Compensation to States and Borrower of the Last resort!

 India's FM is an unenviable position. Given the penchant for two steps forward and one step backward in all economic decisions, FM is in the eye of the storm unendingly ever since the pandemic struck India. In fact, even before that, India's GDP was sliding YOY from 2016-17 onwards. It hit a high of 8.26% in 16-17 and hit the lowest so far in Fiscal 19-20 at 4.2%.

GST collections have also ebbed along with the GDP since even Nominal GDP has grown only by 7.2% in Fy 19-20.It was growing at 11.76% in Fiscal 16-17. So, this skidding of the nominal growth rate coupled with a reduction in GST rates in 2018 led to a shortfall in GST collections even though the tax base widened. The good thing about the One Nation, One tax has been the acceptance of this Taxation in lieu of VAT at the individual state level and Excise duty at the Central level. The consensus behind GST has been bought by Arun Jaitley with the commitment for providing Central funds at the growth rate of 14% YOY to the individual States, by levying Compensatory cess on luxury and sin goods. However, the Central Govt is caught on the wrong foot this year due to the pandemic. The tax collections are abysmally low and this has forced the Central Govt. to consider reneging on its promise of providing compensatory funds to the states.

In the recent 41st GST Council meeting, FM has been compelled to use the insurance phrase of Act of God i.e force majeure(or Hand of China?!), to describe the extraordinary situation due to the Covid pandemic. Due to this compulsion, the Central Govt has presented two options to the States to consider and give their replies in a week's time. Under Option 1 States may borrow Rs.97K cr at a special interest rate and the principal and the interest will be later on paid out of Compensatory cess on Cars, Soft drinks, tobacco, pan masala, and coal. Under Option 2 States can borrow up to Rs.2.35lac cr and States will have to pay interest at the market rates.Only the principal will be paid out of Compensatory Cess later and the interest will have to be provided in the States' Budgets. In this GOI has made a fine distinction between GST implementation loss and Covid induced tax revenue loss which is also hair-splitting and needlessly academic, if not contentious.

Now the overall emerging scenario is one of confrontation between the Centre and the States. All economists are now supporting the States saying that since it is the commitment of the Central Govt. it has to find the resources for funding this GST collection shortfall. Of course, they are of the view that the Central Govt can source this fund at a much cheaper cost than what the States could bargain for.This is an important point. However Finance Secretary has gone on record saying that if the Centre resorts to this borrowings, overall bond yields may go northwards, which will raise the cost of borrowings for both the Public sector and Private Sector. As a consequence, the sovereign rating of the country may be adversely impacted which will be detrimental to the interests of all sectors of the economy. But the moot point is this can happen even if States borrow for this purpose.

In the meantime some of the opposition ruled states are considering approaching SC for a direction to the Central Govt, saying that the Centre is trying to hide behind AG's legal opinions, shirking its responsibility in honoring the revenue commitment in letter and spirit. But such an outcome may not augur well for federal relationships and for the future of cooperative federalism which is touted as the big success point behind GST introduction.

However, in all this surcharged situation over who should shoulder the borrowing burden, the missing point is how well or badly States are containing their deficits in the last few years despite being given higher level of funds without much of efforts from their side. Any additional funds given without caveats are being frittered away by them in giving freebies, free EB and in unplanned revenue expenditure. So who is going to discipline them and rein in their penchant for spending without answering for outcomes? Even in May 20, when Centre gave permission for Additional borrowings through the WMA window, many states incl. Tamilnadu objected to the thinnest of the sticks like DBT transfer of EB subsidy to BPL families, that came with the carrot. States only want the carrot as their right without any strings being attached.

That said, Central Govt. must seize this opportunity to bring to light the importance of fiscal discipline at the State level by finally agreeing to resort to the borrowings on their behalf.

If you consider the Center and the State as the right and the left hands of the same person, sometimes when your right hand is full of weight to be lifted, the left hand also should chip in to bear the weight in order to balance it. Left cannot accuse the right of transferring some of the weight to it!!

Inflation, Monetary policy and India

 The minutes of the recent meeting of Monetary Policy Committee  of RBi which were released this week, contain some interesting mentions. One of the news columns said that RBI minutes mention 'uncertainty' 12 times, 'growth' 43 times and 'inflation' 147 times It has expressed concern over inflation and it seems to be valid as CPI has remained above 6% which is more than the tolerance limit of RBI. Alongside, India is experiencing severe GDP growth pangs as its IIP has remained in the negative territory in the first quarter and in July also. Services sector is in a deeper mess except of course ITES, SAAS etc. which have been affected to a lesser extent. It looks like only Agri sector has not been impacted adversely so far ,as the progress of monsoon has been satisfactory and the spatial dispersion also fairly good.

