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Is it time to reduce the stimulus?

February 17, 2010 10:58 IST

GrowthWith private consumption growing 3.6 per cent versus 18.1 per cent for government in April-September 2009, and investment growth falling to around half, any decision on phasing out has to be taken carefully.

Indranil Sengupta, Economist, India Research, DSP Merrill Lynch Limited

All drivers of growth -- household demand as well as corporate investment -- are picking up. So a gradual withdrawal won't hurt

We believe that the government should begin to gradually withdraw last year's fiscal and monetary stimuli as the economy recovers.

A doctor, after all, has to ask the patient to discontinue taking pills as a patient recovers. In the last upcycle, the People's Bank of China and the Reserve Bank of India were the first two central banks to follow the US Federal Reserve in hiking rates in mid-2004.

It is not a coincidence, in our view, that China and India have also seen the highest growth rates ever since.

On our part, we expect RBI to hike the cash reserve ratio by 75 basis points and the policy rates under liquidity adjustment facility by 150 bps in the financial year 2011 to drain out easy money.

Too much money chasing too few goods for too long can only spill over into inflation. Besides, we expect RBI to re-tighten provisioning norms on bank loans to real estate to pre-empt a possible bubble.

Finally, we expect the Union Budget to roll back, partially at the least, past excise duty cuts. A high fiscal deficit would only crowd out private credit as economic recovery strengthens loan demand.

Can growth survive, we are often asked, a phasing out of the fiscal stimulus. Yes. The baton will pass to a turnaround in consumption and investment demand, as is only natural during an economic recovery.

First, the urban consumer is beginning to spend again with an improving job security. Second, rural consumption demand should also revive if the rains in 2010 are as normal as we expect.

As of now, at the least, the Australian weather bureau has predicted that El Nino, the phenomenon of warming of the Pacific that impacts Indian rains, is subsiding. In fact, higher sugarcane prices and the prospect of a good winter wheat crop are also moderating the impact of the autumn drought on rural consumption demand.

Third, export demand should continue to recover with global growth likely to expand by 4 per cent in 2010 after a contraction of 0.9 per cent in 2009.

Fourth, infrastructure investment plans are returning to the drawing board with international capital markets opening up once again to finance the projects.

Fifth, home investment is also picking up on the back of improving urban consumer confidence and low mortgage rates.

Most banks are reporting higher home loan demand. Sixth, conventional corporate investment should also join in by the end of this year, with greater visibility of growth prospects.

And, would a tighter monetary policy not kill recovery? Not really. To begin with, we do not expect bank lending rates to firm up till the next industrial busy season beginning October, even if RBI continues to tighten.

This, in turn, means that the present soft-lending- rate regime will continue to support growth for another six months. Why? Because bond and credit markets have already priced in a degree of RBI action.

Not very surprisingly, most banks have already announced that they will not hike lending rates immediately after the recent 75 bps cash reserve ratio hike. Besides, the demand for loans tapers off in the industrial slack season of April-September when the summer and the monsoons slow down economic activity.

Also, we do not see bank lending rates going up so sharply that they hurt growth. In fact, we estimate that banks will likely hike prime lending rates by a moderate 75 bps between October 2010 and March 2011.

In our view, lending rates would need to go up at least 150 bps before they constrict growth. In fact, the pressure on lending rates would only escalate if the government borrowing programme is not checked at least at levels the same as those of the last year.

Can RBI really calibrate the revival of growth with an exit strategy? We can certainly point to three wise decisions. Early monetary action in 2004 scripted healthy growth.

Second, a build-up of forex reserves during the upcycle years of 2004-08, despite much criticism about 'excess reserves', allowed India to fund outflows during the global credit shock without having to ask the US Fed or the International Monetary Fund for help.

Finally, aggressive monetary easing in late 2008 enabled India to weather not only the worst global recession since the Great Depression but a devastating drought as well. And, to end on a positive note, let's hope for a fourth wise decision.

A Subba Rao, Group CFO, GMR Group

Once we keep in mind that the West is not out of the woods, withdrawing the stimulus sharply will be fraught with risk

Finance Secretary Ashok Chawla recently said, "Too much of stimulus, when the body is getting healthy, is not good; it can be injurious to health."

Stimulus treatment is like steroid therapy. While sudden injection of steroids can save one's life, their sudden withdrawal can be fatal -- the debate on phasing out the government stimulus has to be seen in this light.

When it was needed, the government unleashed a series of life-saving measures to prevent the debilitating convulsions caused by the global financial crisis from devastating the Indian economy.

After the stimulus was provided, and having observed the recovery of the economy barely for just two quarters, the wishful diagnosis seems to be that the patient (the Indian economy in this case) has got better and hence we can remove her from the life-support systems (stimulus packages).

While it is important to be aware of the long-term repercussions of the continued stimulus, it is equally important for us to make sure that its withdrawal happens only when the economic recovery is beyond all reasonable doubt.

Moreover, the withdrawal must be gradual and calibrated to avoid any reversion to the crisis.

No doubt, most key indicators of the health of our economy suggest the economy is in a much better shape.

The Index of Industrial Production numbers have been posting secular gains; GDP trends have been looking good; exports have stopped going down further; all key sectors, with the exception of agriculture, are getting back to their old growth rates.

However, these initial trends should not lead us to become complacent and end the stimulus. Before we move on to a hasty phasing out of the fiscal and monetary stimuli, it is critical to assess the sustainability of these initial positive trends of the recovery.

Had the crisis been caused by stand-alone factors, it would have been sufficient to consider the stand-alone recovery trends to judge the state of the economy.

However, it was the global financial crisis that affected the economy's health. After the chastening experience that we have just gone through, let us realise that if the world is still reeling from the crisis, we need to be cautious in judging the durability of our economic health indicators which are on their way to recovery.

Reports show that the US, Japan and Europe are still not out of the tunnel and there is fear of fresh trouble in certain parts of Europe. In the backdrop of this reality of the continuing economic woes of the major economies of the world -- from where we get the substantial liquidity to speed up our economic growth -- any decision to significantly downsize the recovery is fraught with risks.

The government-administered stimulus kit had two significant parts: Tax cuts to promote demand and liquidity infusion with soft policy interest rates to promote investment and demand.

Financial stimulus would invariably lead to higher fiscal deficits, causing some strain to the economy. We also must be wary that the doctor herself should not become a patient due to her untiring efforts while treating her patient.

We must strike a fine balance to ensure the sound health of the doctor too!

It is also true that only sustained and sound economic growth can keep the fiscal deficit in the healthy range. Hence, the doctor (the government), in her own interest, must identify what treatment to continue, what to phase out, when to phase out and how to phase out.

True expertise lies more in the right timing and phasing of the steroid withdrawal than in administering it.

Since the genesis of the recession lies in the availability of liquidity, that should be continued without any dilution till the recovery is comprehensively established and the recent liquidity-trimming should be reversed.

Tax cuts can be partially reversed, say by 2 percentage points, in the coming Budget. Finally, the patient (economy) can be discharged from the ICU but not from the care of the doctor and certainly no case exists for any significant discontinuation of the stimulus.

BS Reporter in New Delhi
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