Taking Stock of the Indian Economy with Prachi Mishra

SHRUTI RAJAGOPALAN: Welcome to Ideas of India, where we examine the academic ideas that can propel India forward. My name is Shruti Rajagopalan, and I am a senior research fellow at the Mercatus Center at George Mason University. 

Today my guest is Prachi Mishra, who is a Professor in the Department of Economics, and Director and Head of Isaac Center for Public Policy at Ashoka University. Prior to joining Ashoka, Prachi was Chief of the Systemic Issues Division and Advisor in the Research Department at the International Monetary Fund. We spoke about the current state of the Indian economy, India’s growth trajectory, if the rupee is overvalued, India’s fiscal consolidation, and much more. We also spoke about Trade, but this episode was recorded before the big tariff announcements on April 2.  

For a full transcript of this conversation, including helpful links of all the references mentioned, click the link in the show notes or visit mercatus.org/podcasts.

Hi, Prachi. Welcome to the show. It’s such a pleasure to have you here.

PRACHI MISHRA: Pleasure to be here, Shruti.

Current State of India’s Economy

RAJAGOPALAN: I want to start by asking you to paint a picture for us about the current state of the Indian economy. There’s the broader issue of structural transformation and where India is on that trajectory, and also where India is in the current business cycle. I don’t even know what the current business cycle is. I don’t know if it’s post-COVID or post-Trump, but we’re recording this early April 2025. If you can set the stage for us, I think that would be super helpful for the listeners.

MISHRA: Sure. Shruti, if you want to assess India’s current economic landscape, I think it’s very useful to begin with some fundamental technical considerations regarding how we measure and how we interpret economic performance. As you rightly said, we have to distinguish carefully between cyclical and structural issues. Let me start, I think, with the state of the economy, Indian economy, in cyclical terms as I see it. The most recent quarterly GDP figure we have is for FY25 third quarter, which is October to December. Fiscal year in India runs from April to March.

In the latest GDP report, the year-on-year growth in fiscal year ’25 Q3, that is October to December quarter of 2024 calendar year, that was reported at 6.2%. This is about roughly a 0.6 percentage point rise over the previous quarter of a figure of 5.6%. This is substantial improvement over the previous quarter, and it was captured in the media and other reports you may have seen. I just want to make a point, and again, it’s a technical point, that is, focus on year-on-year comparison between quarters. Basically, you’re comparing 5.6% in July to September quarter and you’re comparing that with 6.2% in October to December quarter.

I think this comparison across quarters in year-on-year numbers really requires very careful interpretation. When growth is decomposed, especially year-on-year growth is decomposed, both change in momentum. Change in momentum is how the economy is actually growing now. Is it very heated? It’s not that heated? That matters, but base effects also play a role. What are base effects? Basically, base effects are driven by how the economy was performing same time last year.

This 0.6 percentage point pickup which I’m talking about between July to September and October to December, it can be broken up between a pick in momentum, and that pick in momentum is about 5 percentage points or something, 5.5 percentage points. That’s offset by a negative base effect of about 4.5 percentage points. This negative base effect reflects the fact that the momentum was very strong same time last year.

The momentum in the economy is typically measured by what is called seasonally adjusted annual rate. If you compare relative to last year, it is true that there’s been a noticeable slowdown in economic momentum in India. The seasonally adjusted annualized rate of GDP at market prices has declined from an average momentum of over 9% in 2023 calendar year to less than 6% now. If you exclude this October to December quarter of last year, which did well, as I said, relatively well, the average momentum in 2024 was less than 5%. We’ve had a 3 to 4 percentage point decline in momentum, which is quite huge. This trend is really aligned, I’m sure you’re following the news, with recent corporate earning results, data on private consumption, and several analysts had been warning about this coming slowdown for a while. 

What are the reasons for this slowdown, and should we be surprised about it? I think it’s important to remember that policy is an important driver. If the monetary policy in India, like in rest of the world, underwent a significant tightening over the last few years, so almost 250 basis points, and considering that there are lags in monetary policy transmission, especially in developing and emerging economies, these effects are likely still unfolding.

Number two, fiscal policy also has seen tightening after the post-COVID stimulus, which we gave. Fiscal policy has tightened by, say, 200 basis points if you think about fiscal year ’24 and ’25. In addition, there have been regulatory measures, particularly those targeting consumer lending, and they have also contributed to the cooling effect. Therefore, this slowdown actually may be viewed as a cyclical adjustment, at least partly driven by the policy normalization following the stimulus measures which were implemented during the crisis, rather than indicating structural economic damage.

What is an appropriate policy response to such a slowdown? It depends really on accurately gauging what is the extent of the slowdown. As economists say, the level of output is below potential, that indicates negative output gap and that warrants policy intervention. If fiscal space is limited, and we can talk more about it as in the case of India, monetary policy presents itself as a viable tool for adjustment. As we’ve seen RBI, we are already starting with an easing cycle, which is likely to continue. This is basically the cyclical view of the economy.

RAJAGOPALAN: Before we get into the structural views, I have one question on the cyclical nature. I want you to help us unpack the consumption element and the capital formation element a little bit. Private fixed capital formation has generally been much lower in India compared to trend. For the last decade it has been disappointing. The jury said that India has this consumption-led growth, which, of course, COVID put a dampener on.

By disaggregating the numbers, can you tell us something about how just the regular folks in the economy are thinking and responding to post-pandemic cycle, or how they think about setting up a new business, or how they think about working on their farm and so on?

MISHRA: Shruti, as I said, if output is below potential, meaning there’s a negative output gap, basically, for macroeconomists, this means the demand is not sufficient. That’s why you have, say, RBI starting on an easing cycle because demand is below potential. Potential you can think about as a long-run supply. Ten years back, when you saw inflation rising and when we had the taper tantrum, if you looked at most macroeconomic indicators, if you looked at inflation, if you looked at current account, they were all very high and the output gap was positive, so the economy was overheated.

During the last 10 years, there have been terrific improvements on the supply side. Basically, you’ve had vast improvements in physical infrastructure, vast improvements in digital infrastructure. Basically that means that while supply has improved, demand is now the binding constraint. As you rightly pointed out which part of demand is not sufficient. I think there has been catch-up. I think it’s been, of course, a lot of recovery. 

See, COVID happened, and then households had a lot of savings under their belt, and that they started spending post-COVID. That demand is waning. Some of it has started to pick up now, if you compare to pre-COVID, but I think the output gap is still negative. RBI is trying to fill that gap. 

RAJAGOPALAN: This is mostly basically people cutting back on discretionary consumption. If we triangulate, this also shows up in corporate earnings, which are low because discretionary consumption is low; it shows up in the pickup of small-ticket loan items, as we can see, which are usually not business related; and it is showing in this year-on-year cooling. Is that a good way to triangulate what’s going on?

