Economics is infamous for the differences of opinion among economists. A consensus is very rare. But in India, now, there is a consensus that economic growth is very tepid and it needs to be accelerated. This has triggered discussion on the possible policy responses to address the problem. There is unanimity in favor of monetary stimulus from the RBI. However, opinion is divided on fiscal stimulus.
The growth slowdown is, indeed, sharp and worse than expected. Q4FY 19 growth rate at 5.8 percent is a 20-quarter low and the FY19 growth rate at 6.8 percent is a five year low. There are no signs of a pick up in private investment and the global environment is fast turning unfavorable. Stimulus is, indeed, necessary. But what form of stimulus and by how much?
RBI rate cut: the right response
The MPC has to be appreciated for coming up with the right policy at the right time. The 25 bp cut in policy rates along with the change in stance to accommodative from neutral is eminently desirable. The 6-0 vote in favour of the rate cut and change in stance makes the policy all the more dovish. The Governor’s statement that “the policy reflects the resolve of the MPC to act decisively and in time” is a reassuring message for the market. The scaling down of the GDP growth rate to 7 percent and inflation target to 3.4 to 3.7 percent for FY 20 will ensure that the policy will remain accommodative for some time.
The fisc is too expansionary
However, the prospects for a fiscal stimulus are bleak. The shortfall in tax collections in FY 19 as per the revised estimates at around Rs1.6 trillion indicate that the fisc is more expansionary than what the budget indicated. Even though the government has technically succeeded in containing the fiscal deficit at 3.4 percent, the fact remains that this has been achieved with off-budget borrowings by public sector entities like the FCI. Therefore, the more realistic indicator of the deficit is the combined fiscal deficits of the Centre and States at 7 percent and Public Sector Borrowing Requirement (PSBR) at 8.5 percent. And the government debt to GDP ratio is inching up to 70 percent. This is hardly the macro backdrop appropriate for a fiscal stimulus.
Keynesians who argue for pump priming by government should ponder over the externalities of a fiscal stimulus. One of the reasons why monetary transmission is poor is that banks are finding it difficult to bring down the cost of funds by cutting deposit rates. At a time when deposit growth is lagging credit growth, banks cannot afford to cut deposit rates, particularly when small savings offer higher rates. Higher small savings rates, while enabling the government to finance the fiscal deficit, are diverting savings away from banks. In brief, higher fiscal deficit not only crowds out private investment but also negatively impacts credit growth in the economy. In this scenario, further fiscal stimulus will do more harm to growth than good.
PM Kisan is expected to cost around Rs 87000 crores in 2019-20. Other welfare programs promised in the election manifesto would also need huge resources. Growth alone can generate the revenue buoyancy to fund these programs. The government’s focus should be on implementing structural reforms – land and labour reforms – that can raise India’s potential growth rate.
Bold reforms needed to revive the animal spirits
It was the Structural Adjustment Program initiated in 1991 that pushed the Indian economy to the high growth path of around 6.8 percent during the last 26 years. We need similar structural reforms now to raise our potential growth rate. Foremost on the agenda should be reform of labour and land: Labour reforms to facilitate easy recruitment in the organized sector and land reform to enable easy acquisition of land for non-farm purposes.
Even though the economy is facing lot of headwinds the market has been climbing all walls of worry. Why? There are broadly three reasons: One, globally stock markets have been bullish since early February due to the risk-on triggered by the stance-reversal of the Fed. Markets that had discounted three rate-hikes by the Fed early this year are now discounting easing by the Fed. Two, the strong mandate for the NDA and the consequent political stability has triggered a ‘hope trade’ anticipating bold reforms by the government to kick-start growth. Three, the rally has been driven by 10 to 12 high-pedigree large-caps, which have decent earnings visibility.
Perhaps the broader market is a true reflector of the economic headwinds. Even though the Nifty is up by 6.73 percent YTD (as on 17th June), Nifty Mid-cap and Nifty Small-cap indices are down by 3.04 percent and 4.13 percent respectively. Stocks of highly leveraged companies are sharply down. Most retail investors whose portfolios are biased towards mid- and small-caps have not benefited from the current rally.
Going forward, the market is likely to be influenced substantially by external factors like the outcome of the trade skirmishes between the US and China, global growth, Fed policy, US bond yield and capital flows. Domestic factors like policy initiatives from the government, particularly the budget, are crucial. Recently, global bond yields have declined sharply and hot money is chasing returns. Market signals – crash in global bond yields, decline in commodity process, and spike in gold – indicate sharp decline in global growth. Declining bond yields are good for the stock market. Softening crude prices and relative immunity from global trade skirmishes are clear positives for India. That said it is important to appreciate the fact that there is no valuation comfort in the market now. Nifty near record high is trading at a trailing PE of around 28 and forward PE of around 19. Investors need to be cautious about valuations even while remaining optimistic. Market volatility is likely to persist in the run up to the budget.