Is it time to recast India’s fiscal and monetary policy frameworks?

With the onset of the Coronavirus disease (COVID-19) pandemic, a number of macro parameters of the Indian economy have been thrown out of gear. The fiscal deficit on the combined account of centre and state governments in 2020-21 may increase to 11-12% of estimated GDP. Consequently, the combined debt-GDP ratio of the central and state government may reach close to 81% of GDP at the end of 2020-21, more than 20% points above the targeted threshold of 60% as per centre’s 2018 amendment to the Fiscal Responsibility and Budget Management Act (FRBMA). The CPI inflation rate breached the upper tolerance limit of the monetary policy framework (MPF) in the last quarter of 2019-20 and the first quarter of 2020-21. In fact, India’s economic crisis predates the pandemic. The infirmities of the FRBMA and the MPF had already started becoming visible with 2019-20 real and nominal GDP growth rates plummeting to 4.2% and 7.2% respectively. It is high time that we consider recasting India’s fiscal and monetary policy frameworks. In this article, we review these frameworks, identify their inconsistencies, and consider remedial changes so as to serve India’ future needs and compulsions.


Introduction
The combined fiscal deficit of central and state governments may turn out to be in the range of 11-12% of GDP 1 in 2020-21 leading to a sharp upsurge in the debt-GDP ratio. This will lead to a significant departure from the target debt-GDP ratio of 60% for the combined government as per the centre's 2018 amendment to the Fiscal Responsibility and Budget Management Act (FRBMA). The CPI inflation rate has also breached the upper tolerance limit of 6% in the last quarter of 2019-20 and the first quarter of 2020-21. In July 2020, the CPI inflation rate was 6.9%. While the immediate impact is that of COVID, even prior to the pandemic, India's macroeconomic parameters were slipping with real and nominal GDP growth falling well below desired levels in 2019-20 at 4.2% and 7.2% respectively. In the light of the current challenges and India's future needs, it is an opportune time to review and recast India's macro policy frameworks consisting of fiscal and monetary policies.
After the introductory section 1, section 2 deals with the key features of the fiscal policy framework as it evolved from 2003 onwards and as it stands presently after the 2018 amendment. This section highlights the impact of centre's FRBMA and some of its internal inconsistencies particularly after the 2018 amendment. Section 3 undertakes a review of India's MPF which took shape in 2015. This section highlights India's inflation experience after the adoption of the MPF and its implications for nominal growth. Section 4 follows up by providing a review of India's growth experience in real and nominal terms including an analysis of the structural and cyclical reasons underlying the fall in trend growth as also a very sharp fall in actual growth in recent years respectively. Section 5 discusses the coordination issues between monetary and fiscal policy frameworks including some inbuilt inconsistencies in their implicit assumptions. Section 6 then provides the relevant considerations for modifying fiscal and monetary policy frameworks individually while keeping in mind mutual consistency and coordination issues. Section 7 provides a summary and concluding observations.

Fiscal policy framework: evolution and key features
The In the 2003 FRBMA read with its Rules, centre's fiscal deficit to GDP ratio was targeted at 3% and the revenue account was to be kept in balance or in surplus. The 2018 amendment changed the target variable to debt-GDP ratio and used the fiscal deficit-GDP ratio only as an operational target. The objective of revenue account balance was given up. For the combined account of centre and state governments, the debt-GDP ratio target was kept at 60% with centre's share at 40% and states' share at 20%. The central government was given a countercyclical role with a flexibility of 0.5% points of GDP in its fiscal deficit-GDP ratio subject to certain conditions and rules.
The state governments had enacted their FRLs individually following the guidance given by the Twelfth Finance Commission (12 FC). Although some of them amended their respective FRLs from time to time, their basic features remained the same while changing the target dates. Some of the important features of the state FRLs related to limiting the fiscal deficit to GSDP ratio to 3% and keeping the revenue account in balance if not in surplus. The 12 FC had given an indicative benchmark of 28% as the debt-GSDP target for states. Correspondingly, the benchmark value for interest payment to revenue receipts was provided at 15% i . Even though the central government amended its FRBMA in 2018, the state governments did not bring about corresponding changes in their respective FRLs which would have required reducing their individual debt-GSDP ratios to 20%.

Trends in fiscal imbalance of Centre and states
Chart 1 shows the fiscal deficit of centre and states during the period 2000-01 to 2019-20. In the case of centre, there was some initial success with centre's fiscal deficit falling to 2.6% of GDP in 2007-08, the only year in which it was below the FRBM target of 3% of GDP. Fiscal deficit relative to GDP sharply rose to 6.1% and 6.6% in 2008-09 and 2009-10 respectively partly in response to the 2008 global economic and financial crisis. After that, although there was a steady reduction, it could not be brought down to the targeted level. Instead, the central government resorted to postponing the target dates. In 2019-20, centre's fiscal deficit increased to 4.6% of GDP. In 2020-21, it is expected to rise to a range of 6-7% of estimated GDP 2 . States, considered together, have been more successful in keeping their fiscal deficit below 3% of GDP. After 2004-05, there are three years namely, 2009-10, 2015-16, and 2016-17 in which states' combined fiscal deficit was above 3% of GDP.