MISHRA: Yes, I think it is, but I think if you want to structurally think about it, if you want to structurally think about it, you can think about it in terms of employment also. You can get more employment, higher wages. Real wage growth in India, if you look at PLFS data, for example, has actually been quite minuscule. You can relate the deficient demand to also weak real wage growth, which we are seeing for all categories of workers in the PLFS data.

Actually, there’s excellent work going on at the Ministry of Statistics and Programme Implementation. I think they may already have started. We have high-frequency data on employment now. I think, if I’m not mistaken, PLFS is already quarterly, and it was going to be monthly going forward.

RAJAGOPALAN: Wonderful.

MISHRA: We don’t have a back series, but globally, macro research is actually quite focused on employment and unemployment. You use a lot of where you are in the cycle. While what I talked about was based on GDP, most countries would look at it in terms of employment. I’m sure with even higher frequency PLFS data, we should be able to do it. Basically, I think employment growth looks fairly good for both regular and self-employed workers. I think casual workers, they’re about one-fourth of the labor force, they are facing negative or very low growth in jobs.

Also, the rate of growth of self-employment is faster than that of regular wage jobs, which is, by the way, also a sign of weak labor demand, if self-employment is growing faster. The demand deficiency, to some extent, may be related to the employment issue as well.

India’s Structural Transformation

RAJAGOPALAN: This is a nice lead-in to where India is in the trajectory on structural transformation, because India has been a little bit of an outlier. That standard view of the way, say, the old European countries developed, then Korea and China and everyone developed is, there’s a mass exodus of workers from agriculture into industry, and as they grow richer, from industry into services, and the knowledge economy, and R&D, and so on. India has not exactly followed that script in the last 30 years since liberalization. One question is, how do you think about India’s structural transformation? Within that, where are we in the current moment?

MISHRA: Sure. Shruti, I think before we go into the components of GDP growth, I think if you want to take a structural view of the Indian economy, I think let’s get some broader facts straight. Again, I think technical issues are important, especially for analysts, students who are trying to look at the Indian economy, I think we have to be very careful about some of the technical issues. I think looking at absolute levels of GDP is very important, rather than looking at growth rates, which we are always very focused on. This is particularly important.

Again, it’s a technical point, but I think it’s particularly important in periods proximate to a crisis, especially in an unprecedented one like the COVID-19, where the response to the crisis itself led to the global recession. We were locked inside because of health, to deal with the health crisis. The response to the health crisis itself led to the global recession. I think what I mean, let me again elaborate on the technical point. If any economy contracts during any recession by, say, 10%, it goes from 100 to 90. In the following year, if the economy grows by 10%, can we say, “Wow, the economy is really growing at very high rates. This is a terrific growth rate”? The answer is no, because after the 10% growth rate, the economy would still be at 99, from 90 to 99, still 1% below the pre-crisis level.

Had the crisis not happened with normal rates, say, 5% for any economy, the economy would have been at 105. You would need a growth rate of 17% to get the economy to a pre-crisis path. Bottom line, again, as analysts, as students, as faculty, I think we have to be clear that when an economy is recovering lost output after contraction, growth rates can be really misleading.

I did some calculations for the Indian economy to see where it is relative to a pre-pandemic trajectory. Had the pandemic not happened, let’s assume very conservative growth rates. Indian economy was slowing even before the pandemic. Let’s assume a conservative growth rate of, say, 6% to project the pre-pandemic path. As I said, don’t take into account the slowdown that preceded. We have still not recovered the lost output from the pandemic fully. I think we have covered a lot, but there’s still a gap, and my calculation suggests that there’s still about a 3.5% gap. This gap underscores the need for more ground to be covered to fully recover the lost output.

By the way, this is true for most EMs. Of course, it depends on the assumptions, but if you did this calculation for Brazil as well, assuming 2.5% pre-pandemic growth path for Brazil, you would still be about 1%, 1.5% below its pre-pandemic path. Of course, advanced economies, they recovered, particularly the United States. Keeping aside what is happening currently, I think we always talked about US exceptionalism, and US recovered very fast. Basically, in the bottom line, if you compare Indian economy to a pre-pandemic path, there’s still a 3 - 3.5% gap, which we have to cover.

Another way to assess where Indian economy, structurally relative to our goals, is relative to our goal of Viksit Bharat. A target, again, that requires sustained focus beyond short-term economic fluctuations. A lot of press and media reports focus on the short-term economic fluctuations, and for good reasons. This goal of Viksit Bharat can of course have broader connotations beyond GDP. It’ll include inclusive development, sustainable development—

RAJAGOPALAN: Job growth.

MISHRA: Correct, job growth. If you want to interpret it, again, as a macroeconomist, very matter of fact way, narrowly, in terms of an advanced economy by per capita income, what would India need to become an advanced economy by 2047 based on the thresholds given by the World Bank? Let’s assume for simplicity that those thresholds don’t change. 

In 2024, India’s per capita income in nominal GDP terms is estimated at $2,700. If you do simple compounding, I think if India can maintain 8% growth in nominal per capita dollar terms, it would cross the upper middle-income threshold, that is about $4,400, in 2031, and it would cross the high-income economy threshold of $13,485 in 2045. This is very simple calculation.

Then you can ask the question that what do these numbers imply for real and nominal GDP, not GDP per capita growth in rupee terms. There it becomes tricky because you have to make assumptions on population growth and you have to make assumption on exchange rate depreciation. I think every macroeconomist knows that, especially the latter, predicting movements and exchange rates is very hard. If you make reasonable assumptions, say 1% population growth, 1% rate of depreciation, you would need a nominal GDP growth of about 10%, but each year. If you assume 4% inflation consistent with our target, this would imply a 6% real GDP growth but on a sustained basis.

RAJAGOPALAN: Every year without exception, so it compounds.

MISHRA: Every year. 6% growth aligns with India’s average growth over the past two decades if you take a simple average, but sustaining it for another 20 years, that presents a significant challenge. You’ve seen the world development report on the middle-income trap and what the challenge is, and only selected so-called miracle economies have done it. You spoke about Korea. Korea is an excellent example of that.

The State of the States

RAJAGOPALAN: This is useful to get into because when we disaggregate further into India and start looking at some of the bigger states, if India were to follow the standard trajectory, that is grow like this at 6%, with all the assumptions of population and exchange rate and all baked in, one would automatically assume that the poorer states are the ones that are growing faster than the richer states. In India, that’s not true actually. The poorer states are both poorer than the richer states, but are also growing slower than the richer states.

The states within India are also diverging, and the richer states have fewer people, but they’re a larger share of GDP. The 6% year-on-year trend also frightens me for that reason, and seems a little bit unrealistic because that means that Uttar Pradesh and Bihar have to unleash 7-8% growth of their state GDP year-on-year, which is simply not happening.

