The task of MOF

Business Standard, 28 May 2017

The Indian macroeconomy is unstable. We lurch from one crisis to the next. This has far reaching implications for the economy, ranging across issues such as investment to corporate finance to planning for old age. The prime task of the Ministry of Finance is the fiscal, financial and monetary institution building that will create macroeconomic stability. We need to reinvigorate the Ministry of Finance with this sense of purpose, and build capacity there for its prime task.

Private sector confidence is weak

The essence of the progress of a country is private investment. The most important problem of the Indian economy is the retreat of private investment. As the graph shows, private projects under implementation, as measured in the CMIE Capex database, peaked at Rs.53 trillion in 2011. This has steadily declined to Rs.42 trillion in 2017. In this period, private `announced' projects dropped from Rs.43 trillion to Rs.26 trillion. These values are in nominal terms. The declines (-21% and -40%) would be worse by roughly 25 percentage points if we took inflation into account.

Private persons build for the long term through tangible investments projects. Even more important is the quiet process of sacrificing the short term to build organisational capital. Every firm faces tradeoffs between making profit right now versus building capabilities of the organisation. Investing in organisational capability gives higher output from the same capital and labour. It is likely that such thinking has also shifted in favour of short-termism in recent years. This harms productivity growth.

What has gone wrong? One important element that has gone wrong is the excessive level of macroeconomic drama.

The boom and bust of the last 17 years

Let's look at our recent memory, from 2000 onwards:

  1. We started with the IT bust and the Ketan Parekh scandal.
  2. There was a banking crisis, and firms such as UTI and IFCI collapsed.
  3. Then came the 9/11 attacks and a period of global uncertainty.
  4. Then came a remarkable boom from 2002 to 2008 - the biggest ever business cycle expansion in India's history.
  5. But within this, on 17 May 2004, when the UPA won the election, we had a stock market collapse.
  6. Then came the Lehman crisis in which India was badly affected.
  7. In 2013, MOF and RBI mounted a defence of the rupee, raising rates by 400 basis points, which helped the BJP win in 2014.
  8. Then we got demonetisation, a major macroeconomic shock.
  9. From 2009 onwards, we have been hiding a big banking crisis.
  10. Along the way there were smaller crises like NSEL, Satyam, and Andhra Pradesh's ban on microfinance.

I have just enumerated 10 macroeconomic events and 3 smaller events in a period of 17 years. As a thumb-rule, I think that India goes through one dramatic macroeconomic event every one to two years. This level of drama is a problem.

Why macroeconomic volatility matters

Private persons are constantly tugged between the short-term and the long-term. The future is uncertain and investing is risky. The risks about the future come in two parts. On one hand is the micro-economic risk: the risks associated with one firm and one industry. But the second part is macro-economic risk: the risks associated with the entire economy. With our track-record of one big mess every one or two years, the macro-economic environment is daunting. This encourages people to be cautious.

Corporate finance has to plan for this rough environment. In an environment of recurrent crisis, it is safer to have more equity capital. This drives up the cost of capital, so certain projects become unviable and are not undertaken. This goes beyond firms to households. Macro stability shapes the behaviour of households on savings, choice of assets, and planning for old age. A household in the UK is certain that CPI inflation in the next 100 years will average 2%. This is not the case in India.

Institution building for macro stability

Why do we suffer from macro instability? The problem lies in our institutional arrangements for fiscal, financial and monetary policy. Most of the institutional infrastructure around us dates back to the time when India had a $200 billion GDP and was a closed economy. The country has been transformed - we have become a much more open economy and GDP has gone up by 10 times. But our institutional infrastructure is largely unchanged. We are like a teenager who has grown limbs but lacks the mental capacity to control them. Some shocks come from outside (e.g. the Lehman shock). But our weak institutions imply that we fumble and mis-handle them..

In fiscal policy, what is required is prudence on deficits and debts, and sound methods of borrowing. In financial policy, what is required is micro-prudential regulation of financial firms, a resolution corporation which shuts down weak financial firms, systemic risk regulation and good sense in capital controls. In monetary policy, what is required is an RBI that has one objective: to stabilise CPI inflation at 4%. Our present institutional infrastructure is faulty on all these fronts. These reforms require a group of properly working financial agencies such as RBI, SEBI or PDMA, that stand outside the Ministry of Finance, and they require a restructured Ministry of Finance with new capabilities.

There is sometimes a temptation to comparmentalise the three wings of macro/finance policy (fiscal, financial and monetary). But there are rich inter-connections between all three. The Ministry of Finance must see all the moving parts of this machinery, and plan out the day-to-day tactical moves that take us to the full design.

Institution building for macro stability: This is the task of the Ministry of Finance. It has to plan out this full institutional landscape, and execute the required transformation. Once the transformation is complete, it can operate the levers of the system as is done by the treasuries of mature market economies, but that is many years away. The prime function of the Ministry of Finance today is institution-building on fiscal, financial and monetary policy. This runs from the high decibel political battles all the way to sound technical teams that will obsess on implementation.

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