India’s long-term growth potential remains high. The young population is gaining formal education and hands-on training. Gains from internal and international trade are increasing. While elements of the Raj persist, India has largely moved to a market economy. Lately, however, India has been undergoing a sharp downturn. Two years ago the economy generated tremendous optimism. Today, despite the long-term story being intact, widespread pessimism prevails. This has brought a fresh focus upon the policies of macroeconomic stabilization that could dampen business cycles while ensuring that India remains on the path of steady state growth.
Conditions in the economy are daunting. Investment and growth have collapsed, and inflation is in the double digits. Savings have dropped, with households flocking to gold. The fiscal soundness of the government is questioned. What is occurring in the downturn is inevitably related to the events of the boom that preceded it. During the boom years, inappropriate macroeconomic policy spread the seeds of the difficulties seen today, with a faulty fiscal stance and inappropriate monetary policy that produced India’s biggest-ever credit boom.
There is a considerable focus on the problems of approvals and legal bottlenecks faced by investment projects, particularly in infrastructure. However, even if clearances are given to projects that have been stalled, they would still face serious obstacles in the financial system. The banks that binged on infrastructure lending during the boom are now not able to finance the next wave of infrastructure investment.
With a large current account deficit, the country needs capital inflows. Yet, the policy framework for capital flows is outdated, with various restrictions on cross-border flows. While India has de facto opened up its capital account, innumerable capital controls remain that do not allow capital to flow in. In 2013, policymakers embarked on a questionable adventure in trying to defend the rupee, an attempt that failed and caused heightened uncertainty. This episode serves as a reminder that macro/finance policy in India today is an idiosyncratic affair that lacks a well understood framework with deep institutional foundations. The country lurches from one crisis to the next.
Global financial markets are likely to remain in turmoil for several years, until the United States returns to normalcy. Until this comes about, international financial markets will experience many shocks. Deep and liquid markets in a country’s domestic economy are the essential shock absorbers through which the perilous waters of international financial integration can be navigated. Achieving such deep and liquid markets requires large-scale financial sector reforms, with a complete replacement of the existing regulatory framework.
These developments from 2008 onward have highlighted India’s lack of a proper framework for macroeconomic and financial stability. When India was a low-income country with a largely closed current and capital account, it could afford to have the present institutional, legal, and regulatory framework. But there is a large mismatch between the institutional machinery of a developing country and the requirements of a $2 trillion economy. Until India reforms its fiscal, financial, and monetary policy frameworks, macroeconomic and financial uncertainty will only worsen.
Why Is Macroeconomic Stability Important?
Policymaking in India is often based on the assumption that the economy will follow a linear trend growth rate. This implicitly assumes that the Indian economy does not have business cycles—a continuation of the old socialist thinking, when the government determined the level of investment in the economy, agriculture was a large share of the economy and depended on monsoons, and services production was dominated by the government. When India was a socialist developing country, the sudden downturns that it experienced were due to exogenous shocks such as droughts, oil price shocks, and wars. The economy did not have investment-inventory cycles of the kind seen in all market economies.
These old instincts have not yet been erased, even though India is now a market economy and has graduated from being a developing country to being an emerging market. Both government officials and businesses seem to believe that India is in a world where its economy stays at the trend growth rate with no fluctuations around it. Every cyclical up or down is treated, all too often, as a “new normal” or the new trend growth rate. However, as in the typical emerging economy, India has growth rate cycles around a trend. Emerging economy business cycles are more volatile than those in advanced economies. India’s growth swings from 4 percent to 10 percent, which is quite different from what is seen in places like the United States, where the range of values is much more modest.
The most important single issue in Indian economics is that of achieving high and sustained trend growth. If, hypothetically, India is presented with a choice between a high average trend growth rate, with sharp volatility around it, and a low average trend growth rate that is smooth and stable, the former is of course superior. As an example, South Korea went through painful macroeconomic crises in 1997 and 2008. However, South Korea achieved higher trend growth than India, and consequently is now a prosperous country. If avoiding crises were all that was important, India would have been better off than South Korea.