MISHRA: I think you’ve touched on an extremely important point, Shruti, about when they got independence, basically our forefathers had envisioned that you would have a more egalitarian society, you would have balanced development of different regions. Active state intervention was envisaged to reduce these disparities. That’s why now we have had 15 Finance Commissions, we had the former Planning Commission. Now, the 16th is in progress.

Despite all this, divergence across states has increased and might have, if anything, assumed extreme proportions. I’ve written about it and it’s very close to my heart because I am from Bihar. No state exemplifies this other than Bihar. This article I wrote was titled “sub-Saharan India.” Basically, Bihar fits in with the typology of a low income sub-Saharan state in terms of economic indicators and standards of living. It is actually comparable to countries in sub-Saharan Africa like Liberia, which had a number of civil wars, et cetera. Bihar’s per capita income only is higher than Sierra Leone, Malawi, and Niger in sub-Saharan Africa. If you exclude Patna and Begusarai—

RAJAGOPALAN: Then it’s even lower.

MISHRA: Then it’s even lower. This is at a point in time, as you correctly said, it’s basically, the divergence has increased over time. Bihar accounts for 9% of India’s population, less than 2% of India’s GDP. Its current per capita income is about $700. It’s comparable to Liberia, as I said, as one of the poorest countries, inflicted by civil wars. What is even more striking is that Bihar continues to lag other states in economic growth and development. If you were to plot per capita income, you’ll see that the divergence with other states is increased. If you look at Karnataka and if you compare over two decades—

RAJAGOPALAN: That graph, I’ve plotted it. It’s a little scary, but for me, Bihar, the relevant comparison is not even Karnataka. It feels like the relevant comparison is something like Odisha, which was quite poor and at par with Bihar at the time of independence and so on. But in the last 25 years, Odisha has done remarkably well in a way that Bihar and UP have still really lagged.

MISHRA: I did some calculations, number of years it’ll take Bihar to catch up to some of these states.

RAJAGOPALAN: Oh, wonderful. I would be very curious to hear this stuff.

MISHRA: It would take 17 years for Bihar to catch up to Orissa and 61 years to catch up to even half of all India average, forget about comparing with Gujarat or Karnataka.

RAJAGOPALAN: This is at current rates of growth.

MISHRA: It’s at current rate of growth. And Bihar—because the level is so low. Again, that’s what I said.

RAJAGOPALAN: The level matters.

MISHRA: Because the level is so low, you cannot interpret growth rates too much because I think it is out of a low base. I think this is a development across different states and behind balanced development across regions, and why despite having so many transfer mechanisms, we don’t have equality across states. And why is that not coming down, I think is really something we need to think through carefully. 

Related to all the things, you talked about manufacturing, you talked about services, there are hardly any industries in Bihar. I think services is doing well, especially health services. Education services are all doing well. Again, I’m giving the example of Bihar because I come from Bihar. By the way, Bihar has improved a lot on ASER, on primary school enrollment, but higher education gross enrollment is still—or if you look at learning achievement scores from national achievements survey, NAS, they’re all among the lowest. These statistics are by the way appalling for a state with the rich history of education, as well as strong intent and aspirations of its citizens. That is very evident. I don’t know if you’ve traveled through Bihar.

RAJAGOPALAN: I have. Everybody wants to do well in the standard exams and 10th standard and become an IAS officer and so on, right? It’s remarkable.

MISHRA: [crosstalk] number of coaching institutions.

RAJAGOPALAN: Marriage prospects are terrible if you’re not well educated in Bihar. That’s the pulse for me on how much a society cares about education. If you think about Bihar as a country and not as a state within India, it’s basically at this point, a semi-remittance economy. A lot of the Biharis actually have to leave Bihar to find work. This is both at the top end and at the bottom end. That is, the very low-skill, informal workers are going into construction in other richer states and urban areas, and the very elite knowledge workers have to move to Bangalore or Bombayor something, to find work. The way Bihar works is that the family is left behind. It’s a remittance economy, which is also interesting, because the track record of remittance economy countries growing very fast and having a structural transformation into development has not historically been very good.

MISHRA: Yet, Bihar has the youngest population in the country.

RAJAGOPALAN: That’s true.

MISHRA: Close to 60% of population are under the age of 25. Bihar reports the highest fertility rate in the country at 2.98, if you look at the latest NFHS, much higher than the replacement rate of 2.1. Meaning that Bihar’s population will continue to grow at a fast pace, much more than all India average. Many states actually have much lower fertility rates than replacement rates. That compounds Bihar challenges, but at the same time, I think it’s even more urgent for policymakers to think carefully about how we can seize Bihar’s demographic dividend, and how we can spur economic growth and development in a comparatively brief period of time because I think time is running out.

India’s Growth Potential

RAJAGOPALAN: Yes, absolutely. For compounding, time matters more than anything else. On the overall picture of the structural transformation, I think you’ve made your point on the level issue very, very clearly. If we disaggregate, how does India do between the different sectors? Where has India shown the most growth potential? Where has it shown the least growth potential and so on?

MISHRA: I think the big issue, as you’re well aware, is the share of manufacturing in GDP has remained stagnant over the last two decades or so. See, India is ultimately a labor-abundant country, and yet India’s manufacturing is increasingly becoming more capital intensive, even its exports. We’ll talk about trade in greater detail, but even its exports are becoming more capital intensive. The big policy question, or the big implementation question has been how to spur labor-intensive manufacturing that can help the manufacturing problem, but also, most importantly, the employment problem of the country.

Services, definitely has seen services production, as well as trade, has seen phenomenal growth. Particularly, if you look at our current account, Shruti—again, we’ll talk more about it when we talk about trade—but if you look at our current account, if you look at merchandise current account, it’s almost under services. Basically, had it not been for services, the current account deficit would have been much higher. Services provides a big portion to the Indian current account. Currently, the current account deficit is about $50 billion roughly, and $300 billion is the merchandise trade deficit, which is equal to the surplus on the services and secondary income.

Secondary income, actually, I think remittances, for example, is counted as secondary income. $50 billion deficit basically is only equivalent to the primary income deficit. Surplus on services and secondary income basically completely balances the merchandise trade deficit.

India’s Current Trade Policy 

RAJAGOPALAN: You talked about trade and that’s a really big part of India’s lack of manufacturing pickup and so on. Again, before we get into specific trade policies on how that affects India’s manufacturing sector, or labor and wage elasticities and so on, can you just give us a sense of how to think about India and its trade policy in the current moment? 

