a one-time cash transfer. This follows the government’s poor decision to raise MSP by at least 1.5-times the production cost in 2018. Other social welfare commitments—health care, pension for unorganised sector—currently don’t entail large monetary allocation, but will likely incur higher expenses in coming years. In the absence of higher goods and services tax revenues, this suggests an upside risk to the future fiscal deficit path.
On the monetary policy front, changes are more subtle. With average headline inflation below 4% since 2017, this had resulted in higher realised real rates. In his maiden monetary policy statement, the RBI Governor, Shaktikanta Das stated that the surprise rate cut in February (notwithstanding high core inflation) was a result of low headline inflation and that, once the price stability objective had been achieved, RBI would address the objective of growth. It indicates a higher weight being assigned to headline inflation (relative to core) and to growth. This possibly signals lower realised real rates in the coming years. On the regulatory front, RBI has eased risk-weight norms for non-bank finance companies due to the shadow banking crisis. Three public sector banks were taken out of the prompt corrective action (PCA) framework in end-January. It also permitted a one-time restructuring of existing loans to Micro, Small and Medium Enterprises (MSMEs) that have become stressed. Report of the expert committee on economic capital framework is also awaited on whether the RBI holds excess reserves on its balance sheet.
Accommodative macro policies do not necessarily imply imprudence. If growth is weak, then counter-cyclical macro policies are essential. At the same time, we believe it is essential for policymakers to halt when pragmatism starts to morph into imprudence. Many small steps could cumulatively create the foundations for future instability. For example, ensuring adequate liquidity for non-bank finance companies is essential to prevent a liquidity crisis from morphing into a solvency crisis; but too much liquidity is also a bedrock of future inflation. Forbearance only kicks the can down the road.
In the short-term, the effectiveness of recent policy easing will be partially lost due to transmission lags and implementation hurdles. The farm package will likely encounter implementation challenges because not all states have computerised land records; those that do, don’t necessarily have accurate records; and many states do not have bank accounts linked to these land records. Similarly, the impact of RBI’s rate cut will be delayed and uneven. Banks that have the capacity to lend are already garnering market share from shadow banks (after last year’s crisis) and hence have elevated CD ratio/tighter liquidity constraints, which will delay any reduction in lending rates. In addition, some sectors, such as the low-tiered shadow banks, are credit-constrained because of the perception of higher ‘credit risk’ and may not benefit from the rate cuts as much. Retail lending, on the other hand, continues to benefit.
The global backdrop (weak global demand), lagged impact of tighter credit conditions due to the shadow banking crisis and a likely slowdown in investments due to political uncertainty implies that growth will continue to disappoint in the near-term, despite domestic macro policies turning accommodative. Predictions are that GDP growth will slow down from 7.1% y-o-y in Q3 2018 to 6.6% in Q4 and further to between 6.0–6.5% in H1 of 2019.
Low global food prices and domestic balance sheet constraints also imply that there is no imminent inflationary risk. Weak growth and lower cost pressures should moderate core inflation. RBI’s more optimistic growth projection amid below-4% inflation will support a further rate cut. Pencil in a 25 bps rate cut in Q2 (most likely in April) and attach a 20% chance to one more in Q3. Expect GDP growth to pick-up to slightly above 7% by end-2019 and into 2020.
Edited excerpts from Nomura’s Asia Insights India: The ‘Frown curve’—why politics and economics don’t always smile (February 14)