Rollback of Stimulus: A Risk or need?

“The good news is that we may be at the end of a free fall. The rate of economic decline has slowed. The bottom may be near – perhaps by the end of the year. But that does not mean that the global economy is set for a robust recovery any time soon. Hitting bottom is no reason to abandon the strong measures that have been taken to revive the global economy”.-Joseph Stiglitz (in “Stimulate or Die” dated 8 Dec 2009)
Economics defines business cycles as economy-wide fluctuations in production or economic activity over several months or years. It includes periods of rapid growth and those of relative stagnation as well. The world economy is on a revival path from the huge contraction that it suffered due to the subprime crisis. As the credit crunch gripped the entire financial system, the central banks moved in unison to avert further deepening of the recession by injecting liquidity into the system. These stimulus packages have provided crutches to the crippled world economy. But these crutches come with a caveat , the longer that you hold on to these crutches the more you get used to them and the lesser become your chances of standing up on your own. This analogy applies to the stimulus packages as well. The government needs to return to a path of fiscal consolidation to avert dire circumstances like hyperinflation which have the potential to ruin a perfectly healthy economy.

Stimulus Packages across nations

The size of stimulus has varied significantly across nations. Including the measures undertaken in 2008, the U.S. stimulus is largest (a cumulative 4.8 percent of GDP during 2008–10), while Italy and India are at the lower end of the spectrum. Two sets of factors help explain the relative size of stimulus packages: (i) differences across countries in the need for stimulus; and (ii) differences in fiscal space. Source: IMF database & 2010 forecast
Countries in which the automatic stabilizers are larger need smaller discretionary stimulus. Government size is a proxy for the impact of automatic stabilizers and is smaller in China, India, the U.S., Canada, and Japan, and it is negatively related to the fiscal stimulus.

Growth impacts and needs

Stimulus efforts, together with the impact of the automatic stabilizers, provide an important boost to growth and help forestall a negative downward spiral. According to IMF Preliminary staff estimate, fiscal policy may have contributed 2–2½ % points to PPP-weighted growth of the nine countries in 2008 and may provide 2–2¼ % points in 2009 and ¼–½ % points in 2010.The decreasing impact of fiscal stimulus is indication for the rollback of stimulus worldwide.

A rollback of stimulus is necessary to bring the economy back to its natural growth path. This artificial growth is not sustainable in the long run and needs to be dealt with on priority. The global markets are upbeat on the magical carpet of the stimulus packages, but the real test for these economies would be when they would be left all alone ,high and dry, in mid air. The action plan should now involve a gradual and judicious withdrawal of the stimulus package as any sort of misconceived notion of a V shaped recovery will be disastrous to say the least. The central banks need to work on their strategies to maneuver themselves on this tight rope with the help of an effective monetary policy.

Risk Analysis

The systemic risks have been substantially reduced following unprecedented policy actions and nascent signs of improvement in the economy. Even with the momentum significant risks remain. These are as follows:
• The recovery is driven largely by government spending in many economies
• Commodity and asset prices have risen aided by high levels of global liquidity
• Emerging market economies which are generally recovering faster than advanced economies, are likely to face increased inflationary pressures
• Uncertainty about the pace and shape of the global recovery
• The surge in oil prices, if global recovery is stronger than expected
• Sharp increase in capital flows, above the absorptive capacity of the economy, which may complicate exchange rate and monetary management
• Large fiscal deficits command a bigger risk to both short-term and to medium-term economic prospects

Global Scenario

Last five year the world has seen a dramatic downside in term of negative growth in their domestic products. All the major economies except China and India have undergone contraction varying from -2.5% (France) to -10.2 % (Brazil) during 2009, as evident from the chart.


The IMF says that, led by China, the world economy is bouncing back strongly from its 2009 decline. US growth is projected to reach 2.7% this year, a nice rebound from last year's 2.5% decline. The IMF, in its latest financial stability report, says there is an urgent need for more regulation of financial institutions.

This entire fiscal stimulus comes at the price of greatly expanded debt. The Congressional Budget Office this week said the US deficit will for the second straight year exceed $1 trillion, an amount equal to about 10% of GDP. This explosive volume of debt will at some point have to be halted and rolled back. But, says the IMF, not yet. The exit from stimulus towards fiscal balance should come only when there is a tangible pickup in consumption, investment and exports. Unfortunately none of these elements are yet present.

Indian Scenario

The economy is steadily gaining momentum, though public expenditure continues to play a dominant role, and performance across sectors is uneven, suggesting that recovery is yet to become sufficiently broad-based. The baseline projection for GDP growth for 2009-10 is now raised to 7.5 per cent.
The Industrial Growth in India has been significant with 7.6% growth rate up to 3rd Q and 11.7% in November but the closest indicator of Industrial growth, bank credit has not exhibited a parallel picture. Growth in Bank credit is sluggish at 8.8% for the first 3 Q of year as against 12.5% last year. This can be due to either low demand of funds from industry or the banks are not lending easily.
Industrial Growth has been high at 6.3% but according to a recent study of 1752 manufacturing firms, done by RBI, financial performance of these firms has declined by -1.6% while net profit were up by 9.6%.This happened mainly due to sharp cut of 9.3 % in raw material cost. The import of capital goods and raw material usually increases during industrial growth but this is yet not visible and it has been negative for November. The fourth indicator of state of industry is the movement in price. Growths of manufacturing industry prices are still low at 5%.

Conclusion

There is a need for a prudently planned exit from the fiscal stimulus. A phased rollback of the stimulus is essential to maintain a balance between delivering sustainable growth and stabilizing the economy. A hastily worked out stimulus could end up being disastrous and counter-productive for the industry. There also needs to be greater coordination between fiscal and monetary exits to avoid conflicting results between them. We need to understand that we are not out of the woods yet and that the darkness might prevail for a longer time tha