The CliffsNotes version is India was almost autarkic in 1950. In 1991 we famously have the big bang reforms. India starts liberalizing on the trade side and tariffs systematically come down over the next 20-odd years. In the last decade or so, there’s been a bit of a U-turn on that. There is some back and forth going on sectoral parts where the tariffs start going up. Now, one, there’s a greater recognition that that’s not doing very well for India or Indian manufacturing, because exports become very expensive, especially with tariff inversion in certain industries. Also, with the new administration in Washington, DC, and the upending of WTO and the old-world order and now having country by country retaliatory tariffs, or whatever the new regime is, but this is the regime as of April 2025, what is a good way to just think about where India is now before you walk us through the other parts?

MISHRA: As you pointed out, the big global event shaping geopolitics is the new US administration and the Trump tariffs. I like to think a little bit systematically about what these are, and how much of it is reality. The way I think about it is, how much has been implemented on these Trump tariffs, how much has been announced but delayed implementation, and what is probable? I think 25% on steel and aluminum has been implemented, 20 percentage point increase for imports from China, and 10% to 25% Canada and Mexico. These are a small share of imports not covered by US, Mexico, Canada, the USMCA. 

This is one, what has been implemented. What is ordered and not implemented, I think 25 percentage point additional tariffs on Mexico and Canada. I think the implementation was postponed for a second time. Then what is likely? I think April 2, I think by the time probably your podcast is out, we’ll know about it, the whole thing about reciprocal tariffs and the tariffs on critical imports, at least 10 percentage points higher tariffs and 25% on auto imports.

I think we need to think carefully about what has been implemented, what’s been ordered, but not likely to be implemented, what is likely to be announced, say, next week. Again, even those, implementation may take time. I think we have to be clear about that. When we think about the macroeconomic impact, we think very systematically. I think we think about US, what the impact on the US is going to be. It’s not very clear. I think immediate impact, of course, higher prices, lower consumption. But again, in the medium term, they might be offset by certain things like regulatory easing, et cetera.

On China, it’s really not clear. I think we have to see how China retaliates. So far, China has actually been quite restrained. I think if China retaliates, then there’s going to be—

RAJAGOPALAN: Snowballing.

MISHRA: Yes, but imports are also going to decline and net exports might not have an impact. Then, as you know, there’s a Xi-Trump meeting going on. There’re side deals of Chinese purchase of manufactured goods, and China has policy tools to offset any impact. Even the impact on China is not that straightforward. For rest of the world, and including India, first of all, I think the impact on the US and China itself important for India, because I think they’re important trading partners for India. India is not that important for the US, but US is very important for India, and so is China.

The first thing is to be clear about what the impact is going to be on the United States, what the impact is going to be on China, because they have very important implications for India as well. Then, of course, if you’re thinking about more globally, the way I always think about tariffs is that US adding tariffs, pushing back Chinese goods into the non-US global markets, that is potentially leading to dumping in other markets. This will reduce India’s competitiveness, not only in the American market, but also third markets globally. Of course, if China resorts to currency devaluation as a broad stimulus strategy like the approach in the 1990s—that displaced demand for products from competitor countries like India, Sri Lanka, Bangladesh.

RAJAGOPALAN: On the other hand, our largest share of our imports are from China, so imports will be cheaper. This sort of cuts a little bit both ways, right? On the import side, China is our biggest trading partner. On exports, it’s the United States.

MISHRA: Absolutely, and there is a silver lining that is behind all these dark clouds, because excess supply of Chinese goods outside the United States will reduce global prices and will probably lead to lower inflation in the rest of the world. If you think about India specifically, which is what we started with, I think the question is, the space which is vacated by countries which are directly targeted, maybe China in particular, could India capture some of the space?

As I said, I think India, despite being a labor-abundant country, India has increasingly shifted towards capital-intensive production in both domestic production and exports. Think about electronics, engineering goods. The old-age exports like textiles, et cetera, are no longer our top exports. Trump could be an opportunity in this to reorient and to aggressively really expand labor-intensive manufacturing, especially sectors like textiles.

Here, if I may say, The Convergence Foundation is a foundation based in Delhi, has done some excellent work on textiles, basically to say, four-prong strategy for India to capitalize on this opportunity. I think expedite FTAs, I think some of it is already going on, but expediting some of these. I think second is reforming some of our labor regulations. Again, we talked about Bihar. I think Bihar’s per capita income is lower than Bangladesh. I think labor laws in Bihar are way more stringent. In Bangladesh, it’s much easier to do different shifts, for women to work, et cetera. In Bihar, I think both minimum wages as well as regulations more generally are much harder. Then strengthening raw material ecosystems is a big thing, and creating large-scale efficient, special economic zones with comprehensive infrastructure. 

We have these PM MITRA Parks, but again, scaling is important. I think in all this, positioning India in the global supply chain will be crucial because as China continues to move up the value chain, as costs rise and competitiveness declines, because of Trump or because of other reasons, if you think about the flying geese model of economic development, India has to identify where its comparative advantage lies, whether in upstream or downstream activity.

If you think about iPhone assembly, for example, see, China earns about $9, $10 per unit, domestic value added, similar to what India earns. The difference is that China assembles 230 million to 250 million units annually. India assembles about 30 million to 40 million. 

I should point out that India’s recent budget actually moved some of the custom duties you pointed out. I think it moved towards rationalizing some of the custom duties. They’re eliminating rates above 20% and reducing those above 70%. I think some moves were taken. Again, I think you are asking the right question. Could the shock be a trigger for some hard-to-achieve reforms and to build consensus on this? I think I wrote somewhere that behind every challenge, there’s a Trump opportunity.

RAJAGOPALAN: Bear with me if I’m not phrasing this as precisely as one should. When I think about tariffs and I think about the two problems that you mentioned, on one side, we need a raw material supply chain, which is increasingly more and more globalized. We need to be plugged into global supply chains, not just figure out our own cold storage and warehousing and things like that.

When we think about plugging into global supply chains, that requires large degree of rationalization of tariffs and low tariffs overall. The whole picking and choosing sector by sector, policy uncertainty over tariffs, that doesn’t do well when it comes to trying to integrate that supply chain, especially on low-end raw materials. On the other side of this problem there is very good literature by you and many of your colleagues that find that there is an inverse relationship when you look at labor elasticities and the level of protectionism. 

If we think about a place like Bihar or any relatively poor region in India which is now trying to scale, they would do better on wage elasticities and increase if there’s greater protectionism. On the other hand, they would do better on kicking off new industry and plugging into supply chains and raw materials if the tariffs are relatively low and relatively certain. Is there a fundamental tension between these two things? 

MISHRA: Shruti, I think, overall, what matters is competitiveness. I think that’s how we should be thinking about it. How do we get more competitive in, say, textiles, or footwear or other labor-intensive manufacturing and how we kill two birds with the same stone, that is boost manufacturing as well as boost employment? That’s how I would think about it, rather than breaking it down into what is the impact of tariffs, what is the impact of labor regulations, et cetera. Overall, I think the impact on competitiveness and how to make our firms more competitive, and I think size is important. Scale we talked about. We know from a huge literature that larger firms are more productive, they tend to export more. 

