Tuesday, 26 January 2016

Ditching the Washington Consensus?

Pulapre Balakrishnan and Ila Patnaik take opposing views on how to revive the economy. He advises revving up public investment, she says-follow easy monetary and tight fiscal policy.

Who is (more) right?

Both focus on the need to increase private investment. This is backed by the mid year economic review that shows that its contribution to GDP growth has been muted in FY 2015 and 2016 compared to the period from 2004-11.

Theoretically either method could work. If we assume the flexible accelerator model of investment, producers are looking to reach a certain 'desired capital stock'. Higher the expected GDP of the economy, higher would be the desired capital stock, because of higher likelihood of output produced being sold. Producers will typically adjust slowly to this desired level of capital. How much they add to the capital stock in a given period (that is, investment), depends on the cost of making the investment. This could be rate of interest or regulatory factors (for example, a temporary investment subsidy or tax holiday).
More public investment => producers expect higher demand for their output in the future = increase investment.
Easy monetary policy => lower rate of interest => ability to finance the investment more easily.

Other findings of the mid year economic review:

    • Real consumer credit has picked up while industrial credit has slowed. Note that this slowdown is in spite of the RBI's loosening of money supply.

    • The Review conjectures that stressed balance sheets have caused corporates to go slow on investment. Interest cover-i.e. the ratio of earnings to interest payments have been on the decline. Profit after tax between FY15 and FY14 also dipped slightly.
Both above facts make it difficult to understand how a (further) lower interest rate in isolation will help increase investment. This is because-
1. If the RBI already reducing rates has not helped increase investment, while consumer credit has picked up, this is possibly due to a lack of credit demand from the corporate sector.
2. If the balance sheets already stressed, reducing interest rates henceforth does not help the past issues.

[The government is planning to ask the RBI to change NPA classifying norms such that projects that have more than 2 years of delay (currently classified as NPA) not be classified as NPA if the delay is not due to the fault of the promoter. Similarly, they are asking that banks be allowed to provide additional funds to promoters to meet cost overrun on projects, even if the overrun is greater than 10% of the initial cost (10% being the current limit for such additional support, at present).]

Hence, stepping up public investment so that it boosts profit expectations more likely to help in activating 'animal spirits'.


  • It is possible that increasing investment only props up the desired capital, and not the yearly investment which is more sorely needed.
  • In that case, temporary investment incentives may be given, announcing clearly that these incentives will not be available, say three years hence. Businesses likely to want to take advantage of these incentives then.
  • More public investment does mean higher rate of interest, thus dulling the ability of the private sector to invest. So Patnaik right about the undesirability of 'tight' monetary and easy fiscal policy. 
  • The Mid year Review seems to suggest that the RBI should not stick to its avowals of reaching the set CPI inflation target and possibly follow easy monetary policy. But then why go to the trouble to announce inflation targeting as the goal of monetary policy and sign an RBI-government agreement  'guaranteeing the same', if you backtrack at the first hint of trouble? But then this is the classic discretion versus rule based monetary policy dilemma.
  • More public investment likely to worsen the fiscal deficit and the debt to GDP ratio. Already the 10 year G sec yield exceeds the nominal GDP growth. Balakrishna says rejigging the public finance- away from unproductive subsidies to productive investment and raising more funds through disinvestment may help reconcile the two objectives of growth revival and fiscal consolidation. 
  • I bet you are now smirking at how welfare subsidies are a waste while subsidies for investment are seen as incentives [hence not a waste].  
  • Arun Maira takes the easy way out by plumping for institutional change and nice alliterations.
  • I am now beginning to wonder whether the call for reducing non-merit or unproductive subsidies is also an easy way out...given that you can pretty much expect that the government will never follow through on that. [The reduction in the LPG subsidy has been an exception, but then that too will not affect a large part of the voter base].

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