Budget not crucial for monetary policy : Business Line 9th March 2016

That’s because interest rates are aligned to inflation rather than fiscal deficit, and the Centre’s borrowings seem stable

March 8, 2016:  

It is a healthy practice that advice is passed on from the Ministry of Finance (MoF) to Reserve Bank of India (RBI) and vice versa; it means that the two arms of policy are talking to one another.

Such discussion should not be construed as being intrusive. However, the more pertinent issue is the policy significance of the Budget, or rather government borrowing and fiscal deficit targets, for setting monetary policy.

An inflation targeting monetary policy, which revolves around consumer price inflation, lends added importance to the question. The Budget has also formally spoken of the monetary policy committee to be set up, which will ostensibly be guided by the same objective.

Of course, CPI is said to be driven by food prices, which are not within the purview of government deficits.

Little inflationary impact

So far, there has been limited demand side inflation emanating from the government side. In fact, when subsidies were high they provided insulation from inflation to an extent. Pay Commission hikes in the past have been beneficial for consumer durables and auto segments – but could not really have been linked with inflation.

In fact, if the Pay Commission impact of ₹1.1 lakh crore is to be broken down, it appears that about ₹70,000-80,000 crore would have been provided this time. Of this 20-25 per cent would flow back to the government as tax revenue, while another 30 per cent would be saved.

Hence, only half of the incremental amount would be spent in industries where demand conditions are low. Higher demand will only help these companies in a non-inflationary manner.

The other reason for analysing the Budget from a monetary policy viewpoint could be to make an assessment of future liquidity, especially if the borrowing programme is large. The government has ensured that the borrowing this year will be around ₹4.25 lakh crore. But here it is not exactly monetary policy action (or rates) that matters, as much support during the year is through OMOs (open market operations) by the RBI, based on immediate conditions of liquidity shortage.

Interest rates and fiscal deficit

Recent experience shows that governments evolve different ways of containing the fiscal deficit. How critical is this number for the RBI?

The table gives the revealed nature of monetary policy behaviour. The fiscal deficit ratio has been coming down since FY13 but the repo rate has been aligned more to inflation.

In FY11 when the deficit decreased, interest rates were increased as inflation remained high at above 10 per cent. This means that the fiscal deficit ratio per se may not be very pertinent.

The level of net borrowings has remained broadly range bound at ₹4.3-4.7 lakh crore in the last five years and hence has not come in the way of monetary policy. In two years, FY12 and FY15, interest rate action was aligned with the quantum of change in borrowings, while it was opposite for the other four years.

The RBI response to liquidity conditions through OMOs has not been linked with the net borrowings in the system and is more of a reaction to the prevailing conditions.

Therefore, whether we target a 3.7 per cent or 3.5 per cent deficit target for 2016-17, the net borrowings will be budgeted in the same range as there will always be other income streams like disinvestment to balance the same.

Importance of Budget

Further, inflation targeting is the dictum to be pursued, where price shocks have emanated primarily from the food side. Now, with global commodity prices being low, in the current context, decisions can be made without worrying about demand pull inflation. Liquidity, however, will be a concern especially if private demand picks up. But then one can never be sure if this will happen and the OMOs have to be used based on prevailing conditions.

Hence, it is possible to argue that the budgetary outcomes are not really be very pertinent from the point of view of monetary policy action.

However, the content of the Budget is of relevance for the central bank to take a view on the state of economy and its prospects. The two can proceed quite independently and there can be little reason for one to wait for the other.