Baton for driving economy has passed from RBI to govt

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If the government wants to restore economic growth, it needs to revive capital formation

A significant portion of monetary accommodation which began in January 2015 seems to be now coming to a close. The RBI in the past two years has cut policy repo rate by 175 bps, while the liquidity stance also witnessed a regime shift in early 2016 when RBI, in its annual policy, transitioned from a deficit liquidity stance to a neutral liquidity stance. This was an indication that the central bank was comfortable with neutral to surplus liquidity situation, as monetary transmission was expected to be achieved without a deficit scenario.

In addition, the recent demonetisation drive has added to easing the liquidity scenario as a big chunk of cash in circulation has come back into the formal fold, and it is likely that a nontrivial portion of cash deposits will not be withdrawn and hence remain with banks.

With a better part of monetary accommodation – both through lower rates and surfeit liquidity – in the past, and several segments of the economy, particularly rural India, SMEs and capital formation, yet to show material signs of recovery, the baton for stimulating the economy has passed on from the RBI to the government. The urgency of a fiscal stimulus is now increasing to complement the impressive monetary accommodation which has resulted in interest rates now declining to a seven-year low.

Elevated oil and commodity prices, the strengthening US dollar, and the prospect of rising bond yields in developed markets could constrain the RBI in pursuing an aggressive monetary policy accommodation this year after a two-year period which has seen policy interest rates decline by 175bps.

If the government wants to restore economic growth – sustainably towards a 7.5 per cent to 8 per cent range – it needs to revive capital formation, which unfortunately cannot be revived meaningfully without a pickup in private sector capital expenditure. The combination of a more than six-year low in interest rates (government 10-year treasury yield at 6.4 per cent, AAA one year corporate bond 6.9 per cent and SBI’s mortgage rate at 8.65 per cent) coupled with a radical rehaul in direct taxation (income and corporate taxes) could be a game changer in aiding capital formation.

The combination of lower interest rates and sharp reduction in direct taxes may be the most appropriate solution to reviving India Inc’s capacity utilisation rates which have now stayed sub optimal for almost five years, holding back the need for new capacity creation.

It is true that the government may need to look at additional sources of tax revenue to fund any major reduction in personal and corporate taxes. A very modest banking transaction tax could provide the government with substantial fiscal manoeuvrability to attempt a rehaul of direct taxation – income and corporate taxes.

Investors will however need to be realistic of India’s political economy, with 2017 being the third year of the political term of the government and a national election due in 2019. Expenditure on social spending, poverty alleviation programmes and rural infrastructure is set to rise, which may again create the need for additional resources. India’s tax GDP ratio needs to rise substantially if the government wants to achieve the double objective of jumpstarting aggregate demand through direct tax cuts while also raising public spends on infrastructure, agriculture and poverty alleviation schemes.

There is a strong likelihood of the government implementing its pro-poor, prorural policy via several announcements in the upcoming Union Budget. A significant hike in budgetary allocation is expected for rural construction, agriculture and poverty alleviation programmes. It remains to be seen how the finance minister walks the tightrope of achieving the twin objectives of jumpstarting aggregate demand to stimulate capital expenditure and raise spending on rural infrastructure and poverty alleviation schemes.

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