RAJAGOPALAN: We have a number of papers on that. Why we are not able to scale labor, why we’re not able to scale on electricity and power plants and things like that. On that part, I think at least the empirical history and what we can learn from countries that have actually advanced to the developed country stage, low tariffs and certain tariffs seems to be the number one ingredient for export competitiveness.

One, because it’ll keep the price of imports relatively low, and two, because it forces domestic manufacturers to compete, which they don’t do and will never do with protectionism. Then would the policy prescription be, just pick a number, ideally below 10, stick to it, doesn’t matter what the rest of the world is doing, just stay competitive on tariffs?

MISHRA: First of all, you have to balance external orientation and industrial policy. For example, if we are talking about textiles, we are talking about footwear, we are talking about apparel, it’s in India’s interest to target sectors which are relatively labor-intensive because India is a labor-abundant country. I think employment is a huge challenge.

It’s okay to target sectors which are relatively more labor intensive, but at the same time, you have to have external orientation in these sectors. I think carefully balancing—I think it’s very much a tightrope walk—carefully balancing external orientation and industrial policy in this day and age, I think is very important. How to capitalize to your advantage, I think is super important. It’s a more nuanced view of globalization in this world.

RAJAGOPALAN: No, no, absolutely, but if I think about it in a “how do we conduct policy?” lens, would it just make sense to keep tariffs only in mind for export competitiveness, keep them low, keep them very stable so that people can figure out their cost structures and plug into global value chains? That’s the idea of it. Any intervention you want on industrial policy side, do it through subsidies.

Don’t do it through tariffs, because tariffs seem to be a terrible lever to keep pulling on and off. They also cause massive uncertainty, and it kind of makes people freeze in the tracks when they want to enter one of these businesses, which are enormously reliant on global value chains. And increasingly, more and more businesses are reliant on global value chains. Is that the way to think about this? The nuanced approach would be, keep it simple on tariffs, domestic subsidies can adjust and ebb and flow with the tide.

MISHRA: Again, I want to take the example of textiles. As you talk about supply chains, you have to take into account the input/output structure. Strengthening raw material ecosystems is very important. For that, I think international trade costs need to be brought down, but also domestic costs need to be brought down. They’re equally important.

Again, that’s what I mean by carefully balancing external orientation and industrial policy in this day and age. You have to be very careful about the input/output structure. You have to be careful about international trade costs, but also domestic costs and logistics costs. There’s so much which goes on. I think, again, it needs a very careful and nuanced approach, especially in this world. I think especially in the world with all these geopolitical risks, uncertainty, how to use these to your advantages. I think it requires careful thinking. 

RAJAGOPALAN: It’s a combination of tariff policies, subsidies, infrastructure supply and connecting the dots, making the country a one single trading unit by rationalizing GST. It’s a really big bouquet of policies that you need to get right.

MISHRA: Comprehensive set of reforms basically. I think many times, for example, for textiles, the four things which I said, how India can capitalize on this Trump opportunity: Expedite FTAs; reform labor regulations; strengthen raw material ecosystems; scale up SEZs with comprehensive infrastructure. I think everything is known. It’s not that what I’m telling you is something new, but I think it’s how to overcome the implementation challenges. Implement, implement, implement, I think is more likely to go really in a big way to capitalize on this opportunity. I think the implementation challenges are enormous.

RAJAGOPALAN: This is a side tangent and not exactly what you were discussing. One of the things I find complicated and messy when we do reforms in India is, there’s always a cluster of constraints. It’s not a single constraint. Labor law is one constraint, tariffs, it could be infrastructure, it could be SEZ, it could be contract enforcement. The problem is we are not always sure which is the binding constraint. That’s problem number one.

Even when we know it’s the binding constraint, let’s say we reform a particular kind of contract enforcement, or we loosen labor regulation, or we loosen the thresholds at which the labor regulation kicks in. Instead of 100 people, it’s 300 people or whatever. The trouble is, then that ceases to be the binding constraint, and something else is the binding constraint, so you still don’t see the results you need to see.

At some point, I think we need to get into kind of some general equilibrium–informed comprehensive reform program, which will remove a number of constraints or a cluster of constraints simultaneously, so then none of them end up becoming the binding constraint. Then industrial policy still doesn’t take off. That’s how I view what’s happening in India. We do bit-by-bit tiny reforms, and they just don’t seem to land.

MISHRA: A lot is going on, Shruti. A lot is going on. I think when we start seeing in the numbers, especially on the manufacturing side, textile and apparel exports have increased dramatically, but the target is $100 billion or so by another five years. That seems like a tall order. It does require a lot of coordination across different ministries and departments, I think, to pull this together in a shot. Again, five years if you want to have a very large increase in manufacturing spots, I think a lot of coordination is required. 

India and Globalization

RAJAGOPALAN: On the second part of what you’ve been writing about trade, especially relevant a little bit more recently, is this question of, one, there’s an upending of the globalization order, the WTO order. This is done in large part because of the labor issues in those countries domestically, including the United States, where for, I think, the last five presidential elections, the labor problems in the Rust Belt and the deindustrialization, all these have been very hot political items.

Simultaneously, in India, we need to increase both exports and we need job-led growth. First, can you tell us how to think about this problem for an emerging economy like India, where we do need to be part of the global trading order, we do need to increase our exports and our export competitiveness, both, and we need to do it in a way that’s inclusive on jobs and the wages? We have this multipronged problem in India. How to think about that for India, and also how to think about that for the rest of the world, where everything is up in flames right now when it comes to the old order.

MISHRA: That’s a good question, Shruti, I’ve been doing this with co-authors. We’ve been looking at this: What is the real reason globalization is under fire, and is it about globalization? I think Stiglitz, in one of his books, had said that it’s not about globalization per se, but in how it’s managed. What we are doing in some ongoing research is, if you think about it, the conventional economic case for globalization is that aggregate economic gains that this creates. For example, productivity, you talked about, expanding consumer choice, technological change.

I think a critical aspect, which is often overlooked and which is actually very international trade 101, that globalization inevitably creates winners and losers in the short term, even though long term its effects are positive for the society. The theoretical underpinning for these aggregate benefits to accrue is that losers can be compensated. However, in practice, they have not. Globally, we have not succeeded in compensating the losers. The benefits and costs of globalization have not been evenly distributed across types of workers, industries, regions. Basically, this points to inadequate implementation of some of the supportive policies, such as trade adjustment programs, social protection measures, regional development initiative, even industrial policies.

