The Indian press is getting the implications of the Indian interest rate rise wrong here. They’re saying that it poses a danger to Narendra Modi’s budget plans. That’s really not the way to think of an independent central bank raising the nation’s short term interest rates, not the way at all. India’s budget deficit is 3.3% at present, not something that it will have difficulty financing. Quite the opposite in fact, rising interest rates means the technocrats think the economy is booming. This isn’t bad for budget plans, not at all.
The rate increase, the first in more than four years, is likely to be followed by one or two more this year, economists predict, pushing up overall borrowing costs for the government and companies alike.
Higher interest rates are likely to make it tougher for the government to borrow from the market and hurt a recent pick-up in the economy, while dampening revenue collection and burning a bigger hole in the government’s fiscal deficit than the budgeted target of 3.3 percent of gross domestic product.
All of that could even be true in detail but it’s not how the net effect will work out.
“The rate hike will push up the government’s interest financing cost and add to the fiscal deficit pressure on one hand,” said Soumya Kanti Ghosh, chief economist at State Bank of India. “And on the other hand, the nascent recovery in growth on the back of consumption demand will also slow down as retail lending rates will go up sooner than later.”
Again that’s to miss the important point here.
Why has the RBI raised interest rates? Because the economy is growing faster than it thought it would. That’s what is pushing up against the capacity restraints of the economy and thus stoking inflation. It isn’t because of imported inflation as a result of oil price rises etc. Because interest rates don’t attack that form of inflation and yes, the RBI is a good enough central bank to know this.
We need to add one thing here. The government’s tax take is highly geared with respect to economic growth. More growth than planned means much more revenue than planned.
Think it through. For near every tax out there there is a tax free amount, an allowance for income tax, you only register for GST over a certain turnover and so on. More growth means more business will go through that registration limit, more growth means more incomes exhaust that allowance, even the lower income tax rates. The net effect of this is that 1% economic growth produces more than a 1% rise in tax revenues.
Say, just to invent numbers, that the Indian central government gains 15% of GDP in tax revenues. And they had planned for 5% growth but the out turn is 10%. They do not gain just that 15% of the extra GDP growth. Tax revenue doesn’t go up by 15% of 5%. Because of the gearing tax revenue goes up by more than the economic growth. Tax revenue will rise as a percentage of GDP, not just with GDP. Again, to invent, extra growth will lead to revenues being, say, 16% of GDP not 15%. And it’s 16% of that higher GDP too. Which makes a very nice indeed dent in a 3.5% of GDP budget deficit, doesn’t it?
We can see the proof of this in post-2007 Europe. When economies shrank by 8 and 10%, government revenue didn’t fall by 8-10% but by very much more than that. Because the gearing works in both directions.
The RBI has raised interest rates because they think growth – even if only nominal growth – is going to be higher than currently planned. That’s good news for tax revenue as revenue is geared with respect to economic growth. The extra income from the higher growth will be higher than the effect of higher borrowing costs upon government debt. That is, an excess growth driven interest rate rise frees the government budget from pressure, not causes it.
And that’s before we even consider the effect that inflation caused fiscal drag has on raising tax revenues.