Mint Street To North Block: ‘I Have Your Back’
Finance Minister Nirmala Sitharaman and RBI Governor Shaktikanta Das, at the RBI headquarters in New Delhi, on July 8, 2019. (Photographer: T. Narayan/Bloomberg)

Mint Street To North Block: ‘I Have Your Back’


The government earlier this week unveiled the FY22 union budget, which seems to have ticked most of the boxes despite the Covid-induced challenging macroeconomic backdrop. Instead of getting into the customary analysis of the budget arithmetic, let’s indulge in a postscript zoom-out to assess how fiscal policy is likely to be perceived by the central bank, including its Monetary Policy Committee.

The MPC since its inception in 2016 has witnessed six union budgets, including one interim budget. While the consolidated MPC voice on fiscal policy is rather euphemistically distant, few individual opinions within the MPC—as per the minutes of the meeting—have in the past highlighted the role of fiscal policy in demand-supply generation in the economy as well as its impact on inflation.

The Track Record

So, how has monetary policy performed under the MPC given the usual dominance of fiscal policy in India? At the outset, we acknowledge that since the MPC does not have a long history, any conclusion made would suffer from inadequate data bias. Nevertheless, it is instructive to note that between FY17 and FY19, the government remained close to the budgeted target with an average fiscal slippage of 0.1% of GDP. In this backdrop, the MPC was also able to remain close to the inflation target, with average CPI inflation turning out to be 0.2% below the medium-term target of 4% target during this period. However, FY20 saw the emergence of a sizeable fiscal slippage of 1.3% of GDP with a slowdown in the economy setting in prior to Covid-19 becoming a pandemic. Coincidentally, this also happened to be the time when the MPC saw the first sizeable deviation from the inflation target, with actual CPI inflation—led by food prices—turning out to be 4.8%.

Mint Street To North Block: ‘I Have Your Back’

Then came the pandemic with a never-seen-before disruptive impact on the economy. In this environment, we would refrain from making any inference between the trajectories of fiscal and monetary policy vis-à-vis the targets as the pandemic resulted in a temporary suspension of the exogenous rules-based framework in both the policy arenas. We wholeheartedly empathise with the policymakers as the pandemic warranted a ‘whatever it takes’ policy approach to mitigate the health, economic, and financial spillovers from Covid-19.

Departure And Return To Normal

In this context, the record fiscal slippage of 6.0% of GDP in FY21 (as per the revised estimates, FY21 fiscal deficit is now expected at 9.5% vs. the initial budget estimate of 3.5%) is likely to be looked through by other stakeholders, domestically as well as internationally. After all, the Covid-induced recession ensured that fiscal policy turned distinctly Keynesian at a global level. The slippage on inflation targeting front in FY21 has already been communicated by the MPC (with average CPI inflation estimated at 6.4% as per RBI’s forecasts), with the committee taking a persistent accommodative view on monetary policy, along with an accommodative stance on liquidity and regulatory forbearance from the central bank, since the beginning of the pandemic.

While India is expected to achieve its pre-Covid GDP by Q3FY22, the gradual economic normalisation process is currently underway (thanks to prompt policy interventions, peaking of Covid-19 infections, and prompt roll-out of vaccines), with few lead indicators of activity already attaining their pre-pandemic levels. Hence, FY22 is likely to witness a gradual policy transition towards re-establishing of the rules-based framework.

North Block’s Roadmap

In this context, the FY22 union budget has already made a beginning by projecting a record degree of fiscal consolidation (by 270 basis points) with a fiscal deficit target of 6.8% of GDP. At a headline level, this is likely to provide comfort to the MPC as it signals the government’s intent to get back on the path of calibrated fiscal consolidation. Digging deeper, the comfort on the fiscal policy strategy is likely to get stronger for the central bank, as:

  • Fiscal consolidation strategy in FY22 is expected to be led by compression in total expenditure to 15.6% of GDP from 17.7% in FY21.
  • Even as total expenditure is getting compressed in the coming year, the government has chosen to hike the outlay on capex to a 17-year high of 2.5% of GDP, which in turn implies a sharp reduction in revenue spending to 13.1% of GDP in FY22 from 15.5% in FY21. This capex push will be led by the transport sector, which is in line with the National Infrastructure Pipeline, and an important enabler in ease of doing business. Overall, this switch in expenditure pattern will boost the quality of fiscal adjustment and would augment the supply side of the economy in the medium run.
  • Qualitatively, the intent to augment financial sector capacity in asset quality resolution (via the proposed ‘bad bank’ type structure) and long-term debt financing for infrastructure (via the proposed Development Finance Institution) are commendable initiatives. The ARC structure and the strengthening of the IBC-NCLT framework would, hopefully, some of the concerns on asset quality raised by the RBI in its recent Financial Stability Report. Further, relaxation in FDI limit in insurance and the proposal to start diluting stake in public sector banks are equally important steps for financial market development.

In our opinion, the overall budgetary focus on reviving durable growth in an inflation neutral manner along with financial sector reforms should help the MPC members in continuing with their accommodative monetary policy stance in the upcoming policy review later this week, which further finds credence and support from the recent decline in inflation (to 4.59% as of Dec-20 vis-à-vis the 6.8% average during Jan-Nov 2020).

While that would be welcomed by market participants, the increase in market borrowing by Rs 80,000 crore in FY21 has spooked bond investors, with the 10-year yield up by 17-18 basis points since the announcement of the budget. Sentiment turned further cautious as the net borrowing estimate of Rs 9.2 lakh crore for FY22 turned out to be higher than the consensus expectation of Rs 8.0-8.5 lakh crore.

What This Means For Mint Street

We believe this calls for the central bank to continue with its yield management strategy via OMOs to curb the pressure on term premium (spread between bond yield and the monetary policy rate), which has shot up post Budget. In FY21 so far, the central bank absorbed around 26% of net government securities supply while its Operation Twist purchases managed to offset the adverse pressure on duration from the government’s debt switch operations. In FY22, the anticipation of a V-shaped economic recovery will manifest in higher credit offtake from banks, which could, in turn, reduce their appetite for the absorption of fresh large g-sec supply given the overhang of comfortable excess SLR holding (especially by public sector banks).


  • The RBI would need to fill the demand-supply gap in the g-sec market with a similar aggressive operation as in FY21 with proper communication to market participants. This would help in lowering the upside in yields and turning it in sync with the accommodative policy stance.
  • In addition, the government (as stated by Finance Ministry officials in their post-budget press conference) could also explore India’s entry into global bond indices after codifying long term fiscal discipline with revision in the FRBM Act. This should attract demand from debt FPIs, who have avoided India for three years in a row.

As we move into H2FY22, greater clarity would emerge on the growth-inflation-fisc situation amidst vaccination drive reaching some minimum level of critical mass. This hopefully would allow the RBI to start the process of monetary policy normalisation by re-adjusting the LAF corridor to 25 basis points from the existing spread of 65 basis points, by gradually hiking reverse repo rate while keeping repo rate unchanged at 4.00%. If key economic variables move along the anticipated trajectory, the central bank would also opt for an eventual hike in the repo rate, but that’s not before the presentation of the next union budget in February 2022.

Vivek Kumar is Economist, Yuvika Singhal is Economist, and Shubhada Rao is Founder, at QuantEco Research.

The views expressed here are those of the authors and do not necessarily represent the views of BloombergQuint or its editorial team.

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