INDIA’S government is trying to stick to tight fiscal policy in the face of a depressed farm sector and a banking sector overburdened with bad loans, writes World Review Expert Pramit Pal Chaudhuri.
In keeping with tradition, Prime Minister Narendra Modi used the latest budget to lay out his government’s macroeconomic strategy and policy priorities for 2016 and beyond. The key message is simple: India will hold the line on the fiscal deficit, sticking to a target of 3.5 percent of gross domestic product (GDP).
There is a catch, though. While popular with most analysts, foreign investors and the central bank, such a policy greatly complicates the challenges of tackling India’s three worst domestic economic problems. They are: a rural population in distress after two poor monsoons, weak capital investment from private corporations and a festering bad loan problem in the banking sector.
Mr. Modi chose to divert a revenue windfall from low global oil prices (India is a net energy importer) to provide funds to farmers. He is also gambling that a sufficient amount of private capital can be attracted to India’s infrastructure projects and replace economic stimulus from the government. As to the bank loans crisis, Mr. Modi has decided on his favorite gradualist approach: it is going to be step-by-step reforms and seemingly small improvements rather than big, government-financed bailouts.
The government’s economic forecasts in the budget are optimistic. They project India’s GDP will grow by 7.75 percent in real terms and 11 percent nominally in the 2016-17 fiscal year. This would be above the fine result of 7.5 percent growth recorded in 2015. The forecasts are generally in line with external agencies’ estimates.
In 2014, Mr. Modi promised to halve the 6 percent fiscal deficit he inherited from his predecessor by 2018. He has repeatedly come under political pressure to ease this target but has stood firm, arguing that the costs would be too high for India.
One such cost now would be spooking foreign investors – just as their investments in India have rebounded to $73 billion in 2014-2015 from the low of $8 billion in 2008-2009. Another concern was triggering a fall in the rupee exchange rate. Many trading desks had taken long dollar positions against the rupee before the budget, expecting the rupee to fall. Instead, during the three weeks following Mr. Modi’s decision to stick to its fiscal targets, the rupee rose 3 percent against the dollar. As of April 2016, in terms of the real effective exchange rate, the rupee is at its highest point since 2011.
Most importantly, the prime minister was persuaded that lowering the fiscal deficit would allow the central bank to cut interest rates. The base lending rate for Indian banks is above 9 percent, among the highest real rates in the world. Reducing it would ease the debt problems of India’s corporate sector, encourage consumers and significantly reduce the government’s own interest burden. Today, interest payments consume a full quarter of the annual budget.
The poor fiscal policy records of previous Indian governments have so badly undermined New Delhi’s credibility with financial markets that the effects of monetary easing have been neutralized. In 2015, the Indian central bank cut its benchmark repo rate (the level at which it lends to commercial banks) a full 125 basis points in four separate cuts – without affecting bond yields. Apparently, the widespread doubts about India’s fiscal rectitude have had something to do with this. Now Mr. Modi is trying hard to restore monetary policy as an effective instrument.
However, the backdrop to all this is severe economic distress in rural India caused by two poor monsoons in a row and a slump in agricultural commodity prices. The profitability of growing major crops has shrunk to a mere 5 percent, down from 20-30 percent just two years ago. As two-thirds of India’s population still dwells in rural areas, New Delhi predictably responded by ramping up expenditure on crop insurance, rural workfare and irrigation schemes.
Mr. Modi is under no particular electoral pressure this year – his Bharatiya Janata Party is not a major contender in any of the five states that are going to the polls in 2016 – but it would have been politically suicidal for him ignore pains in the countryside.
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Publication Date:
Thu, 2016-04-28 05:00
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