Impact of slippage in fiscal deficit on the debt-GDP ratio
The debt-GDP ratio at the end of a fiscal year depends on three factors: (a) level of fiscal deficit in the current year ( ), (b) debt-GDP ratio of the previous year ( − ), and (c) nominal growth rate of the current year ( ). The increase in debt-GDP ratio between two successive years ( − − ) would be higher if (i) the current fiscal deficit is higher, (ii) the current nominal growth rate is lower, and (iii) the previous year's debt-GDP ratio is lower. The relevant relationship is given below with variables defined as above.
Accordingly, in Table 1

Infirmities in the fiscal policy framework
The combined debt-GDP ratio is estimated to rise by nearly 3% points in 2019-20 and 9% points in 2020-21. This cumulated increase of nearly 12% points would render the 2018 amendment completely out of alignment. In fact, the 2018 FRBMA has a number of other infirmities as discussed below: 1. Elimination of revenue deficit target: Maintaining balance or surplus on revenue account is critical since it is linked to government sector dissavings ii . For realizing India's potential growth, it is critical to maximize the savings rate. One important instrument for this is to maintain government's revenue account in balance or in surplus. This was also the primary objective of centre's 2003 FRBMA. The objective of maintaining a revenue account balance has been given up in the 2018 amendment to the Centre's FRBMA.

Inconsistent targets for debt and deficit for centre and states:
It can be seen that maintaining a fiscal deficit target of 3% of GDP for both centre and states is inconsistent with targeting debt-GDP ratio at 40% for centre and 20% for states. Simulations indicate that they should both be equal if the fiscal deficit targets are equal. Charts 3 and 4 show that they would converge to an equal level if fiscal deficit to GDP ratios are equal and the nominal growth rate is common. In this example, the nominal annual growth rate is assumed to be 12% and fiscal deficit is assumed at 3% of GDP each for the centre and states. 'structural reforms' and the magnitude of actual departure became much larger than 0.5% points of GDP 3 . Further, in a pandemic kind of situation also, the magnitude of permitted departure proved to be too inadequate.

Monetary policy framework
Monetary policy in India has evolved from a multiple indicator approach and a focus on WPI inflation to a regime of flexible inflation targeting and focus on CPI inflation. have much influence on IPD-based inflation. IPD-based inflation has an important bearing on nominal GDP growth (Chart 6).

Chart 5: CPI inflation Chart 6: IPD based inflation and nominal GDP growth
Source (basic data): MOSPI

Policy anchor: relative merits of alternative inflation measures
There are three main measures of inflation available in India namely CPI, WPI and the implicit GDP deflator. The GDP deflator is available only at quarterly and annual frequencies. A new CPI series became available in January 2011. Historically, the WPI has been maintained on a consistent basis for the longest period of time in India but has been considered inadequate for policy guidance since it does not include services and does not reflect prices that consumers actually pay. For policy guidance, many countries use CPI inflation rate as an anchor. Sometimes, using core CPI inflation which excludes food and fuel prices is considered to be better since these two are determined largely by exogenous factors.
Even if CPI is chosen as the policy anchor for inflation, it is important to keep in mind its relationship with the IPD-based inflation as this has a bearing on tax revenue growth and therefore on the fiscal side of the economy.

Reviewing growth experience in India: real and nominal
One key macro policy objective is to ensure that the actual growth in the economy remains close to its potential growth (Rangarajan and Srivastava, 2017). While there are a number of methods for measuring potential growth, it is often captured by estimating the trend growth rate over a longer period of time which is estimated in a manner such that cyclical movements are ironed out. For this purpose, we consider the 2011-12 base GDP series.

Analyzing movement of IPD-based inflation
A link is provided between the monetary policy framework and the fiscal policy framework through the profile of IPD-based inflation. The monetary authorities manage the CPI inflation and by implication also manage the IPD-based inflation. This has a bearing on GDP in nominal terms which determines tax revenue growth, which in turn critically affects the fiscal space. If tax revenue growth falls unduly, it will affect the public sector saving rate by adversely affecting government's revenue deficit. It will also force the public authorities to borrow more and thereby affect the fiscal deficit. Thus, fiscal and monetary policy decisions must be coordinated for optimum results. This coordination is discussed in the next section.

