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Posted by: Deepa Vasudevan on Sun, Oct 6th, 2019

A Monetary Policy about Growth, not Inflation

The shocker of the October monetary policy was not the 25-bps cut in the policy repo rate, but the cut in FY20 growth estimate from 6.9% to 6.1%.  The fact that economic growth is slowing down has been quite obvious to investors and markets for some time now, but RBI’s drastic downgrading of growth marks an official acceptance of the growth deterioration (See Pic 1).


Pic 1: Steady Drop in FY20 growth forecasts

In fact, this policy was focused chiefly on growth, rather than inflation. That seems natural, given that inflation has stayed benignly below 4% since July 2018, and is expected to remain there through FY20. Unfortunately, growth plunged to 5% in Q2FY20 (Pic 2). Subsequent high frequency indicators and corporate sales figures suggest that the slowdown continues. 

Pic 2: Growth vs. Inflation

The greatest shock to the system is the decline in consumption growth. The consumption engine fuelled India’s growth through the 2004-07 boom, the 2008-09 crisis, and the policy paralysis years of 2011-13. Since FY06, consumption growth has never fallen below 6% year-on-year (Pic 3).


Pic3: The Steadiness of Indian Consumption

As a result, the steady growth in consumption aspirations of India’s youthful population has come to be viewed as an unchangeable economic fact. But now, it appears that consumption is dropping, both in urban and rural India: private consumption grew by 3.4% in Q1FY20, sales of automobile and FMCG companies are slowing, and the latest RBI survey of consumer sentiments indicates that households are less optimistic about income and expect to postpone discretionary spending.  

Export growth- never India’s strong point- is unlikely to pick up because trade prospects have been adversely impacted by the US-China trade war and overall slowdown in global growth.  Investment is a derivative of these two growth drivers: companies invest in new capacities only if there is internal demand (consumption) or external demand (exports) for their output. So we can safely conclude that investment will not pick up without a recovery in consumption and/or exports.   That leaves government spending, a factor that has already been pushed to its limits by the recent corporate tax cuts. It is expected that the official fiscal deficit will be higher than the budgeted 3.3%, and the actual fiscal deficit (including off-balance sheet items and public sector borrowing from small savings) will be closer to 9% of GDP.  Bond markets recognize this problem, which is why they were not fooled by the government’s announcement that its borrowing for the year remains unchanged. They fear that the government will have to resort to practises like not paying dues, or persuading companies to overpay tax with a promise of a quick refund in order to meet its expenses. These cannot be called borrowings, strictly speaking, but by reducing the availability of funds for the private sector, they end up having the same effect as extra borrowing. 

As a result, there is not much joy from the latest rate cut, which brings the total reduction in repo rate since January 2019 to 135 bps. Stock markets have fallen at the gloomy growth forecast. Bond yields are up, and bond prices are down, because of fiscal concerns. Geopolitical tensions and trade war issues are worsening market sentiments.

If the markets are not pleased by the combined fiscal and monetary stimulus, then what is the solution? There are many problems, both structural and temporary, but at this point, the economy needs three major fixes. First, the panic that has gripped the financial system after a series of bankruptcies and defaults has to be addressed. The government and RBI have to work together to restore confidence by managing liquidity in the short term, and improving regulation and audits in the long term. Second, GST compliance has to be improved by ironing out systemic glitches. Finally, policy has to focus on improving investment in agriculture and SMEs. The former employs half of India, and feeds all of it. The latter is a crucial source of jobs and income for many of India’s semi-skilled and semi-educated youth. The big corporates have been given what they asked for, it is time to allow the smaller folks to grow.

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