The movement of equity and bond markets after the announcement of the budget is threatening to look like a re-run of early 2008 when falling stock markets and rising interest rates delivered a double whammy to the economy. Monetary policy needs to respond to this threat and avoid a similar double whammy now.
To recall what happened in early 2008, the stock market dropped by nearly 40% from mid-January to mid-July, while the 10-year government bond yield rose by over 180 basis points. The corporate sector found that both equity and debt were either unavailable or too expensive. With a lag, this funding squeeze had a highly negative impact on investment and on the broader economy.
The rise in interest rates at that time was due to the tight money policy followed by the RBI in response to double digit inflation caused by rising prices of food and oil. What nobody knew then, but is evident now is that the inflation of early 2008 was a transient phenomenon that was being killed by the global economic downturn. In retrospect, the tightening of interest rates was unnecessary.
The situation now has some similarities. The failure of the monsoon so far is causing fears of food price inflation. These fears would weigh on RBI and could induce it to keep monetary policy too tight. At the same time, the spending and borrowing programmes announced in the budget has caused long-term interest rates to rise. Interest rates would rise even further if RBI does not accommodate the borrowing through monetary easing.
Loose fiscal policy combined with a monetary policy fixated on inflation can cause interest rates to explode. In the US, in the early 1980s this was what happened when President Reagan embarked on a spending spree while the Federal Reserve under Paul Volcker declared war on inflation. The yield on long term US government bonds crossed 15% and shorter maturity yields rose even higher. This combined with the rising dollar (itself a result of the high interest rates) brought about a nasty recession in the US.
A recession induced by high interest rates is the last thing that India needs today when the economy is being kept afloat by a large fiscal stimulus. If we take away the support provided to the core sectors from government spending on infrastructure and the support provided to consumer durables by the sixth pay commission, the economy is in pretty bad shape. In this context, the fiscal stimulus is unavoidable and the only question is whether the central bank will accommodate the fiscal deficit through its monetary policy.
A lot of the discussion on the fiscal deficit in recent days has focused on the ‘crowding out’ of private borrowing by government borrowing. In today’s environment I worry more about private borrowing being crowded out by high interest rates, and fortunately monetary policy is a tool that can prevent this.
Many countries are running large deficits. The fiscal deficits of the US and the UK are much higher than ours as a percentage of GDP. The big difference is that in those countries, extremely loose monetary policy has worked in tandem with the fiscal policy. At extremely low interest rates, higher levels of government debt are sustainable simply because the cost of servicing the debt is low.
In India on the other hand, we have turned to fiscal policy long before exhausting the limits of monetary policy. This means that the government is undertaking huge borrowing at relatively high interest rates. The resulting high interest bill will only make the fiscal position worse in coming years.
In the event of a failed monsoon, tight monetary policy can control food price inflation by ensuring people run out of money before they run out of food. It is, however, much less painful for the broader economy to take advantage of our comfortable foreign exchange reserves and tackle food price inflation through aggressive imports.
Turning to the stock market, a modest decline in stock prices is not worrying. There is little point in propping up asset price bubbles when the economic fundamentals are as weak as they are today. What I find more worrying is the possible closing of the primary equity market that had begun to open up for Indian companies in May and June in the form of private placements.
There are signs that this window is closing again due to rising global risk aversion as well as changing risk perceptions about India. If this were to happen, then the corporate sector would be starved of risk capital as it tries to restructure and deleverage while grappling with the challenging economic environment. It is important to keep the primary market open for sound companies that are willing to raise equity at realistic valuations.