Issues of coordination between monetary and fiscal policy frameworks
There are notable inconsistencies between implicit growth and inflation targets in major macro policy decisions which were taken roughly around the same time. In the case of fiscal policy decisions, two implicit assumptions regarding nominal GDP growth are important. First, with respect to GST which was implemented on 1 July 2017, the states were guaranteed a growth of 14% in nominal terms in their share of GST revenues. This guarantee was implemented through the mechanism of the compensation cess. A 14% growth in GST revenues assumes a combination of GST buoyancy and nominal GDP growth. The higher the buoyancy, the lower would be the implicit assumption of nominal GDP growth.
It would be reasonable to assume that at the time of transition to a revenue neutral GST, a buoyancy Second, for stabilizing the combined debt to GDP ratio at 60% with a 6% combined fiscal deficit-GDP target as per 2018 amendment to the centre's FRBMA, the implicit nominal GDP growth rate works out to be nearly 11% (see Table 2). In fact, the FRBM Review Committee mentioned a target growth rate of 11.5%. These growth assumptions turned out to be much higher than the nominal GDP growth outcome driven by the MPF. As discussed earlier, the MPF targeted a CPI inflation at 4%. We note that the IPD based inflation during 2014-15 to 2019-20 was below the CPI inflation by 1.2% points on average. This implies that a CPI inflation target of 4% was associated with an IPD based inflation of Thus, there is a built-in inconsistency between the two macro policy frameworks. The outcome of this independent pursuit of two macro policy frameworks was that the monetary policy pursuits kept driving the nominal GDP growth down, thereby reducing government's fiscal space which is dependent on tax buoyancy and nominal GDP growth. This led to persistent upward pressures on the fiscal deficit thereby making the central government miss its target of 3% year after year. The GST revenues also fell well short of the implicit growth of 14%. There is thus a clear need for removing the inconsistency between the two macro policy frameworks.

Fiscal policy framework
The centre's FRBMA has been thrown out of gear because at the end of 2020-21, the policy anchor namely, the combined debt-GDP ratio is likely to be close to 81%, more than 20% points higher than its target value of 60%. Given the history of correction in the debt-GDP ratio, bringing it down from 81% to 60% may prove to be extremely unrealistic. The average annual rate of change in the combined debt-GDP ratio over the period from 1990-91 to 2019-20 is close to 0 (0.030% points) with some patches where inter-year variations were relatively larger. This historical experience shows that achieving a reduction of more than 20% points is highly unlikely. It may be more appropriate to recast the FRBMA particularly in view of the need for the central government to play a more active role in uplifting investment and growth.
There is a case to consider asymmetric debt-GDP targets for the centre vis-à-vis. the states. In fact, the central government may be given a higher target in view of (a) its higher current debt-GDP levels, (b) its relatively more important macro stabilization role, and (c) its pivotal role in building defence and non-defence infrastructure under the current circumstances faced by India.

Deriving sustainable debt and deficit combinations relative to GDP with respect to simulated growth rates
Sustainable levels of debt and fiscal deficit ( * * ) can be derived as pairs with respect to a given level of nominal GDP growth rate ( ). This relationship is given in equation (1) below. For detailed derivation, see Rangarajan and Srivastava (2005). Here, by sustainability, it is indicated that if a given target nominal growth rate is achieved, and fiscal deficit is maintained at the level given in equation (1) year after year, debt can be maintained at a stable level, year after year. In this sense, debt-GDP ratio can be considered as sustainable. * = * (1 + ) (1) In  It would be useful to work out the adjustment path to reach this level from the expected peak level of debt-GDP ratio at the end of 2022-23. Another important change that is required in centre's FRBMA relates to the strategy for dealing with countercyclical interventions.

Distinguishing between agricultural and non-agricultural cycles
In this section, we consider the desirability of developing countercyclical policy instruments which are different for dealing with agricultural vis-à-vis. non-agricultural cycles.
In spite of cumulated investment in irrigation across India, Indian agriculture remains heavily dependent on monsoon and therefore, the cycles that get generated linked to the cyclicality of the rainfall relative to its long period average. This cyclicality is regular in terms of its periodicity, broadly comparable in terms of the related cyclical amplitudes, and its impact on agricultural output and incomes as well as the overall economy. There are two major countercyclical instruments which can be embedded in the FRBMA. One is to establish a stabilization fund iii from which governments may withdraw in slowdowns while replenishing the fund in expansionary phases. The other instrument is to allow a flexibility in the fiscal deficit limit in relation to its target value, borrowing more than average in slowdowns and less than average in expansionary phases. It may be useful to utilize both instruments in India's case. A stabilization fundbased approach may be effective for tackling agricultural cycles. Further, since agriculture is a state subject and often agricultural droughts tend to be state-specific, states may be given the facility to draw from the fund which should be established and managed by the central government so that discipline is maintained. For the non-agricultural cycle, a flexibility of about 1% point of GDP in the fiscal deficit may be provided for the central government. In macro stabilization literature, countercyclical policy is the main responsibility of the central government. However, these instruments are meant for regular and periodic agricultural and non-agricultural cycles. This framework would break down in the case of structural breaks such as a pandemic or a war. In these exceptional circumstances, it may be better to have an institutional framework which can devise appropriate methods for dealing with such situations requiring coordination between central and state governments as well as fiscal and monetary authorities.