Therefore, I think what we are seeing, the significant social and political backlash against globalization, both in the US and globally, should not be very surprising. This sentiment has become a decisive factor in elections after elections in the United States, but elsewhere as well. You’ve heard all these terms: fragmentation, deglobalization, slowbalization, offshoring, friendshoring—but the seeds of these were germinating way before US elections.

RAJAGOPALAN: They’re all over Europe too. It’s not just the US. This is an advanced economy phenomenon, and it’s everywhere.

MISHRA: Correct. What we do is we put together systematic database across a number of countries and we evaluate policy approaches that have facilitated or hindered adjustment to globalization and trade shifts, technological change, and we study the China shock in particular. We do find, as expected, that on average—many people have shown this—that China shock can lead to deteriorating labor market outcomes in the manufacturing sector in particular. We measure it by higher job separation rates for prime-age males. Because manufacturing sector, typically across the world, is quite intensive in male workers.

What is unique to this study is that we find that countries where labor market mechanisms are stronger, I think these are countries where there are active labor market policies, training programs, skill development initiatives, employment subsidies, and passive labor market policy as well. Passive labor market policies are policies like unemployment insurance benefits.

Countries where these support mechanisms are stronger, these experienced relatively smaller increases in job separation rates in response to the China shock. We don’t have much data outside the OECD for these labor market programs. With emerging markets, including India, I think they have a lot of underinvestment. Even globally, I think the global median for the spending, I think it’s below 1% of GDP. It’s very small.

I think even for India, there are a few active programs. Of course, MGNREGA is the big one, but the allocation for MGNREGA has declined quite a bit. It’s at 0.2% of GDP. Other active programs are like PMKVY, DDU-GKY. There are a lot of PMEGPs for microenterprise creation. They are very small, and we don’t have much data on passive labor market policy, but you can guess that unemployment benefits, for example, is very small. 90% of jobs in India are informal. There’s no social security benefits. Workers have minimal support in between jobs.

If you really want to make globalization politically sustainable, and even have successful sector-specific industrial policies, it really requires effectively managing transition costs for workers and effectively managing this resistance to change. This is coming back again and again in different reforms we try to implement. There’s urgent need for policies focused on reducing these transition costs, and likely true, effective labor market programs.

Structural Adjustment Programs

RAJAGOPALAN: Here, again, there’s a tension. One would expect that this would affect services and manufacturing the most since those are the large share of exports. Also our services are more competitive when it comes to exports and some parts of manufacturing. A very big problem in India’s structural transformation is the exit from agriculture, which is unproductive to start with.

Do the same labor adjustment programs that are designed towards trade, do they also work for the structural transformation India needs to undergo now because it’s just reducing frictions in transition? Or do we need a new set of policies that target these two things separately?

MISHRA: Generally, as I said, globally, these policies are really small. Even if you look at countries like Denmark, Sweden, Netherlands, they lead in spending on these active labor market programs; they are allocating 1.5% of GDP max. Median spending globally on OECD countries where we have data is 0.3% of GDP. 90% of countries spend less than 0.7% of GDP.

For a country like India, which is very populous, there’s huge population, 90% of the jobs are informal, they lack social security benefits, to implement these policies is very, very challenging, I think. The challenges are really formidable for countries with large population and substantial informal employment like India.

To talk about such policies to aid transformation, I think may be a bit far-fetched, and we have to start small. I think agriculture itself, if you think about labor-intensive sectors or high-value agriculture, it could be actually quite a profitable sector for the country as a whole.

I think there is a lot of potential there. And very related to trade. India is the largest producer of pomegranates but we hardly export any pomegranates. I think high-value agriculture, processing, food processing, allied activities, they can actually create a lot of potential and be one of our star sectors. If we solve some of the—

RAJAGOPALAN: Scale issues.

MISHRA: —scale issues, and also some of the fundamental problems there. We have very stop gap policy on trade policy and agriculture. It’s on-and-off policy for imports, for exports. You can have any policy, but I think we do need certainty in policies. Trade policy certainty is very important, which can actually propel the sector, influence economic agents or whoever is the relevant entity to look for new markets, look for new products.

I think high-value agriculture is a bit different view from what you said. High-value agriculture can actually be a sector which can be, again, a big boost. Labor-intensive, not manufacturing, but you can have labor-intensive push to agriculture in particular and high-value agriculture.

Is the Rupee Overvalued?

RAJAGOPALAN: Yes. That would make me happy because that would mean I’ll get better and cheaper mangoes in the United States. Currently it’s for a couple of weeks and they’re very expensive. On a more serious note, I want to talk to you also about how you think about the Indian rupee. There has been a lot of press around this. This is very important for our overall trade and industrial policy. Is the rupee currently overvalued, undervalued, how do you perceive it?

MISHRA: Again, in my new role as an academic I tend to go on the blackboard. I think, number one, let’s summarize what the evidence is on the exchange rates. I think anybody who’s been tracking India knows that INR has depreciated over time. I think therefore our policies must have allowed INR to depreciate.

If you compare—I think it depends on what timeline you’re looking at. If you look at the longer-term picture, say compare pre-COVID and now, if you look at annual averages, which is perhaps the most appropriate way to look at it rather than you’re looking at particular points of time, if you look at INR, rupee to the dollar has depreciated by close to 20%.

Nominal effective exchange rates, when you put trade weights to your trading partners and look at the exchange rates in a trade-weighted term, that’s nominal effective exchange rates, it’s about 13% depreciation. In real terms it’s been flat, but of course real terms, this is also the period when our trading partners are advanced economies. In China as well inflation had begun to decline.

In the short run, I think there’s been a lot of focus. I think if you compare January ’23 to December ’24, again, you look at the averages in these months, the rupee has also depreciated. It’s about 4% against the dollar. If you look at against a broader basket I think they’re both strengthened. Both nominal effective exchange rates and real effective exchange rates have strengthened.

Real effective exchange rates have strengthened by 6.5%. Basically, again, real effective exchange rates reflect inflation movements in India’s trading partners relative to India’s own inflation. Of course, if you look in six months, I think January to June 2023, the INR was more stable, but again, it was a short period of time.

I think the question you asked, is it really overvalued, what is the definition of overvaluation? It’s in reference to an equilibrium, the different ways in which you can compute the equilibrium. One of the ways typically you compute it is you look the current account deficit. I think I wrote a paper with Dr. C. Rangarajan, former head of the RBI.

RAJAGOPALAN: He’s been on the podcast, he’s wonderful, and talked about some of these themes.

MISHRA: I see. We had estimated about 2.5% norm. Maybe that norm has shifted, but if you think that that is the norm, I think currently your current account deficit is less. Current account deficit we talked about it. Because of the huge services revolution and services providing a cushion. Your current account deficit is running at 1 - 1.5%.

