Deficits, Debt And Liquidity — RBI Makes The Case For Normalisation

After nearly two years of extraordinary monetary and fiscal policies, the Reserve Bank of India is making a case for normalisation to fight unintended consequences of pandemic-time accommodations.

"The recovery in economic activity remains stimulus-dependent, even as new risks to growth and inflation have emerged from the war in Ukraine and normalisation of monetary policy in the U.S," the RBI said in its annual Report on Currency and Finance.

"For restoring and recreating a policy environment conducive for private sector-led growth post-Covid, timely rebalancing of monetary and fiscal policies may become necessary given the current configurations of debt and liquidity," the central bank's report said.

The report highlights possible negative consequences of three aspects — a large liquidity surplus, a wide fiscal deficit, and a high government debt-to-GDP ratio.

As the pandemic hit, the RBI eased surplus liquidity conditions significantly. As of March-end, the liquidity surplus was at close to 5% of net demand and time liabilities, or broadly put, bank deposits.

Analysis in the RBI's report suggests that a surplus of more than 1.52% of NDTL could be inflationary.

The results show:

• A one percentage point increase in surplus liquidity above this threshold value could push up inflation by 60 basis points on an average in a year.

• The cumulative impact over about six quarters, however, exceeds 200 basis points.

The RBI said that this surplus liquidity has to be withdrawn in a "calibrated manner". At the April monetary policy review, the RBI had indicated that this would be a "multi-year" process.

The RBI, in its report, also made a case of a clear medium-term fiscal consolidation path.

"As recovery gains further momentum, fiscal consolidation should ideally precede monetary policy normalisation to minimise trade-off costs," the report said.

According to the RBI's studies, fiscal multipliers of increased government spending are positive when the economy is in contraction. However, as the economy recovers, its impact wanes.

Fiscal consolidation is also a necessity for allowing the private sector to sustain the growth momentum and mitigating the potential drag on growth from fiscal activism once the economy fully recovers.

The report calls for targeted consolidation via strategic policy efforts on taxes and expenditure. The central bank advised caution on relying "on the wobbly comfort from a favourable interest rate minus growth condition of debt sustainability".

India's debt-to-GDP ratio is estimated at close to 87.4% in FY22, with the central government's debt-to-GDP ratio seen at above 60%.

According to the RBI's studies:

• When the central government debt exceeds a threshold value of 55% of GDP, every one percentage point increase in the debt-to-GDP ratio causes the term premium in bond markets to harden by about 22 basis points in the short run.

• The impact could increase to as high as 56 basis points in the long run.

• Moreover, when general government debt exceeds another critical threshold level of about 66%, it is found to dampen growth.

• The general government debt may not decline to below 75% of GDP over the next five years.

The report goes on to call for a medium-term strategy of debt consolidation aimed at reducing general government debt to below 66% to secure the medium-term growth prospects of India.