Ensuring consistency with saving investment profiles
For the fiscal framework, the internally consistent target real GDP growth rate is set at its potential level of 8%. This would require an investment of about 36% of GDP, which may be financed by domestic savings of 33.5% of GDP and net capital inflow of 2.5% of GDP which is consistent with a corresponding sustainable level of current account deficit (CAD). The domestic saving rate of 33.5% requires uplifting the current rate of about 29% by more than 4% points. This is to be brought about mainly by eliminating revenue deficits of the central and state governments and by marginally uplifting savings of household and private corporate sectors together by margins of 0.5-1% point of GDP.

Modifying Monetary policy framework
The monetary policy framework is due for a review every five years. Thus, it should be reviewed in March 2021. In view of the earlier discussion, the following changes in the monetary policy framework may be considered: 1. The RBI may continue with CPI inflation as the target variable.
2. The average targeted CPI inflation rate may be kept at 5% with a tolerance range of +/-2%, so that the IPD based inflation is targeted at 4% on average. Council (or Fiscal Council) may prove to be quite effective.

Coordination issues: role of Macro Policy Coordination Council
There are important coordination issues in managing fiscal and monetary policy frameworks. This is a highly specialized task requiring periodic monitoring, and informing the policymakers both on the for the states. Correspondingly, the fiscal deficit targets should be 7% for the combined government with 4% for the centre and 3% for the states.

Summary and concluding observations
We have reviewed India's monetary and fiscal policy frameworks which have guided policymaking during the last five years. We have noted that there are certain infirmities and inconsistencies in these policy frameworks. Further, there has been a lack of coordination between the pursuits of fiscal and monetary authorities to ensure desirable growth and inflation outcomes. In fact, there is an inconsistency in their implicit assumptions. In view of these observations, it may be useful to recast these frameworks for which the following may be considered.

a. Fiscal framework
1. The 2018 version of FRBMA should be re-amended.
2. The new FRBMA should bring back revenue account balance as a key target for both central and state governments.
3. There is a case to consider the need for introducing asymmetric targets for fiscal deficit and correspondingly for debt relative to GDP for the central government vis-à-vis. the state governments. Centre's fiscal deficit and debt may be kept at somewhat higher levels in the current circumstances of the Indian economy given the macro stabilizing role that the centre undertakes and the need to build infrastructure in the next five years or so. We may consider a combination of 40% of debt-GDP ratio and 4% of fiscal deficit to GDP ratio for the centre and 30% of debt-GDP ratio and 3% of fiscal deficit-GDP ratio for the states considered together ( 3. The target variable may continue to be CPI. 4. The target CPI inflation rate may be kept at 5% on average with a tolerance range of +/-2% points. This would be consistent with an IPD based inflation rate of 4% on average ( Table 4).

A Macro Policy Coordination
Council should be established. It may serve a number of objectives but the most important would be to provide a framework in which monetary and fiscal policy decisions are coordinated. It may also deal with instances of structural breaks caused by extraordinary exogenous events such as a pandemic or a war. Growth and inflation targets should be defined for both of these frameworks in a mutually consistent way.

The Macro Policy Coordination
Council may aim at a potential real GDP growth rate of 8%, a nominal GDP growth in the range of 11-12%, and CPI based inflation of 5% 5 with a flexibility of +/-2% or equivalently, an IPD based inflation of 4% with a flexibility of +/-2%. The combined debt-GDP target should be 70% with 40% for the centre and 30% for the states. 4 In fact, the amended RBI Act of 1934 provides that the primary objective of monetary policy is to maintain price stability while keeping in mind the objective of growth 5 There has been a discussion around determining a suitable threshold level of inflation for India which may be close to 5%. Correspondingly, the fiscal deficit targets should be 7% for the combined government with 4% for the centre and 3% for states.
These suggestions are summarized in Tables 3 and 4 below.

Concluding observations
The economic impact of the COVID-19 pandemic and economic trends preceding it have highlighted certain infirmities and inconsistencies in India's macro policy frameworks as consisting of fiscal and monetary policy frameworks. These need to be recast and supplemented with an institutional framework such as the setting up of a Macro Policy Coordination Council which can coordinate between monetary and fiscal authorities. This is also needed considering India's contemporary economic challenges in the backdrop of the evolving global situation. In this paper, it is demonstrated that with marginal changes in the fiscal and monetary policy frameworks, India can aspire to achieve and sustain a real GDP growth of 8% while keeping CPI inflation close to 5%.