How to bring India back on the growth path

As long as mandarins in the finance ministry can restrain their urge to push the Reserve Bank of India into irrelevance, it should be possible for Mr Raghuram Rajan to make the RBI bureaucracy see the merit of rules-based monetary policy, notes Andy Mukherjee

In his maiden Budget speech, the new Finance Minister Arun Jaitley asked regulators to ‘take early steps for a vibrant, deep and liquid corporate bond market’.

He also said that it was ‘essential’ to have a modern monetary policy framework -- which basically means targeting an acceptable level of inflation -- to meet the challenge of an increasingly complex economy.

The idea is to boost household savings and turn more of them into growth capital. If the plan succeeds, sustained eight per cent-plus rates of gross domestic product growth should be within reach in a few years.

It’s easy to be cynical.

Policymakers have desired a corporate bond market in India for at least nine fruitless years.

Similarly, at least four different, high-level committees have suggested that rather than chase multiple goals, the central bank sharpen its focus on managing inflation.

But the new government deserves the benefit of the doubt for three reasons.

First, its reform ideas aren’t all airy-fairy; good intent is backed by specific proposals.

Mr Jaitley said he would allow international settlement of Indian debt securities.

With this, the cost for foreign investors of buying and selling rupee-denominated bonds would drop.

Their interest should perk up, and a deep corporate debt market will no longer look like a pipe dream.

Another bold move is a proposed tenfold increase in financial institutions’ investment in municipal debt.

While the nascent Indian municipal bond market gets going, this could help fund continued urbanisation.

The second reason to expect a reform push is political. Prime Minister Narendra Modi’s big electoral win in May gives him an opportunity to carry out changes that previous administrations, burdened by pressures of coalition politics, were too distracted to undertake.

Finally, sub-five per cent GDP growth over the past two years amidst double-digit inflation has shaken policymakers.

Any plan that promises to end India’s worst growth performance in a quarter century should overcome the objections of the Reserve Bank of India, which has historically believed that the only way to keep the financial sector sound is to keep it small.

The stock of credit to non-financial borrowers in India is about 57 per cent of GDP, the third lowest in Asia after Indonesia and the Philippines.

Reserve Bank of India Governor Raghuram Rajan won’t stand in the way of genuine reforms, many of which he has himself recommended in the past.

As long as mandarins in the finance ministry can restrain their urge to push the Reserve Bank of India into irrelevance, it should be possible for Mr Rajan to make the RBI bureaucracy see the merit of rules-based monetary policy.

A ‘grand bargain’ between the finance ministry and the monetary authority could result if the ministry’s plan to overhaul financial regulation does not drastically curtail the RBI’s remit.

A bigger obstacle might be policy wonks in New Delhi, who say ‘inflation targeting’ could lead to slower GDP growth.

There is so much nervousness about sacrificing output in the short run by raising interest rates that the long-term benefit of stable inflation expectations -- which depend primarily on the central bank’s credibility -- remains elusive.

Assuming Mr Jaitley is serious, the two goals he has chosen -- a corporate bond market and a modern monetary policy -- couldn’t have been more apt or urgent.

To see why, consider how slumps in India’s private investment and household financial savings have gone hand in hand.

The former has plunged from 17 per cent of gross domestic product before the 2008 crisis to nine per cent of GDP; the latter has crashed to seven per cent of GDP from 12 per cent. Inflation is the unseen link between the two.

Financial savings collapsed because of surging consumer prices and negative real return on bank deposits.

The central bank’s interest-rate increases between 2010 and 2011 weren’t enough to slay inflation, but they did push up debt-servicing costs for highly leveraged infrastructure companies.

Soon enough, the Manmohan Singh government got embroiled in a series of corruption scandals.

Crippling delays in project clearances and shortages of coal and gas dashed any hopes of raising new equity.

Instead of investing, the power and toll-road companies began to deleverage.

The investment rate slumped.

The absence of a corporate bond market made things worse.

The state-dominated banking system, which had lent money to infrastructure projects, has chalked up huge losses.

Even now, the lenders are nowhere near recognising the true extent of the bad-loan problem.

To recapitalise them, the government might need to put in $45 billion (about Rs 2.7 lakh crore), according to a Breakingviews analysis.

Reviving the investment cycle without lowering inflation expectations or creating a source of patient financing outside of banks will lead to another unstable, short-lived boom.

But a long-term solution to shortage of growth capital will require budgetary discipline.

That will mean getting the spending priorities right.

The public sector’s consumption accounts for about 12 per cent of GDP, while its investment is just eight per cent of GDP. Shifting the emphasis of government Budgets away from subsidies and handouts to deepening the productive capacity of the economy will be naturally disinflationary.

Ending wasteful subsidies will be politically controversial, but if better budgeting makes the market see the government as more creditworthy, it will reduce the cost of capital for all Indian borrowers, leading to more investment, jobs and tax revenue.

Naysayers will ask if India really needs to be so preoccupied with finance.

China has become the world’s second-biggest economy by paying more attention to trade, worker productivity and physical infrastructure.

It still has a fairly rudimentary financial system.

But India doesn’t have the luxury of China’s high savings.

India’s annual rate of investment has never exceeded 37 per cent of GDP.

Getting the most juice out of scarce capital remains a priority for the country to resume eight per cent-plus growth.

That is where new wiring for the financial system will help the most.

Andy Mukherjee is the Asia economics columnist at Reuters Breakingviews in Singapore. These views are his own.

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