The National Democratic Alliance’s decisive election victory has understandably buoyed markets and raised expectations of big-bang reforms (land, labour, capital) to drive the next burst of growth. It’s important, however, for policy-makers not to get ahead of themselves. The first order of business must be to stabilise an economy that finds itself on a precarious wicket.
Growth has slowed discernably in recent quarters. To be sure, some of the pressures are transient: Sharp cuts in government spending to meet the 2018-19 fiscal deficit target, election-related uncertainty, and regulatory-induced one-time price-increases in the auto sector. These pressures will reverse in the coming months. But, even adjusting for this, underlying growth momentum has slowed meaningfully. Indian growth has largely been flying on one engine — consumption — which has progressively exhausted itself. Rural consumption is hurting because the terms-of-trade confronting agriculture continued to worsen in 2018-19. Slowing urban consumption reflects the disruptions in the non-banking finance companies (NBFCs), auto and housing sectors, as well as the inevitable limits of dipping into savings to prop-up consumption when income growth has slowed. Simultaneously, the outlook for exports has worsened as global trade wars deepen. Slowing exports and consumption together create the worrying prospect of hysteresis. Therefore, even as the strong election result is likely to rekindle animal-spirits, they must contend with formidable headwinds.
The real challenge, however, is that counter-cyclical policy space is either exhausted or currently inefficacious. Calls for a fiscal stimulus appear irresponsible, since India’s total public sector borrowing requirement is almost 9 per cent of GDP, consuming all housing financial savings, keeping market interest rates elevated and impeding monetary transmission. Any stimulus will likely be counter-productive, simply pushing-up interest rates further, accentuating crowding-out risks and financial fragilities in the NBFC sector. Monetary policy has been eased but is not transmitting, with the yield curve still very steep, and bank lending rates barely budging.
What then can policy-makers do to arrest the slowdown? While markets remain focused on the demand side, the optimal response, in our view, is to focus on the supply side. Fixing the plumbing in three areas must constitute the near-term policy agenda:
1. NBFCs: its solvency, not liquidity
The relentless pressure that NBFCs have been under since last year has translated into their credit offtake collapsing , thereby compounding the consumption slowdown. While bank credit has stepped-in, it cannot completely offset it, because these are very different business models that target different end-users.
The NBFC slowdown shouldn’t be surprising. Financial conditions have meaningfully tightened in the sector with average spreads of NBFC bonds significantly above their pre-IL&FS levels. Importantly, this is despite liquidity conditions easing. Interbank system liquidity has eased, core-liquidity is now in a surplus, and several NBFCs are holding much higher cash levels on their books. Despite that, spreads have not softened, clearly suggesting these are reflecting credit risk, and not liquidity, premia. Mutual fund flows have dried up and even bank lending to NBFCs — a key source of refinancing and disbursements — has slowed, suggesting banks, too, may be getting wary of credit risk. Contrary to the market clamour, therefore, this is not a liquidity problem. It’s an underlying solvency concern.
A missing middle?
This, by itself, should not warrant any policy intervention. Lenders re-assessing risk and charging higher risk premia is just the market mechanism playing itself out. Any intervention will simply induce moral hazard. That said, there is a growing concern that asymmetric information may be compromising allocative efficiency. The best NBFCs are easily able to attract funding and those with the most well-known vulnerabilities have understandably been rationed out. The problem is not at the extremes. It’s likely in the “missing middle”. It’s likely that a vast swathe of NBFC s in the middle are unable to attract funding or raise equity, because investors are unsure about their underlying asset quality. This is the classic asymmetric information problem. One can’t distinguish good apples from the bad ones, and so stops lending to all apples. In turn, this is forcing several NBFCs to demonstrably hoard cash — and thereby cut back on disbursements — to “signal” that are not amongst the bad apples. But this is a very inefficient signaling mechanism. More generally, asymmetric information about underlying asset quality is leading to allocative inefficiency and weighing on financing, equity raising, credit off-take and therefore on GDP growth.
Needed: credible signaling
What is therefore needed is a credible external signaling mechanism. This can best be provided by the regulator undertaking an asset quality review (AQR) of the NBFC sector. Once concluded, this would credibly distinguish the good apples from the bad apples, eliminate the “trust deficit” that looms over the sector, and allow the good apples to raise equity and funding. Operationally, an AQR will need to be delicately handled and artfully managed. It may lead to temporary disruption. But doing nothing also has a very real cost — the risk of accidents and that of foregone growth, quarter after quarter.
