CEA Krishnamurthy Subramanian explains the economic rationale behind Modi govt’s policy response to Covid
Start with three key propositions. First, when only aggregate demand is raised without any change in aggregate supply, both price and quantity go up. So, resulting GDP growth combines with high inflation. High inflation requires monetary policy to switch to a tightening mode, thereby reversing the increase in demand generated by fiscal policy. So, when only aggregate demand is raised without any change in aggregate supply, monetary and fiscal policies end up working at crosspurposes, leading to an ephemeral growth impulse.
However, when both aggregate demand and aggregate supply are increased, quantity increases more disproportionately without price going up. So, growth increases more but without concomitant high inflation. Minus high inflation, monetary policy can continue to be supportive and support the demand push provided by fiscal policy. The growth impetus is then long-lasting.
Rev With Capex
In this context, revenue expenditure (revex) by GoI has no impact on aggregate supply, as no assets are created. In contrast, capital expenditure (capex) creates assets, thereby increasing aggregate supply. Also, reforms that eliminate supply-side frictions also increase aggregate supply.
Second, increasing only revex is myopic while increasing capex is far-sighted as the former increases aggregate demand ephemerally, while capex generates a sustained increase in demand. Capex increases construction activity, creates jobs and enhances demand, and creates jobs and investments in linked sectors such as steel and cement.
Subsidies don’t provide assurance of income like a job because one is uncertain when the subsidy will be withdrawn. Therefore, revex doesn’t generate sustained increases in demand.
Third, capex crowds in private investment, while revex crowds it out, as GoI borrows more but the pool of savings does not increase with revex. Savings pro-cyclically follow economic growth. As capex creates growth, the pool of loanable funds increases, thereby enabling both public and private sectors to draw from the same to fund their investment.
In their 2015
study, Ashima Goyal and Bhavyaa Sharma show that the multiplier for capex, which captures the value added to the economy from Rs 1 of capex, is 2.4-6.5 times the revex multiplier. The impact of revex is felt only in the first quarter and vanishes thereafter. Consistent with capex-enhancing aggregate supply, capex also reduces inflation more over the long term.
In their 2013 study, Sukanya Bose and N R Bhanumurthy show that increase in revex by Rs 100 only adds Rs 98-99 to the economy. Increase in capex by Rs 100, however, adds Rs 245 to the economy in the same year and Rs 480 over the next several years. Therefore, given India’s stage of development, capex is what policymakers must choose to wisely spend the taxpayers’ money.
Following the global financial crisis (GFC), revex increased sharply by 27% in 2008-09, while capex declined by 4.83% in 2008-09 compared to the previous year. The farm-loan waiver, which benefited only rich farmers, represented the most egregious revex. Due to the myopic focus on revex, gross fixed capital formation as a percentage of GDP plummeted from 35.8% in 2007 to 31.3% in 2013.
Capex decrease apart, no structural reforms were carried out. Reforms to improve the investment climate for SMEs, struggling due to external demand collapse and cumbersome regulations, did not materialise.
The macroeconomic crisis in 2013 traces back to the policy response in a manner economic textbooks expatiate. On finding it too hot, you turn the AC in your bedroom to maximum, and go off to sleep — only to wake up freezing at 2 am. The act of turning the AC to maximum at 10 pm showed its outcome at 2 am. A similar lag manifests with macroeconomic policies and their outcomes.
The excessive revenue expenditure increased fiscal deficit (FD) sharply, but did not create any assets. From 2.5% of GDP in 2007, India’s FD remained above 4.5% for each year during 2008-13, peaking at 6.5% in 2009 after the farm-loan waiver. As demand increased without any increase in domestic supply, imports accelerated while exports remained anaemic and inflation swelled.
The current account deficit (CAD) deteriorated sharply, from 1% of GDP 2006-07 and 2007-08, also contributed to the runaway inflation.
Crucially, however, non-food inflation increased from almost 0 in 2009 to about 7%, 9% and 6% in 2010, 2011 and 2012 respectively, thereby highlighting the role of increased demand combined with static supply in fuelling inflation. The triple whammy of high FD, runaway inflation and high CAD led to the macroeconomic crisis in 2013.
Growth Minus Inflation
GoI’s capex increased by 17% in 1999-2000 compared to 1998-99, remained at a similar level the next year, and increased again by 14.8% in 2001-02. This capex manifested in the Golden Quadrilateral being built and crowded in private investment in the economy. The gross fixed capital formation as a fraction of GDP increased from 25.4% in 1998 to 29.9% in 2001. This helped to increase aggregate supply in the economy.
Apart from the focus on capex, several structural reforms — removing smallscale reservations, increasing competition and firm size, the disinvestment programme, etc — enhanced aggregate supply. The telecom revolution, too, was ushered in through policy responses.
The increase in both aggregate demand and aggregate supply led to high growth without inflation, or a macroeconomic crisis. Inflation, 13.2% in 1998 following the Asian financial crisis (AFC), declined to 4.7% in 1999 and 2000, and remained below 4% till 2004. In contrast to the sharp deterioration following GFC, India’s CAD improved post AFC. From –1.4% of GDP in 1997-98, it improved to –1% in 1998-99 and 1999-2000, further reducing to –0.8% in 2000-01.
India’s exports as a percentage of GDP increased from 10.7% in 1997 to 17.9% by 2004. Its annual GDP growth rate increased from 4.0% in 1997 to 6.2% in 1998, further increasing to 8.85% in 1999. After economic sanctions post the 1998 nuclear tests caused a temporary growth decline, growth remained at about 8% from 2003 to 2007 because of the salutary impact of the policies adopted post AFC.
Also, compared to 56% depreciation in the currency following GFC, the currency depreciated by 14% by January 1999 against the level in 1997-98. While some may contend that the economy was less open during AFC than GFC, both crises impacted economic growth in India similarly by impacting external demand. So, the comparison of the divergent policy responses following GFC and AFC and their resultant differences in macroeconomic outcomes is apposite.
These have important lessons that have been imbibed in India’s policy response to the Covid-19 crisis. It has focused on enhancing both aggregate demand and aggregate supply. Enhancing aggregate supply is important because high inflation (as was the case following GFC) is likely without policies focused on enhancing aggregate supply. This is particularly the case because the agricultural economy that impacts food inflation remains mired in supply-side frictions.
As food inflation impacts headline inflation, the farm reforms and planned investment in farm infrastructure are critical to extricate India out of the periodic bouts of high inflation stemming from food prices. High inflation can lead to monetary tightening, dousing the impact of the demand push that fiscal policy provides. The slew of reforms focused on strengthening the manufacturing sector are intended to enhance productivity and aggregate supply, while creating organised sector jobs to increase aggregate demand.
The change in the MSME definitions are intended to enable them to reap the gains from economies of scale. The reforms in factor markets (labour and capital) are intended to reduce the supply-side frictions that hobble our economy.
Second, public capex crowds in private investment, an aspect witnessed during the policy response following AFC as well, and is critical to accelerate private investment. CEIC’s seasonally adjusted indicator for investment reached a 20-year high in January 2021, while the composite Purchasing Managers’ Index (PMI) expanded to 56 in the same month. All these point to the start of the virtuous cycle with private investment leading the way. Manufacturing reforms should create organised sector jobs and increase aggregate demand.
The writer is chief economic adviser, GoI