Designing a demand stimulus

Countercyclical macroeconomic policy is used worldwide but is under-appreciated in India. A conservative focus only on the supply side neglected a slowdown in industry and employment growth that was evident since the 2011 tightening. This followed threats of rating downgrade due to widening current account and fiscal deficits and high food inflation. The increasing deviation of growth from potential has at last, however, provoked a debate on a policy stimulus to increase demand.

It is debated whether the downtrend is cyclical or caused by recent reforms. Revision in GDP estimates that raised growth rates clouded the issue. But signs of excess capacity in industry have persisted for long. Over-reaction must be avoided. A demand stimulus can be designed to improve the supply side even as it alleviates credit slowdown, excess capacity and slow employment growth.

Therefore, what shape should a stimulus take?

The UPA’s spend on rural construction had ended up raising rural wages and making food inflation sticky. But today there are conditions of a glut in food. So spending on lowcost housing will ease rural distress, provide alternate employment opportunities, and raise demand.

Mass consumption, which was the only growth driver for some time, slowed after demonetisation and has not recovered even after the pay commission award. Cuts in fuel taxes are likely to have the fastest effect on consumption even as they restrain inflation. As consumption revives, it will reduce excess capacity in industry and eventually induce private investment. Simplifying GST is an alternative but that would take time.

Similarly, it is difficult to ramp up public investment fast, and wastage is possible. Instead, efforts to leverage external funds for infrastructure, use of innovative finance, and releasing stalled projects, many of which are still stuck in States, could be redoubled.

Revival of projects is linked to resolution of NPAs and restart of credit flows. Therefore some of the stimulus must go as capital infusion to banks. This will help the time-bound Indian Bankruptcy Code; its first priority should be to restart production. Clean balance sheets will aid further credit injections as demand revives. Infusion will not reward the corrupt since resolution forces banks and existing management to take a hit. The idea is to act pragmatically in multiple reinforcing areas.

This policy set would help indebted sectors. A package for exports could focus specially on labour-intensive industries such as textiles and electronics. We could rectify factors giving Bangladesh a competitive advantage over us. Since the informal sector has suffered from both demonetisation and GST, firms that buy from small firms below the tax net could be given tax credit for an interim period during which small firms are helped to formalise. Banks can be encouraged to use fintech and big data to lend to small firms.

It could be argued that tax cuts are better than bank infusion since credit expands supply when it is urgent to expand demand. But in India it is essential also to address supply bottlenecks. A lower quantity of public expenditure can deliver an adequate and non-inflationary stimulus if its composition improves. For example, even schemes for the poor could be designed to build capacity.

But where will the money come from? Tax revenue also falls in a slowdown and there are GST-related uncertainties. Since tax-financed expenditure does not create net demand, fiscal deficits (FDs) should be allowed to increase. The 2008 rise in the FD/GDP of 4 per cent was too effective and led to overheating. Therefore a 0.5 per cent relaxation could be adequate now if complemented with other measures. Moreover, it is consistent with India’s fiscal responsibility legislation.

Internationally, there is more use of fiscal tools. India has the advantage of youth and higher potential growth so the case for some expansion is even stronger here. But a relaxation in emerging markets is interpreted as risky, and can trigger foreign debt outflows. India has in the past swung between continuous slippages in deficit or sustained consolidation. But it is changing, maturing. Both fiscal and monetary policy are now rule-bound, preventing large slippages. But such rules, everywhere in the world, leave room for countercyclical policy.

Flexible inflation targeting, similarly, requires responding to growth slowdowns. Outflows would create problems for the RBI. Therefore it is in its interest to contribute to the stimulus, reducing the pressure on the Government to increase deficits. Although international interest rates are rising, the interest differential between Indian and international rates is large enough to withstand some shrinking. It has been so large that it has attracted 12.5 billion portfolio flows, largely debt, in the April-June quarter alone. Debt flows to emerging markets are excessive because their interest rates have under-corrected for fall in inflation. Such surges carry the risk of outflows.

Raising interest rates to keep foreign capital did not work after the taper tantrum. It hurt domestic growth, which also shrinks capital inflows. Other effective ways of managing excess outflows were discovered. Some volatility in the rupee helps but not too much; some depreciation may help exports but not too much.

Policy needs to look through the temporary mid-monsoon rise in inflation, while responding to the fall in growth. There is also room for counter-cyclical ease in macro-prudential regulation. For example, weights currently above Basel III, on housing finance and for consumer loans, could be reduced.

A crash can arise from too much strictness as well as too much laxity. Balance and pragmatism are essential in policymaking. Thus the fiscal stimulus should be a mixture of rise in middle-class consumption from tax cuts, boost to the poor through housing and other public services, infusing funds in banks, reviving projects still stuck at the State level, and changing the composition of government expenditure, with complementary monetary and prudential relaxation. Reducing corruption and shrinking the informal sector are valid goals. But excessively harsh medicine can kill the patient instead of curing her. Some relief is called for.

The writer is a professor at IGIDR and member of the EAC-PM. The views are personal