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Why a pump-priming could be ineffective proposition? Or No short cuts to sustainable growth revival

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Mr.Dhananjay Sinha

Head of Research and strategist.

10 Feb 2016

Resurfacing of systemic liquidity tightness in the banking system, ongoing debate on fiscal containment and obfuscation on the state of the banking sector NPAs are driving in considerable uncertainty. The trinity of these issues encompass the conflicting condition of a still fragile economic cycle, which pose credibility issue for the robust official estimates of 7.0-7.4% GDP growth, and the diverging prescription from RBI governor Raghuram Rajan and Economic Advisor Arvind Subramanian to confront the sustained economic feebleness.

Both Arvind and Rajan believe that fiscal management is a challenge, but their prescriptions differ. Arvind considers the decline in Nominal GDP growth and elevated Gsec yields to symbolize rising Debt/GDP for the government and also adverse private sector debt dynamics, which the existing pro-cyclical fiscal containment approach can exacerbate. Hence, his ardent advocacy to reconsider government’s commitment to fiscal containment. Clearly, Arvind sees counter cyclical fiscal expansion (e.g. 7th pay commission, additional pension obligations etc) as a necessary intervention to crowd in private demand. Given the frailty in the banking sector, which has perceptibly been aggravated by RBI’s interventions forcing banks to provide for bad loans and listing out 150 problem corporate accounts, fiscal expansion and rate reduction by RBI may seemingly make sense. But such an approach can only bring in interim relief. There are both cyclical and structural constraints to such interventions. Hence, Rajan maintains his thesis that fiscal rectitude is necessary for gaining latent productivity and sustain recovery in the medium term. Hence, the difference in approach to revive growth boils down to immediate revival vs sustainable & stable recovery. Here is why the counter-cyclical fiscal expansion could be ineffective over time.

First, Rajan argues that the multiplier effect of fiscal stimulus is low and as experiences of 2010-2011 indicate, the follow up repercussion of higher inflation & deficit and lower growth does not help improve the debt dynamics. According to his assessment, the consolidated fiscal deficit for India increased to 7.2% in 2015 from 7.0% in 2014, which is largest among the comparable countries excluding Brazil. Hence, notwithstanding the fiscal containment adopted by the centre, rising combined deficit suggests worsening fiscal situation for the states. Additionally, with the onset of UDAY scheme their deficits will rise even more.Our estimate, in contrast indicate that the multiplier effect of real government consumption spending is not insignificant. Every 100bp rise in spending results in 150 bp impetus to overall growth over four quarters; Beyond that the multiplier turns negative for several reasons such as higher inflation & interest rates, increased tax burden and widening current account deficit. The positive multiplier impact of real capital outlay on growth emerges only after 6-8 quarters. Several empirical work also show that for emerging economies counter-cyclical fiscal stimulus are less effective; Structural reforms that enhance productivity and efficiency are the desired interventions.

The risk is that with 10 state elections coming up in next 24 months, a relaxation of fiscal containment may end up compromising long term stability in a significant manner. Further to this, the adoption of 7th Pay commission and other expenditure outlays could compromise government’s capital outlay and quality of fiscal spending.

Prospects of higher supply of government papers and tightened liquidity conditions has already seen the Gsec yield curve at the long end and term repo curve shifting up by 40-50bp. Yields on commercial papers have risen by 60bp and banks facing asset-liability mismatch have started increasing their deposit rates. UDAY scheme will lead to further supply of state government papers by approximately Rs 1 tn which could further harden yields.Second, the structural constraints to recovery from potential fiscal expansion is already visible in the sustained tightening in liquidity condition. Ironically, in the backdrop of record low level of credit growth and economic cycle, the banking system is still facing a huge liquidity deficit, forcing them to rely on RBI’s liquidity support to the tune of Rs 1.4tn.

