Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Loose fiscal plus tight monetary policy

I have a column
in the Financial Express today on the dangers of
combining loose fiscal policy with tight monetary policy.

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.

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