The RBI Deputy Governor Mr.Michael Patra had said : "If inflation persists above the upper tolerance band for one more quarter, monetary policy will be constrained by the mandate to undertake remedial action, including an immediate and more than a proportionate response to head off the build-up of inflation pressures and prevent it from getting generalized." So, to sum it up ,we have classic case of "stagflation"- a combo of GDP slowdown and inflation.!

CPI in India has a higher weightage for food and fuel indices and these two are certainly not amenable to monetary policy measures. In India fuel price is driven more by Govt . policy measures and it is feeding into inflation with its rippling effects on the rest of the economy widespread.When pandemic is restricting economic activities profiteering becomes rampant in vegetable and food prices. When the supply chain and free movement of people and commodities happen, the inflation tendencies will come down. Cost push inflation of food prices will not listen to monetary policy signals in the short term in Indian conditions. As India is driven more by cash , there is a quite a lag in food inflation responding to monetary policy measures, if at all it is significant. May be hoarding and black marketing of these vegetables,cereals ,staples etc. may come down a little bit.However Govt. initiatives through Essential commodities and anti-hoarding sticks used by Govt. through other means incl. emergency imports may be more effective in the short term to bring down food prices.

When the economy is awash with liquidity, the prices in general have tendencies to go north .More so when the supply constraints remain elevated due to lockdowns,e-passes and uncertainties compounded by fear for life and livelihood affecting the income. In these circumstances. RBI should look at high CPI as extraordinary during the pandemic period and should start looking at Core inflation now and then revert back to CPI only after the pandemic is seen plateauing.In the meantime, RBI may seek a temporary amendment for its inflation targeting, switching to Core inflation in times of extraordinary circumstances like a pandemic,global financial crises etc. and then have a glide path back to CPI inflation targeting after the crest of the crises is over.

RBI monetary policy and the state of the Indian economy

 RBI's recent Monetary Policy announcement after MPC considered the latest economic factors, CPI etc , came out with no repo rate cut. Primarily because CPI is elevated and at an uncomfortable level as far as RBI is concerned.since the mandated and stated objective of RBI is now inflation control, RBI has decided to hold the rate this time despite the economic slowdown calling for a steep rate cut.RBI also mentioned that this year would see real GDP contraction after more than four decades, but still decided to save the powder for a more rainy day or for a day when the bang will be worth its buck.

India is facing rising prices also esp. food prices, fuel prices and therefore is experiencing a cost push inflation. There is a school of economists who say the inflation is fueled by easy liquidity floating in the economy and the stock exchange boom , gold price rise all indicate to easy money into areas where some quick money can be made.Even RBI is predicting a rise in inflation levels in Q2 but has refrained from an inflation forecast.

Gold price,as Ruchir Sharma in today's TOI blog(link )puts it, rises due to uptick in demand whenever interest rate is lower than the inflation rate. But Gold being a safe haven investment booms when the rest of the economy sees more volatility elsewhere esp. in stable investments. There is a rush of outflow from equity MFs in July but is it going to Debt MFs or to stock market or to gold  is anybody's guess.But there is greater desperation driving up buying Gold rather than preference as an investment.

All this paint a confusing story but with tinges of liquidity bulge which may become an inflation down the road, unless the productive resources are used for assets and jobs creation. But the silverlinings are shallow oil prices, decent monsoon, burgeoning foreign exchange reserves and surplus in current account balance. So, cost push factors in inflation are slightly mitigated in the near to short term.

CII 's recent 111th Business Outlook survey,July 2020, which was released last month revealed that out of three indeces Current situation index, Expectation index, Business confidence index, the Current Situation Index of Q1 of Fy 20-21 is similar to the levels of Q4 of Fy 19-20! Only the Expectations and Business Confidence levels in the economy have deteriorated during Q1 of Fy 20-21 as compared to earlier quarter.

Dr.Manmohan Singh in his BBC interview has also clearly said that this human crisis created by the pandemic calls for greater spending and greater borrowings by the GOI, even upto another 10% of GDP for tackling health, military and economic challenges of the country. His wise words would be worthy of listening now.(link)

But this borrowing must have a clear exit clause linking it to FRBM Act requirement of glided fiscal deficit path to 3% of GDP eventually in the short to medium term of 3/4 years. Only this can bring back investors into the country. Otherwise Fiscal profligacy is the scourge of the growing economies like India.

There are no simple answers but quick actions,as outlined by PM in his speech on the occasion of  Ram janmasthan Temple laying foundation,have to be taken by the Govt. Quoting from Kamba Ramayana he said "காலம் தாழ ஈண்டு இனும் இருத்தி போலாம்" என்றான் இராமன்" which essentially means we should not procrastinate taking actions to rectify the situation. A well focused fiscal stimulus, vaccine or no vaccine, is an urgent imperative.