History lessons and the twin deficits

The following blog appeared on Bloomberg Quint on 9th June 2018 

(https://www.bloombergquint.com/rbi-monetary-policy/2018/06/09/managing-indias-economy-those-who-cannot-remember-the-past)

Over the past few decades, India has endured a few crises associated with external shocks. The 1991 crisis was triggered by the Iraq war. The currency crisis of 2013 came about after Ben Bernanke, then Chairman of the U.S. Federal Reserve, indicated that the U.S. quantitative easing program was set to taper.

While external events did ignite the fires, India was especially vulnerable during those times by sitting on a proverbial powder keg of accumulated external and fiscal imbalances.

Let’s first get a few of things out of the way.

India is not facing any economic crisis at this stage.

Comparisons with 2013 are unwarranted. As are comparisons between India and the likes of Argentina and Turkey in the current context.

But there are signs of some external and fiscal imbalances that are best recognised and addressed early, before they accumulate.

Borrowing To Make Ends Meet

For any household, having to borrow just to fund regular expenses is an uneasy proposition. Such a household will ponder the following:

• Are we doing the best we can to increase earnings and reduce current spends?
• Are we investing adequately in the future?
• Are our lenders dependable?
• Are we confident we can pay off our loans, and be better off than we are now?

The answers determine the sustainability of the household budget. Let’s ask these same questions of our fiscal and external situations.

Quality Of The Fiscal Deficit

Our government borrows each year to fund a part of its current expenses such as salaries and interest costs – and this is traditionally measured as the revenue deficit.

On the other side there is capital expenditure, which measures investments for our future.

The government deserves credit for bringing down the revenue deficit from 3.2 percent in FY14 to 2.0 percent in FY17. Concomitantly, capital expenditure went up from 1.7 percent of GDP in FY14 to 1.9 percent of GDP in FY17. This was largely made possible because the government took the tough call of not passing on the full benefit of lower oil prices to Indian consumers.

FY18, however, saw fiscal deterioration.

• Revenue deficit ended at 2.6 percent of GDP – 0.6 percent higher than FY17.
• Capital expenditure went down to 1.6 percent of GDP – lower than FY14 levels.

For FY19, the revenue deficit is forecast at 2.2 percent of GDP and capital expenditure at 1.6 percent. This looks tough to meet.

The average FY19 (to-date) crude oil price is 32 percent higher than average FY18 levels. The low oil price dividend that the country enjoyed is receding. That, together with the somewhat ambitious targets for Goods and Services Tax collections, the promise of higher minimum support prices and other expenditures could put the revenue deficit targets at risk.

While it’s still early in the fiscal year, at this point it looks like the fiscal slippage could be 0.2-0.5 percent of GDP.

This, in turn, could push the government to reduce capital expenditure if it has to meet its fiscal deficit target of 3.3 percent of GDP.

As an aside, its worth remembering that the Fiscal Responsibility and Budget Management Act no longer sets a path towards lower revenue deficits. The justification offered is that revenue expenditure items such as salaries for school teachers, are actually critical investments for the future. Fair enough. An alternative “effective revenue deficit” was mooted – which incidentally also deteriorated by 0.6 percent in FY18. But even this does not form part of FRBM.

The absence of a focus on bringing down the revenue deficit could give license to a future government to reduce long term investments even more, in favor of immediate doles.

In summary, the quality of our fiscal deficit has deteriorated in FY18, and FY19 looks tough as well. In the medium run, GST and formalisation will improve our tax-to-GDP ratios further. In the short run though, the current nature of imbalance leaves us vulnerable to an oil price shock.

External Imbalances And The Impossible Trinity

On the external side, we run a current account deficit, dominated by current expenditures such as oil, gold and smartphone imports, which needs to be funded by capital flows.

To sustain this, we ideally need permanent capital inflows that are deployed into productive investments, such as foreign direct investment. Such flows channel external savings into our country, and increase output and employment. To the extent FDI does not cover our CAD, we need to rely on other borrowings.

• In FY14, our CAD and net FDI together amounted to a deficit of $11 billion.
• By FY17, thanks to lower oil prices and higher net FDI, that core balance improved to a surplus of $20 billion.
• In FY18, this core balance once again dropped to a deficit of $15 billion, with both CAD and net FDI disappointing.
• For FY19, depending on crude oil prices, the core balance is estimated at a worse deficit of $30-45 billion – a level last seen in FY11.

Despite the core balance turning negative in FY18, the Indian rupee did not depreciate. This is because we saw $60 billion in non-FDI inflows. These included portfolio flows into debt, non-resident deposits, dollar sales by exporters, and speculative positions taken in the expectation of rupee stability.

All of these made their way into RBI reserves, seeking the carry of high real returns that our monetary and forex intervention policies offered.

That brings us to the impossible trinity.

The RBI governor clarified this week that domestic monetary policy is driven by the inflation targeting mandate and does not target any currency levels. Be that as it may, the ‘impossible trinity’ construct tells us that monetary policy will impact capital flows and/or currency levels. We saw this even in FY18, as shown above.

Our monetary policy framework has brought in large non-permanent inflows now, and led to an appreciation in the rupee. During testing times, we may have to continue to keep interest rates high and the currency stable just to ensure the flows don’t reverse.

Monetary policy consistency of high rates may not be as much a virtue, as it is a trap.

There are ways out.

First, we have to let the rupee weaken, as a reaction to the deteriorating core balance. Second, we have to explore ways to make at least some of the carry-seeking flows, such as FPI in debt, more long-term and dependable. Third, the issues facing exporters need to be addressed and we have to find ways of producing smartphones at home rather than importing them from China. Lastly, our monetary policy framework has to be cognizant of the impossible trinity, and we should debate an appropriate currency policy.

Faith, Prayer And Strategy

We could well get by despite these imbalances. For one, if our prayers are answered and crude oil prices drop back below $60 a barrel, there will be no spark to light up any powder keg. Or our next generations may live up to our faith in them, produce the economic miracle that we have always been capable of and easily repay every debt that we take up now.

Faith and prayer are our core strengths but we should do better than make them a cornerstone of our economic strategy.

Ananth Narayan is Associate Professor-Finance at SPJIMR. He was previously Standard Chartered Bank’s Regional Head of Financial Markets for ASEAN and South Asia.

The views expressed here are those of the author’s and do not necessarily represent the views of BloombergQuint or its editorial team.

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