Rajan attributes this to the transitory factors such as seasonal rise in demand for currency, restrained spending by the government and pick up in retail credit. However, we believe that liquidity tightness could persist as it is occurring even against a most favourable backdrop of multi-decade low credit growth, steepest & enduring decline in commodity prices, restrained fiscal policies in FY16 and lowest level of real sales growth since 1980. Hence, even with a modest revival in credit demand, recently improved from a low of 9% to 11.4% by Jan end, has created significant liquidity shortfall. There is also a strong possibility of Indian corporates switching back to domestic banks to service their elevated level of foreign currency borrowing if global financial market conditions remain volatile, thereby accentuating the liquidity pressure.

Supply of liquidity is also constrained by the recent USD 6.3bn decline in foreign exchange reserves to USD 349bn, which may not be transitory in nature. Importantly, the decline in forex reserves in recent periods is witnessed across most emerging economies including China, Asia, Middle East and Latin American economies. In the context of declining contribution of Emerging economies to global growth we believe that there is a fair possibility of further retrenchment of portfolio flows from emerging economies, including India. The redemption of ~USD 27bn during Sep-Nov 2016 of the leveraged FCNR leveraged deposits mobilised in 2013 could also imply some retrenchment of flows for India.

Our assessment of INR/USD movements indicate elevated level of currency inflexibility in the recent past suggesting that RBI may have intervened to prevent sharp depreciation in the currency, which may have added to the liquidity shortfall.

Global excess liquidity has tapered off, not just because of the advent of Fed’s monetary policy normalization, but more significantly, also due to value loss from sharp contraction commodity prices and belated correction in credit, equities and emerging markets. Bank of Japan and European Central Bank moving to negative policy rates have failed to resurrect liquidity, possibly indicating that financial market volatility can sustain.

Hence, given that Indian banks are yet not attained countercyclical buffer (cumulative of credit, Gsec investments and cash as proportion of deposits at 109% is still significantly above 100%), re-emergence of credit-deposit growth wedge emanating from fiscal expansion will translate into frictional liquidity deficit. Potential haircuts on bad loans banks have to take could accentuate the liquidity deficit by snipping off a part of existing bank capital.

Notably, over the past six years the RBI support to banking sector liquidity deficit through LAF and OMOs has been consistently elevated, which is contrary to the notion that it is seasonal and transitory in nature. Clearly, in this backdrop of liquidity tightness rate easing by RBI will become ineffective.

Thirdly, RBI’s proactiveness on getting banks to provide for impaired corporate loans is the necessary near term pain for sustained growth revival over time. But while Rajan considers capital in the system adequate to compensate for the required haircuts, the opaqueness on bank and corporate specific risks and progress made by individual banks has increased uncertainty and caused general price erosion of banking stocks. However, correction in valuation of PSU banks to 0.3-0.7 price to book is making recapitalisation even more difficult. Beyond the present commitment of Rs 750bn over next 4 years by the government, the continued valuation loss will challenge the ability of PSU banks to raise the balance capital from the market, as it will be book value dilutive for minority shareholders. Cleaning of balancesheet will accentuate the capital requirements of the PSU banks and their inability to raise capital from the markets will put further burden on the government to re-capitalize them. RBI wants to address this issue on a priority basis.

India long term cycle and the development over the past couple of years suggest that the economy has undergone just about a third of the required adjustments needed for sustainable growth revival. Impatience to deliver growth through counter-cyclical pump-priming will be premature, and result in transient recovery, which will eventually aggravate macro disequilibrium. It will rather be constructive to deploy the fiscal space to address structural issues such as re-capitalize PSU banks while they clean up their balance sheets. From RBI’s perspective, revert to greater exchange rate flexibility will a better way to rebuild productivity, instead of worrying about the implication of sharper depreciation on capital flows. Also, a greater transparency on the progress banks are making in addressing stressed assets will go a long way in calming uncertainties. While these are desirable paths in our view, what eventually happens will depend upon which side the government and RBI eventually choose to lean.