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Implications of Government's Macroeconomic Perspective - Outside View by S.S. TARAPORE
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Implications of Government's Macroeconomic Perspective
Dec 28, 2015

The government's Mid-year Review is a masterly document which carries the unmistakable imprimatur of the erudite and articulate Chief Economic Adviser, Dr Arvind Subramanian. In the absence of the Prime Minister's Economic Advisory Council's Report, the Mid-Year Review is an authentic benchmark reference document. The Review is a virtual tour de force on the economy and one should readily congratulate the Chief Economic Adviser and his team. There are, however, some serious concerns about the government's thinking on certain vital issues which portend trouble lurking round the corner.

Scaling Down the GDP Forecast for 2015-16.

The government has scaled down the earlier real GDP forecast for 2015-16 of 8.1-8.5 per cent to 7.0-7.5 per cent. This reduction in the GDP forecast for 2015-16, by itself is welcome and comes closer to other estimates both by other Indian agencies as well as foreign assessments. What is of concern is the response of the government on key parameters. It is argued that the potential for growth is higher and as private investment is not accelerating, government should step up public investment. With the additional burden of the Pay Commission Award and the lower revenues resulting from lower than anticipated growth, the Review argues against curtailing other expenditures. This then implies that there is a need to be flexible on the commitments under the Fiscal Responsibility and Budget Management Act (FRBM). The government, however, assures that the immediate target for 2015-16 of 3.9 per cent of GDP would be attained but the target of 3.5 per cent for 2016-17 would need to be eased. Now it is unfortunate that the track record ever since 2003 has been that the targets are frequently postponed on the basis of strong arguments. Thus, over the long run, the FRBM targets are thrown forward and attainment of these targets is becoming a mirage.

Inflation Targets

With the loosening of the target for the fiscal deficit, the Review makes out a case for flexible interpretation of the inflation target of 4 per cent with a gentler glide path (read as a recommendation for a higher target for inflation). It is claimed in the Review that this will give scope for further reductions in policy interest rates. A characteristic of India is that the moment inflation rate falls below 5 per cent the forces for expansion hold sway till inflation reaches double digits. Hence the battle against inflation is invariably in the 5-10 per cent range.

The RBI has already set out the final guidelines for determining borrowing costs based on the marginal cost of funds. This will imply that the pressure for reducing deposit rates would be very strong and depositors have to be ready for further in-roads in their meagre earnings. The year-on-year increase in bank deposits as of September 2015 was 10.6 per cent, as against 12.6 per cent in the previous year. Progressively it should be expected that holders of fixed deposits in banks will balance the risk-return and move over to riskier instruments. While the level of deposits may not fall, the composition of deposits will shift from longer tenures to shorter tenures which could leave banks with huge asset-liability maturity mismatches. It is sheer folly to push banks to continue lowering interest rates.

The US Fed move, albeit gentle, to raise the Fed funds rates from a range of 0-0.25 per cent to 0.25-0.50 per cent, with clear indications of further increases in US interest rates has a major impact on India. If India keeps lowering interest rates while the US continues with upward movements of interest rates, it is obvious that at some stage it will reflect in a massive outflow from India of portfolio capital. What is worrisome is that the Indian official line is that we have enough ammunition to take care of portfolio outflows and that, in any case, foreign investors are comfortable investing in India. The amber lights are clearly showing and we in India must pay heed to these lights.

Implications for the Exchange Rate

It is unfortunate that the political economy of exchange rates is going to be costly for India in the medium-term. Our macho spirits do not countenance any significant depreciation of the rupee vis-a-vis the US dollar. In the present scenario the US dollar is strengthening vis-a -vis other major currencies. But the Indian psyche is stuck on a US Dollar-Rupee exchange rate. We can freely appreciate or depreciate vis-a-vis the Euro, the yen, the sterling and even the yuan but even a small depreciation vis-a-vis the US dollar would not be tolerated. Governor Jalan had provided yeoman service by emphasising that there should not be a fixation to a single currency. It is time the RBI and the government stresses this in their public statements. In the absence of such a campaign we in India will be saddled with a grossly overvalued exchange rate which will be detrimental to the economy.

If, as hinted in the Mid-Term Review, we in India persist with lowering interest rates, accept higher inflation rates and press ahead with fiscal spending to jack up the growth rate, there would be macroeconomic instability. If, in such a situation, we are adamant in holding up the US dollar-rupee rate, economic forces will put the economy into a tail spin. Our endeavour should not be to accelerate growth but to sustain the present level of growth. It is here that the Mid-Term Review gives us cause for worry.

Please Note: This article was first published in The Freepress Journal on December 28, 2015. Syndicated


This column, Common Voice is authored by Savak Sohrab Tarapore. Mr. Tarapore, is an economist and he runs his own Multi-Language Syndicated Column. Mr. Tarapore's other column, which appears in The Hindu Business Line, is titled Maverick View.


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