If your current account deficit is lower than what your norm is, then your exchange is actually undervalued, not overvalued. Importantly, I think people always forget that the norm itself changes. Some people will look at the movement, say from January, 2023 to December 2024. As I said, 6% appreciation in real effective exchange rate, you basically say that it’s overvalued.

Or if you look at longer period between 2019 - 24, and assume 2019 is an equilibrium, or 2023 is an equilibrium, but actually the equilibrium itself can shift. This is the Balassa-Samuelson effect. Basically, if you look at developing countries as labor productivity in the traded good sector rises, spills over to wages and prices or nontraded goods, and leads to an overall increase in price level in the developing country.

As developing countries grow, the productivity improves. It could be a rising price, or an appreciating currency could be an equilibrium phenomenon. If the equilibrium itself shifts, even if you make an argument that the exchange rate is overvalued, it can’t be overvalued by that much.

RAJAGOPALAN: Also, one, the equilibrium shifts and second, the policy priorities in an emerging economy also shift. If I remember correctly, you have this paper with I think Sajjid Chinoy, and I’m forgetting the other author’s name, I apologize, where you talk about how export transference of the exchange rate itself has reduced over a period of time.

This is because over a period of time more and more intermediate goods need to be imported for manufacturing, so you can’t have this problem which impacts certain parts of the economy too much. Even on that, the policy priority also seems to have shifted with the equilibrium.

MISHRA: Absolutely. This is a paper joined with Sajjid Chinoy and Siddhartha Nath. behalf of the RBI. They basically document two major transformations in Indian exports. One is the move from manufacturing to services, which we know. Services is really providing a big cushion to the current account of India. The other is within manufacturing, which I talked about, movement towards more capital-intensive products, like engineering, electronic goods. Then we go on to see what the impact of exchange rate is going to be. Of course, there is some elasticity of exchange rate. There’s some elasticity of exports and output to exchange rate. The fact that exports are becoming as you talked about, more intensive—this iPhone or anything on your table—is not good from any particular country because the intermediate inputs are from everywhere else.

If you think about it, if the exchange rate depreciates, the intermediate inputs become more expensive. You don’t get a kick to competitiveness. The standard competitiveness kick is not there. Of course, there’s elasticity. I think given that exports are becoming increasingly intensive than imports, I think that elasticity is probably lower than what we think.

India’s Monetary Policy

RAJAGOPALAN: Another big change has been in foreign exchange reserves. Again, this has been covered in enormous detail in the press. The liberalization was born out of a crisis of foreign exchange reserves. Historically, the way Indian central bankers thought about it is, we need to really have a big buildup of reserves. The more we trade, the more robust and stable our reserves need to be.

Question one, has that old thinking undergone a shift in some meaningful way? Second, how do you view RBI’s reserves policy over, say the last 18 to 24 months?

MISHRA: I think over longer period, if you think about it again, go back to the blackboard. I think holding foreign exchange resources entails both costs and benefits. The benefits are that their liquidity buffers, smooth against external shocks, you can smooth external shocks without destructive output adjustments.

Generally, there is a literature which establishes that if you have emerging markets, if you have adequate reserve holdings, ahead of the Global Financial Crisis, for example, they suffered smaller output and consumption declines. Carrying reserves also entails costs such as, you are sacrificing some interest. You can use different approaches to see whether foreign exchange reserves are adequate. I think it work done by my team at the RBI, which included, I think Siddhartha Nath and Rajiv Das.

I think we put the system to certain stresses, and you can estimate a model actually, and you calibrate an optimization model, the very famous paper where Olivier Jeanne and Romain Rancière. Basically, you apply that to India. Basically, it supported the hypothesis that India’s foreign exchange reserves are adequate to cover potential stress scenarios.

You can do simple regression analysis where you can look at what drives India’s reserve holdings. It does seem to be the case that it’s explained largely about precautionary motives. Reserve accumulation in light of its growing external sector openness and associated risks.

RAJAGOPALAN: It’s been a while since that paper, so has much changed?

MISHRA: I did not write that paper. It was more my team members who wrote the paper. I would say that paper is even more relevant given all the geopolitical uncertainty, et cetera, which we’ve seen. I think the demand for reserves for precautionary motives is probably even higher, and we’ve gone a long way.

If you go back a decade or so ago, 2013, ’14, and compare it to now, I think we have accumulated more reserves. More recently, I think due to the intervention which you pointed out, I think foreign exchange reserves have been reduced. I think this is day-to-day functioning of any central bank based on what’s happening globally. We have had record equity outflows over the last couple of months.

RAJAGOPALAN: Everything you’re telling me points towards, we should be more careful about reserves and not less careful about it, or deplete reserves. Am I reading what you’re telling me correctly?

MISHRA: Right. I don’t think we are depleting reserves. As I said, if you would redo the analysis, the demand for reserves would still be quite high because of precautionary reasons. If you compare standard metrics of reserve holdings, I think we would still be—there’s certain rules of the thumb for reserve adequacy—I think we would be way beyond those rules of thumb. Of course, macroeconomic management has been very challenging for several reasons. I think global context has changed a lot. We’ve had record equity outflows as I mentioned, particularly from the equity market and domestic slowdown.

A combination of that does require firefighting. Reducing volatility in the exchange rate, which is more an outcome—exchange rates is just a symptom. It’s a relative price. I think the recent reduction in reserves it’s more, I think, firefighting in the current global and domestic scenario, I would say. Longer term, the thinking in my view is still the same.

I think that holding foreign exchange reserves entails more both benefits and costs. These are all the benefits we know from the evidence that if a crisis hits, you have smaller output and consumption declines if you have higher reserves. Balanced against the costs of holding reserves, I think that’s what you have as what you see as the outcome of reserves.

RAJAGOPALAN: Related to this is the question of capital mobility and capital inflows. We’ve had quite a bit of volatility since, I would say, the COVID pandemic particularly. We had massive inflows in 2020, 2021 as the US Fed started dramatically reducing rates and so on.

We’ve seen a big capital flight, or at least that’s how all the panicked people are writing about it in, say, the last 18 to 24 months. What is a good way to think about how to manage capital mobility from the point of view of the central bank in India given the extreme global uncertainty right now?

MISHRA: I think as you correctly pointed out, I think the recent depreciation pressures on the INR have been related to record capital outflows. Particularly for most of it has been from equity markets as related to, I think, three global factors.

One is, we saw dollar appreciation following the new US administration took over. Markets were expecting higher tariffs would be associated with higher inflation and higher rates. That’s why you had dollar appreciation. Number two, amidst all this geopolitical uncertainty, Russia, Ukraine, Israel, Hamas, US is still a safe haven for investors. By the way, US yields running at 4%. If you invest in an emerging economy, and you have to adjust for depreciation, US assets are giving equal or higher yields, especially in a safe haven. 