2. The fiscal-monetary tango
A credible Budget in July is critical. Actual revenue collections in 2018-19 are likely to be much below the revised estimates, making the projected revenues for next year virtually unattainable. The government must therefore (i) reiterate its fiscal deficit target of 3.4 per cent of GDP; (ii) but do so by credibly budgeting revenues and expenditures; (iii) and ensuring that legitimate budgetary payments — like to Food Corporation of India — are not pushed off-balance sheet. Barring this, bond markets are likely to get nervous again, and build in more risk-premia into bond yields, thereby pushing up the cost of capital further. A credible Budget, however, rests squarely on GST revenues increasing markedly, which will necessitate further simplification of the GST and meaningfully-tighter compliance mechanisms.
A credible Budget will also help in boosting monetary transmission. First, it will balm bond yields and ease financial conditions. Second, if bond yields are lower, small savings rates — linked to bond yields — should also come down, making bank deposits more attractive, boosting deposit growth, and helping monetary transmission in the banking system. Third, rampant non-compliance of GST pushed up currency-in-circulation (CIC) in 2018-19. If GST compliance is tightened, CIC growth will fall, deposit growth will rise and provide more fillip to monetary transmission. Fourth, how a fiscal deficit is met matters for growth. Meeting the deficit by slashing public investment — where fiscal multipliers are arguably higher — versus tightening indirect tax collections — can have meaningful implications for growth.
In contrast, if markets worry about fiscal credibility, and monetary policy is simultaneously eased, the yield curve will steepen further, inducing the financial sector to borrow short and lend long — as the margin of temptation from maturity transformation increases – but accentuating financial fragility.
3. Reversing the terms of trade
Tackling agrarian distress — by trying to correct the adverse terms of trade from low food prices —must constitute the third near-term priority. There is limited space on the demand side. The PM Kisan scheme should boost food demand, but total spend is just 0.4 per cent of GDP, and there is no fiscal space for more.
Instead, the answer lies on the supply side. There are early signs that some wholesale food prices have begun to pick-up. Distortive policies — like the stock-holding limits, intermittent export bans, and the Essential Commodities Act — must be done away with, so that some normalisation of food prices is accommodated. Simultaneously, the new government needs to ensure that surplus production is quickly exported to avoid domestic gluts.
Markets are clamouring for stimulus and romanticising about big-bang reforms. But the new administration’s immediate priority must be to stabilise the economic boat by first fixing the plumbing.
The writer is Chief India Economist at J P Morgan
Growth has slowed discernably in recent quarters. To be sure, some of the pressures are transient: Sharp cuts in government spending to meet the 2018-19 fiscal deficit target, election-related uncertainty, and regulatory-induced one-time price-increases in the auto sector. These pressures will reverse in the coming months. But, even adjusting for this, underlying growth momentum has slowed meaningfully. Indian growth has largely been flying on one engine — consumption — which has progressively exhausted itself. Rural consumption is hurting because the terms-of-trade confronting agriculture continued to worsen in 2018-19. Slowing urban consumption reflects the disruptions in the non-banking finance companies (NBFCs), auto and housing sectors, as well as the inevitable limits of dipping into savings to prop-up consumption when income growth has slowed. Simultaneously, the outlook for exports has worsened as global trade wars deepen. Slowing exports and consumption together create the worrying prospect of hysteresis. Therefore, even as the strong election result is likely to rekindle animal-spirits, they must contend with formidable headwinds.
The real challenge, however, is that counter-cyclical policy space is either exhausted or currently inefficacious. Calls for a fiscal stimulus appear irresponsible, since India’s total public sector borrowing requirement is almost 9 per cent of GDP, consuming all housing financial savings, keeping market interest rates elevated and impeding monetary transmission. Any stimulus will likely be counter-productive, simply pushing-up interest rates further, accentuating crowding-out risks and financial fragilities in the NBFC sector. Monetary policy has been eased but is not transmitting, with the yield curve still very steep, and bank lending rates barely budging.
What then can policy-makers do to arrest the slowdown? While markets remain focused on the demand side, the optimal response, in our view, is to focus on the supply side. Fixing the plumbing in three areas must constitute the near-term policy agenda:
1. NBFCs: its solvency, not liquidity
The relentless pressure that NBFCs have been under since last year has translated into their credit offtake collapsing , thereby compounding the consumption slowdown. While bank credit has stepped-in, it cannot completely offset it, because these are very different business models that target different end-users.
