India: More stimulus is coming – definitely monetary, probably also fiscal

Looks like India is getting ready to take further steps to keep the economy from slowing down any further. The latest wholesale price inflation figure (year-to-year, which includes the high inflation interlude last summer) is only 0.44 percent. Consumer price inflation is still running much higher, mostly because food price inflation has been stubbornly high, but forecasters are seeing it coming down soon as well. The high CPI inflation has probably been one reason why the Reserve Bank of India has been so slow to cut interest rates.

Even with elections around the corner, India’s top economic policy makers are not being shy about signaling what they are going to do. Prime Minister Manmohan Singh said on March 28th, “With ample liquidity and low inflation, there is scope perhaps for a further moderation in interest rates.” I would expect the RBI to act on this soon. The PM also noted specific sectors of the economy that seem to be recovering or holding up well, agriculture and automobiles in particular.

Montek Singh Ahluwalia, Deputy Chairman of the Planning Commission, and the most senior economist in the government, finally revised his estimate of growth for 2008-09 (the fiscal year ending March 31) to 6.5 to 6.7 percent. Without providing any specifics, in what were apparently casual remarks, he argued that further stimulus would be necessary. I am not sure what he meant when he said, “But there are certain issues which have to be taken up.” These could be questions of politics, potential political allies and forthcoming elections; concerns about the fiscal deficit (Mr. Ahluwalia noted that the central government’s deficit could be 7 percent, up from a previous estimate of 5.5 percent); or simply technical issues of how to get the biggest and quickest bang for the buck.

Chief Economic Advisor Arvind Virmani also indicated, at the same venue as Mr. Ahluwalia, that fiscal and monetary policy measures are needed. Mr. Virmani predicted essentially zero wholesale price inflation over the next year. He noted that the CPI increase would be higher, which highlights for me the confusion in measuring inflation in India, and lack of clarity in setting inflation targets, and monetary policy making in general.

In my March 17th post, I had mentioned possible public crowding out of private sector investment, which has implications for the impact of any further fiscal stimulus that involves increased government spending. The crowding-out observation came from Saugata Bhattacharya, who wrote on March 6th, “Again, as has been pointed out in the RBI’s [March 4th] statement, yields on the 10 year government securities benchmark have hardened over the past month, based on the unexpectedly large increase in the government market borrowing programme. Although the links between market rates and bank lending rates are not as strong in India as in developed markets, there will inevitably be an opportunity cost-based risk-pricing of bank loans (for say a AA rated corporate) based on the corresponding sovereign yield. These are classic symptoms of the crowding out effects of higher public sector spending.”

In January, 10-year bond yields were down to almost 5 percent, but have since risen to around 6.5 percent, after having been even higher the week before.  The RBI has periodically been buying bonds to provide some market stabilization and liquidity as the government increases its borrowing. But this activity seems to be precisely for those motives, and not for systematically monetizing the deficit, as Arvind Subramanian had suggested (see my last post). In fact, on March 27th, just the day before the two policymakers’ remarks, Moody’s had argued that the RBI would not cut rates aggressively (but they have always cut in small steps). Moody’s predicted growth of 6.3 percent for 2008-09, and 5 percent for 2009-10.

In my last post, I’d mentioned that it would be good to implement some of the Raghuram Rajan committee’s reforms as soon as possible, as a way of spurring growth through some financial sector reform. That committee’s draft report on financial sector reforms was released in April 2008, with the final version being published in 2009. Key relevant parts of the report include recommendations for creating an appropriate credit infrastructure, and opening up government and corporate bond markets, which are still relatively underdeveloped. Credit markets require mechanisms for building and assessing reputations, providing collateral and enforcing agreements. Clear and streamlined procedures for default and bankruptcy are also critical. These are areas where several small steps are feasible, and clearly laid out in the report. There may be areas of reform that are more politically difficult, but those can wait. In November 2008, Professor Rajan was appointed honorary economic advisor to the PM, but I haven’t been able to find anything on what his role is. It may be that he’s focusing on India’s position with respect to the global financial crisis, and current discussions of new types of international financial regulation – he made one pronouncement on that shortly after being appointed.

It seems to me that domestic reform shouldn’t be neglected, however. Improving the efficiency of India’s domestic financial sector ought to help channel domestic savings to productive investment, strengthen the monetary policy transmission mechanism, and reduce transaction costs and risk perceptions in the financial sector. All of these would help bolster growth in the short and long runs. Many of the reforms also do not seem to be politically controversial: it may be that only the fact of forthcoming elections is slowing consideration of implementation.