The Centre is doing its bit to revive economic growth. Unfortunately it is getting little support from the RBI while States are taking decisions that will only dampen growth
Major economic developments took place last week — some of them were positive while others were disappointing. The positive developments occurred on the executive front as Prime Minister Narendra Modi reassured bankers and encouraged them to lend fearlessly to genuine business owners while Finance Minister Nirmala Sitharaman stated that a simpler taxation regime was the need of the hour, no ifs or buts. This reflects the realisation within the Government that tax reforms and banking sector recovery are both important for the purpose of revival of our economic prospects.
To be fair, the Government has implemented some of them. It frontloaded bank recapitalisation in September and announced one of the biggest corporate tax cuts of the 21st century on September 20. Everything possible and suggested on the policy front to the Government by experts seems to be happening. We have heard about the likelihood of labour reforms and the Government is resuming the process of privatisation. Both are long-term projects that were stalled due to the lack of political will. Modi 2.0 has however, demonstrated this resolve and it is precisely why markets seem to be optimistic about the near future prospects of our economy. The possibilities are even brighter in the medium term as we look at international developments and investors keep paying attention to every single policy change made by the current regime.
However, it is also important to focus on downside risks — and nearly all of them are to do with agents other than the Central Government. But first, to the disappointing development of last week — the Monetary Policy Committee (MPC) decided to keep the rates unchanged at a point of time when everyone expected a rate cut. The criticism that followed the decision of the MPC is a breath of fresh air as it suggests many are coming around to my view with regards to the conduct of India’s monetary policy under the MPC.
Perhaps, we need to ask some strict questions regarding its efficacy and whether they’ve adequately captured the extent of the impact of their decisions. The fact that even the international Press was puzzled at the absurdity of their decision is further reassuring, as it brings with it an urgency for the MPC to think, assess and reassess its decision before the February meeting.
Economic recovery fundamentally depends on what the MPC does and so far, it hasn’t done enough. Consequently, what could have been a V-shaped recovery will now be a U shaped one — which means we may be at the bottom for a while. The bottom here is a growth lower than 5.5 per cent which should be a major cause of concern for the Reserve Bank of India (RBI).
The reason to hold rates constant as inflation has increased because of the rising cost of food articles is absurd because nobody is going to borrow to consume onions! Clearly, our inflation-targeting framework is inadequate in terms of distinguishing between supply-side and demand-side inflationary impulses. But, then again, the MPC should be able to distinguish between the same. The solution no longer lies in reduction in interest rates but also in an increase in base money to drive transmission. With our nominal growth at 6.1 per cent and our 10-year Government Security Yield at 6.5 per cent, clearly, we have a fiscal problem that has far exceeded the ambit of a conventional monetary policy.
Therefore, the RBI must start purchasing Government securities through open market operations along with rate cuts until the output gap can be closed. This, when done along with taxation reforms and privatisation, will be instrumental in accelerating our growth rate in the short to medium-term.
The fact that the RBI consistently overestimated inflation in 2017 and till mid-2018 doesn’t help it either. Since then, its got inflation forecasts right but its growth forecasts have been terribly off the mark. This suggests that the problem persists even in the information which serves as an input for the MPC before taking any decision. The sooner we can fix it, the better it will be for the quality of our monetary decisions and consequently, our economic prospects.
Apart from the Central bank, there’s another problem, which is posed by our State Governments. They have failed to acknowledge the growth challenge and consequently take decisions that dampen the process of economic recovery. One such decision is to do with enforcement of contracts that has been seriously dented thanks to the developments in Andhra Pradesh with regard to Amravati and recently in Maharashtra with respect to the bullet train projects.
Foreign investors, including sovereign funds, are going to be sceptical about entering into a contract with State Governments — especially if it is a long-term contract which means that the price paid by the State would be higher to accommodate for the risk associated with the same.
In this entire episode, States will be adversely affected and the credibility of Governments at the State-level will be questioned for decades. This will also have ramifications for the Central Government and therefore, such decisions only stand to damage India’s economic interests. Another problem is with respect to the Goods and Services Tax (GST) collections which have been low in the current financial year. This shouldn’t come as a surprise given that growth as per the RBI is expected to be at five per cent for the current financial year. This means that nominal growth would be close to seven per cent and therefore, revenue surge is likely to be lower than the expenditure growth as per Budget estimates.
The Central Government is already looking at disinvestments and privatisation as sources of non-tax revenue to keep the deficit in check.
The State Governments, however, have come up with a plan to increase GST rates to make up for the revenue loss. One doesn’t know whether to laugh or cry at such absurd economic suggestions, as increasing tax rates during a slowdown will only do more damage to economic recovery.
Under no circumstance should the Central Government allow the GST Council to increase rates, as it will further reduce disposable income and create a negative sentiment that may further impact consumption.
There are many such proposals in the media at present and it is best to junk them. In fact, States shouldn’t expect full compensation for the current financial year either as it will only add severe stress to the financials of the Central Government. Instead, States should look at increasing their non-tax revenue through disinvestment of State Public Sector Undertakings (PSUs). Moreover, States must take ownership of the current slowdown and use it as an opportunity to undertake bold land and labour reforms along with agricultural marketing regeneration.
India is yet to see bold State reformist leaders and that’s why a bulk of the responsibility for economic reforms and growth has fallen onto the Central Government. The fact that States have failed to improve compliance under the GST regime suggests how the assurance of compensation took away any incentive that States would have otherwise had to plug such leakages. Luckily the 15th Finance Commission has submitted its report and perhaps that’s likely to alter the devolution of funds between the Central Government and various State Governments. This may force several of the States to urgently take measures to improve their financial situation. The precarious fiscal situation of State Governments need not be a bad thing given that the quality of expenditure by them is extremely poor, as a bulk of it is concentrated on subsidies and occasional farm loan waivers instead of education, health care and public infrastructure.
Severe fiscal constraints over time would force States to act in a responsible manner thereby prioritising public expenditure — but it may take yet another decade before this becomes a reality. One of the reasons why State Governments and political parties are averse to reforms is because of our voting preferences which continue to ignore the impact of State administration on economic growth. However, Modi’s record as Chief Minister illustrates the rich dividends from emerging as a reformist leader and other Chief Ministers would be wise to learn a thing or two from his stint.
(The writer is a New Delhi-based policy researcher)