While fluctuations are recognized as not bad in and of themselves, fluctuations of gross domestic product (GDP) matter to the extent to which they can damage trend growth. There are several mechanisms through which high fluctuations hamper trend growth. Events such as financial crises, high inflation, or a fiscal crisis can sometimes create long periods of slow growth. Similarly, if the government intervenes in a knee-jerk manner, setting back the development of markets and price-setting in markets, as has sometimes occurred in India, the resulting distortions can continue to create resource misallocation and prevent the healthy functioning of the market mechanism for a long time. This would have the effect of reducing the long-term steady state growth rate.
- Financial crises. In the big booms, investment and credit expand hugely. When the downturn comes, a collapse in the financial system can have an adverse impact on growth. To forestall this, two strategies are required: sound financial regulation and macroeconomic stabilization that reduces the volatility of the business cycle.
- Price stability. Macroeconomic stability is synonymous with low and stable inflation. Sustained low inflation goes along with a low interest rate environment and reduced relative price fluctuations. This creates an environment within which the private sector is better able to make projections. The reduced uncertainty encourages long-term investment. In India, low and stable inflation was achieved for only seven years, from 1999 to 2006. Apart from this, inflation has consistently been high and unstable, which adversely affects investment and growth.
- Inappropriate interventions. The broad policy environment in India has a low threshold for justifying government intervention in the economy. When economic conditions are difficult, the government tends to engage in more frequent and more distortionary interventions in the economy. But rather than rectify matters, intervention merely generates another channel for trend GDP growth to worsen.
- Fiscal crises. In bad times, tax collections are lower and there is greater pressure for populist spending. In the Indian environment of chronic fiscal stress, a business cycle downturn can potentially turn into a damaging fiscal crisis. The state can be crippled in such a crisis for a few years, which would in turn damage trend GDP growth. This generates another channel through which high GDP growth volatility can reduce trend GDP growth.
Fluctuations are not bad in themselves. While economic policy should focus on achieving high long-run trend growth, it is advantageous for India to create the institutional foundations for macroeconomic and financial stability that will set the stage for such growth. Four elements of reform are needed for macroeconomic stability: fiscal consolidation, financial sector reform, capital account convertibility, and countercyclical monetary policy.
A Framework for Stabilization
Fiscal Consolidation
There is some evidence that at present, India has a pro-cyclical fiscal policy. When the economy does well, tax collections go up and the government finds this is an opportunity to spend more. In bad times, taxes go down and fiscal stress is high. The government then tries to reduce expenditure. This contracts the economy further, thus exacerbating the business cycle downturn. Chronic fiscal stress generates pressure for the government to engineer inflation, which is destabilizing in its own right.
The way forward requires two elements. Fiscal policy must get away from chronic stress into soundness. And fiscal policy must smoothly shift between surpluses in good times and deficits in bad times.
The first issue is fiscal soundness. India needs to graduate out of chronic fiscal distress into a framework of conservative fiscal policy. In good times, it should run a surplus of 2 to 3 percent of GDP (consolidated across the central government and the states), and in bad times, this should turn into a consolidated deficit of a similar magnitude.
The Fiscal Responsibility and Budget Management Act, 2003 (and its amendment in 2012), required the government to bring the fiscal deficit down and keep it at a constant level. This limited the scope of countercyclical fiscal policy. The deficit could not expand in bad times, and the government did not have to generate a surplus in good times. A new arrangement is required under which the government can undertake fiscal expansion during bad times. Under this arrangement, the primary balance would be positive in most years, thus ensuring that in all but a few extreme years, the debt-to-GDP ratio would go down. This adds up to a conservative framework of fiscal policy, one that would offer a measure of safety from the fiscal crisis that always seems to be on India’s doorstep.
How can fiscal policy be structured so as to move smoothly from surpluses of 2 to 3 percent of GDP in an expansion to a deficit of 2 to 3 percent of GDP in a downturn? The bulk of this movement should come from automatic stabilizers, or instruments that lead to fiscal expansion during GDP contractions and fiscal contractions during a boom, so that no discretionary actions are required. India has one important stabilizer in the form of the corporate income tax. Programs such as the Mahatma Gandhi National Rural Employment Guarantee Act (NREGA) need to be carefully engineered to ensure that spending goes up in a downturn and goes down in an expansion. The danger at present is that programs like NREGA involve large expenditures that are insensitive to business cycle conditions.