The NBFC slowdown shouldn’t be surprising. Financial conditions have meaningfully tightened in the sector with average spreads of NBFC bonds significantly above their pre-IL&FS levels. Importantly, this is despite liquidity conditions easing. Interbank system liquidity has eased, core-liquidity is now in a surplus, and several NBFCs are holding much higher cash levels on their books. Despite that, spreads have not softened, clearly suggesting these are reflecting credit risk, and not liquidity, premia. Mutual fund flows have dried up and even bank lending to NBFCs — a key source of refinancing and disbursements — has slowed, suggesting banks, too, may be getting wary of credit risk. Contrary to the market clamour, therefore, this is not a liquidity problem. It’s an underlying solvency concern.
A missing middle?
This, by itself, should not warrant any policy intervention. Lenders re-assessing risk and charging higher risk premia is just the market mechanism playing itself out. Any intervention will simply induce moral hazard. That said, there is a growing concern that asymmetric information may be compromising allocative efficiency. The best NBFCs are easily able to attract funding and those with the most well-known vulnerabilities have understandably been rationed out. The problem is not at the extremes. It’s likely in the “missing middle”. It’s likely that a vast swathe of NBFC s in the middle are unable to attract funding or raise equity, because investors are unsure about their underlying asset quality. This is the classic asymmetric information problem. One can’t distinguish good apples from the bad ones, and so stops lending to all apples. In turn, this is forcing several NBFCs to demonstrably hoard cash — and thereby cut back on disbursements — to “signal” that are not amongst the bad apples. But this is a very inefficient signaling mechanism. More generally, asymmetric information about underlying asset quality is leading to allocative inefficiency and weighing on financing, equity raising, credit off-take and therefore on GDP growth.
Needed: credible signaling
What is therefore needed is a credible external signaling mechanism. This can best be provided by the regulator undertaking an asset quality review (AQR) of the NBFC sector. Once concluded, this would credibly distinguish the good apples from the bad apples, eliminate the “trust deficit” that looms over the sector, and allow the good apples to raise equity and funding. Operationally, an AQR will need to be delicately handled and artfully managed. It may lead to temporary disruption. But doing nothing also has a very real cost — the risk of accidents and that of foregone growth, quarter after quarter.
2. The fiscal-monetary tango
A credible Budget in July is critical. Actual revenue collections in 2018-19 are likely to be much below the revised estimates, making the projected revenues for next year virtually unattainable. The government must therefore (i) reiterate its fiscal deficit target of 3.4 per cent of GDP; (ii) but do so by credibly budgeting revenues and expenditures; (iii) and ensuring that legitimate budgetary payments — like to Food Corporation of India — are not pushed off-balance sheet. Barring this, bond markets are likely to get nervous again, and build in more risk-premia into bond yields, thereby pushing up the cost of capital further. A credible Budget, however, rests squarely on GST revenues increasing markedly, which will necessitate further simplification of the GST and meaningfully-tighter compliance mechanisms.
A credible Budget will also help in boosting monetary transmission. First, it will balm bond yields and ease financial conditions. Second, if bond yields are lower, small savings rates — linked to bond yields — should also come down, making bank deposits more attractive, boosting deposit growth, and helping monetary transmission in the banking system. Third, rampant non-compliance of GST pushed up currency-in-circulation (CIC) in 2018-19. If GST compliance is tightened, CIC growth will fall, deposit growth will rise and provide more fillip to monetary transmission. Fourth, how a fiscal deficit is met matters for growth. Meeting the deficit by slashing public investment — where fiscal multipliers are arguably higher — versus tightening indirect tax collections — can have meaningful implications for growth.
In contrast, if markets worry about fiscal credibility, and monetary policy is simultaneously eased, the yield curve will steepen further, inducing the financial sector to borrow short and lend long — as the margin of temptation from maturity transformation increases – but accentuating financial fragility.
3. Reversing the terms of trade
Tackling agrarian distress — by trying to correct the adverse terms of trade from low food prices —must constitute the third near-term priority. There is limited space on the demand side. The PM Kisan scheme should boost food demand, but total spend is just 0.4 per cent of GDP, and there is no fiscal space for more.
Instead, the answer lies on the supply side. There are early signs that some wholesale food prices have begun to pick-up. Distortive policies — like the stock-holding limits, intermittent export bans, and the Essential Commodities Act — must be done away with, so that some normalisation of food prices is accommodated. Simultaneously, the new government needs to ensure that surplus production is quickly exported to avoid domestic gluts.
Markets are clamouring for stimulus and romanticising about big-bang reforms. But the new administration’s immediate priority must be to stabilise the economic boat by first fixing the plumbing.
The writer is Chief India Economist at J P Morgan
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