Mixed economic outlook and macroeconomic policy challenges
When macroeconomic indicators all point in the same political direction, policymaking is straightforward. However, policymaking in the real world is not that straightforward. The economy is monitored using a variety of indicators, which can point in different political directions. These mixed signals, as we are seeing now, make macroeconomic policy quite difficult.
There is a broad consensus that India’s gross domestic product (GDP) will grow by around 9-10% in 2021-2022. Our own ânowcastâ growth is 9.9% (Rudrani Bhattacharya & Sudipto Mundle, NIPFP working paper n Â° 361, December 2, 2021). The strong growth in 2021-22 is mainly driven by the strong base effect of the 7.3% contraction in 2020-21. The important question is how the economy will behave in 2022-2023, when there is no base effect to stimulate growth. Our forecast is 5.2%, significantly lower than the Reserve Bank of India (RBI) projection of 7.8%. But it is similar to one of the growth scenarios projected by the 15th Finance Committee and higher than the pre-pandemic growth of 4% recorded in 2019-20. Of course, all of these model-based projections are pretty fragile in an economy just recovering from a huge shock. More importantly, the actual results in 2022-2023 will largely depend on the policies that are pursued during the year.
Since the pandemic struck in March 2020, the RBI has done a remarkable job of adjusting to the unprecedented scale of government borrowing through unorthodox liquidity measures, while ensuring that bond yields d ‘State remain limited. But now is the time to reverse this ultra-accommodative monetary policy stance. Although there is still a large gap between potential output and real output, GDP growth is now clearly on the path to recovery. On the other hand, with core inflation persisting above the RBI’s target range of 6.1% and the wholesale price index inflation rate having increased to 14.2% after inflated at double-digit rates for several months, inflationary pressures can no longer be ignored. .
The change in policy does not have to be disruptive. Surplus liquidity can be gradually drained from the system. Indeed, while maintaining its accommodative monetary policy and keeping its key rate constant at 4%, the RBI has already moved in this direction through its inverted variable rate auctions (VRRR) since October. VRRR volume should reach ??7.5 trillion by the end of December. Indeed, with an average VRRR of around 3.8%, the repo rate of 3.35% will become redundant and the VRRR will become the main instrument for draining liquidity from the system by January 2022.
Externally, unemployment in the United States is lower than expected, while inflation is unusually high at over 6%, a rate not seen for at least 40 years. In response, the US Federal Reserve said on Wednesday it would accelerate the reduction of its quantitative easing program in preparation for an interest rate hike. This in turn will lead to an exit of portfolio investments from emerging market economies. We can already see this in India, and the depreciation of the rupee that results from it. Hopefully, the RBI’s intervention will be limited to containing excessive volatility as the rupee depreciates, not halting the depreciation. As past experience in India and elsewhere has shown, any attempt to keep exchange rates above their market-clearing level would ultimately fail, thereby burning a large amount of foreign currency. In addition, further depreciation of the rupee could help stop India’s yawning trade deficit, which continues to widen.
In terms of fiscal policy, exercises are now underway for the 2022-2023 budget. Securing growth, as well as income and food aid for the poor, should be its primary focus as the RBI focuses on inflation. The central government needs to adjust its spending program in favor of growth-friendly infrastructure, including social infrastructure such as education and health. It must also ensure, through its transfer program, that states have sufficient spending room to do the same.
A strong spending program does not need to depend on deficit financing. There is no immediate risk of a debt trap, as long as nominal GDP growth exceeds the sharp 9% rate, as I explained in a previous Mint column (April 16, 2021). But if real growth or inflation were to decline sharply in 2022-2023, existing public debt levels could become unsustainable. Thus, the central budget deficit is expected to be reduced through annual counter-cyclical adjustments to around 4% by 2025-2026, as recommended by the 15th Finance Committee. Strong spending can be accommodated despite such a reduction in the deficit thanks to the recent high strength in tax revenues, which are increasing 16-17% year-on-year, even during the pandemic period.
However, much of the increase in tax revenue is due to indirect taxes. Direct taxes have increased at a much slower pace, less than 1% in October 2021 compared to a year ago. Therefore, direct tax policy should focus on increasing its dynamism by minimizing concessions and exemptions and broadening the country’s direct tax base.
Finally, it must be said that appropriate fiscal and monetary policies alone will not allow us to achieve the high and sustained growth rates of 7-8% needed to overcome our enormous problem of unemployment and underemployment. This can only happen through deep and far-reaching structural reforms of the type observed in 1991.
These are the personal opinions of the author.
Sudipto Mundle is a distinguished member of the National Council for Applied Economic Research, New Delhi.
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