These two lines of thought induce macroeconomic stability in two respects. The ever-present fiscal crisis would subside, and fiscal policy would contribute to reducing business cycle volatility.
Reforming the Regulatory and Legal Framework
for Finance
Financial crises are an important source of macroeconomic instability, particularly in emerging markets. India has experienced a diverse array of ailments, including banking distress, international finance crises, bankrupt pension systems, and securities scandals.
A sound framework for financial regulation is required to forestall these problems. This involves six elements:
- Consumer protection: Regulations that are more fair to consumers would reduce risk in the system. They could prevent mis-selling by financial firms and the buildup of risk such as that seen in chit funds and multilevel marketing schemes. Consumer protection would help reduce fraud caused by Ponzi schemes. A two-pronged strategy is needed. First, consumer protection should be the objective of all financial regulation. Regulations need to be written to achieve this objective, and if they do not, it should be possible to appeal and overturn them. Second, there should be a financial redress agency with a presence in every district of the country, urban and rural. It should have a fast adjudication mechanism in which consumers can file cases conveniently and cases do not take years to solve.
- Micro-prudential regulation: One key element of consumer protection that bears individual mention is micro-prudential regulation, where regulatory agencies force financial firms to reduce the probability of failure. This would help address banking distress, bankrupt pension systems, and securities scandals.
- Resolution: A critical piece of institutional machinery in any financial system is a resolution corporation that identifies distressed financial firms and shuts them down, while protecting the interests of unsophisticated consumers. Such an agency is, at present, lacking in India. This leads to the twin maladies of distressed financial firms growing unchecked and turning into a big problem, and then presenting problems that the government inevitably has to address.
- Shock absorbers: Deep and liquid financial markets are an essential tool for risk absorption. When markets are shallow, shocks generate exaggerated price movements. In addition, when markets are shallow, risk transfer is not possible, and many financial firms end up holding on to excessive risk.
- Systemic risk regulation: A strong database about the overall Indian financial system needs to feed into a sophisticated research program on systemic risk, which leads to concerted action by a council of regulators, the Financial Stability and Development Council.
- Regulatory architecture and governance: A sound regulatory framework needs to be established, without overlaps and gaps, where there is clarity about the objectives of each agency, and where all agencies achieve high performance through strong accountability mechanisms.
All these elements are lacking at present. Hence, the current environment involves heightened risks to the economy. In the absence of this framework, policymakers are repeatedly hijacked by crises and respond to them in an idiosyncratic way. The inconsistent responses of policymakers exacerbate the ex-ante risk as perceived by economic agents.
The Financial Sector Legislative Reforms Commission, chaired by retired justice B. N. Srikrishna, has drafted a proposed Indian Financial Code to replace all existing Indian financial law and solve all these problems. The need of the hour is to translate this draft bill into an Act of Parliament.
Capital Account Convertibility
As emphasized above, achieving macroeconomic stability requires ruling out international financial crisis. This is closely related to the question of capital account liberalization.
India has a complex maze of capital controls. A number of public bodies switch controls on and off based on their views. Various financial sector laws and regulations treat foreign investors differently from Indian investors, with a bias against foreign investors. Today, the framework is so messy that even the government finds it hard to enforce its own rules. The various definitions of foreign direct investment and foreign portfolio investment often lack clarity and legal certainty. The lack of a transparent framework frequently turns away even those investors who want to bring money into India.
These controls have led to a complacent view among many policymakers that India is not vulnerable to the problems of international financial integration. This perspective is incorrect. While a maze of de jure capital controls exists, in practice, economic agents are able to move large sums of money across the border through legal and illegal means. When the rules favor equity but not debt, economic agents relabel transactions as equity. When the rules prohibit cross-border activity, capital is moved through trade misinvoicing.
A strong body of evidence now suggests that despite the de jure restrictions, India is largely a de facto open economy. The controls increa...