Third is a China factor. Investors are actually reallocating assets toward China because DeepSeek AI has been a big positive technology shock. Actually some of these factors are already reversing. We’ll find out more on April 2, but I think reciprocal tariffs are most likely now. The probability of US recession is higher and the outlook on Europe is brighter now. We’re actually seeing some of the dollar gains reversing and strengthening of INR from the lows. The bottom line, I think, it’s been very a challenging situation for domestic macroeconomic management, compounded with all the domestic issues, the slowdown, which we talked about, et cetera.

I think the authorities have been focused on, again, domestic output and domestic inflation. To the extent that all these events feed into domestic output and domestic inflation, I think there is a need for an inflation-targeting regime. Price stability is the mandate while keeping in consideration growth. I think that’s been, I think the philosophy as far as I can see it.

India’s Inflation Targeting Regime

RAJAGOPALAN: I have a slightly nerdier question about the Mundellian trilemma in international finance. The CliffsNotes version is where an economy or rather a central banker, has to choose between free capital mobility, fixing the exchange rate, or autonomy over monetary policy.

The way the trilemma is set up is that any central banker or authority can only do two out of the three. All three can’t be done simultaneously, and it’s near impossible. The way I think about how India has done this, is India has not exactly picked two out of the three, but it’s tried to prioritize one or two out of these three different prongs at various points in time.

The US, until very recently, was very clear on this, they chose free capital mobility and autonomy over monetary policy. The dollar was really set in the international market freely. India is not that. How do you see the current version of this trilemma playing out in India? Has it changed substantially in the last decade or so? What is the current challenge that the RBI is facing?

MISHRA: I think the big change is that, now we are an inflation-targeting regime. I think we introduced inflation targeting back in 2014. I think it was legislated in the law, I think 2016 or ’17. We moved to an inflation-targeting regime back in 2014. That has been the big change. We’re in a regime of flexible inflation targeting. I think inflation has declined sharply. I think we were in double digits a decade ago. The latest reading was at 3.6%. We’ve gone a long way.

RAJAGOPALAN: A targeting regime, just for the listeners, is a 4% with a 2% band.

MISHRA: Right. It’s 4% plus/minus 2%. Definitely, it has contributed. If you ask me if this is the only factor, that is probably not. I think, again, my paper with Sajjid Chinoy and Pankaj Kumar, staff at RBI, I think we show that Indian evolution of inflation is very complex mix, a number of things: state of the business cycle, inflation expectation, global factors, institutional structures—

RAJAGOPALAN: Agriculture, weather—we have so many things going on.

MISHRA: Correct. Exogenous shocks to inflation, for example, from say MSP or discretionary component of MSP, as we call it, a new monetary regime, commodity prices came down. They were all perpetuated through backward-looking expectations and domestic institutional structures. That amplified the influence of original shocks. I’m not sure if it’s mumbo jumbo, but basically there were a number of these complex factors which brought inflation down. Of course, that coincided with the inflation-targeting regime.

RAJAGOPALAN: How do you view the performance of this regime in the last 10 years? Now, we have about 10 years of evidence. Of course, there have been some serious supply-side shocks, like we’ve had the pandemic disruption, which was enormous. We’ve had GST rollout, which is not that critical, but it did affect many, many, many different sectors and parts of the Indian economy across states. Overall, there has been a bit of a growth slowdown globally, and therefore it’s also found its way into India. What is a good way to think about the performance just of the inflation-targeting regime?

MISHRA: I think the inflation-targeting regime, if you go actually into the law, it’s about price stability, at the same time keeping growth in consideration. Price stability is the primary objective. If you look at, as I said, headline CPI, Consumer Price Index inflation was in double digits. The latest reading was 3.6%. Definitely, I think we’ve gone a long way.

What is striking is that core inflation has also declined sharply. It’s about 200 basis points over the last two years. In macroeconomics, if core inflation is declining, it’s also an indication of a negative output gap. This relates to everything we talked about demand being the constraint in a cyclical sense. I think that’s how I would summarize it.

As I said, if it’s only the inflation-targeting regime, I don’t think so. I think it’s a combination of a number of factors, because inflation in India is a very complex mix of a number of things. In that paper, I mentioned the paper’s a bit dated because we are looking at the dramatic decline in inflation initially, around, I think this paper came out 2016, 2017. We actually quantify some of the factors. I think it would be a good exercise for any PhD student to update that and see how that— 

RAJAGOPALAN: Because oil prices have completely changed. There are so many parts of that mix, which have changed quite dramatically.

MISHRA: Absolutely. That time people were saying that it’s only good luck. We say that it’s a combination of different things, even inflation expectations, global factors, institutional structures, everything played together and brought inflation down. I think the fact that core inflation has declined dramatically as well, I think something which needs thought, and what does it mean? Is it an indication of negative output gap? How much is output below potential? How much demand is deficient, and what kind of demand is deficient? How does it relate to the employment problem and everything we need to put the different parts of the jigsaw puzzle together?

RAJAGOPALAN: The way I think about it is, I think the MPC and the inflation-targeting regime, they’ve done remarkably well for their core project, which was to bring inflation down. Has it happened at the cost of growth, or is most of that got to do with all these other global events and pandemic shocks and all of that other stuff? What’s a good way to think about that? How would you even begin parsing it out? I guess that’s the question.

MISHRA: Growth has averaged about 6-6.5% over the last two decades. I think that’s where we have been in a sense. If you look at a longer-term perspective, it’s not that we’ve sacrificed growth to reduce inflation. Again, if you’re looking at our cyclical perspective, I think you have to look at where the output gap is and how far are you from potential and how much is the demand deficiency, et cetera.

RAJAGOPALAN: Got it. One other thing that in particular, Prime Minister Modi, I think this has a lot to do with his view of the world. He’s very particular about keeping inflation down. He’s talked about this in a lot of speeches. The other is he really cares about being fiscally prudent and keeping deficits low. Normally, prime ministers don’t talk about these things in just a regular speech.

This keeps coming up in Prime Minister Modi’s general narrative about how much he cares about keeping spending and deficits low. In fact, India was one of the few emerging economies that didn’t go crazy during the pandemic or the post pandemic recovery and so on. 

India’s Fiscal Consolidation

What is a good way to think about India’s recent fiscal consolidation?I want you to answer this, maybe in two parts. One, both how you see this has played out in India, and also you’ve done some very recent work with co-authors, where you distinguish between discretionary fiscal consolidation and durable fiscal consolidation. The big question for me is, how has India performed in its fiscal consolidation, let’s say over the last decade? Because there’s been a huge effort made towards keeping deficits low and towards broader fiscal consolidation, thinking about disinvestment, thinking about reducing the debt to GDP ratio, and so on, so forth. How do you view what’s happening in India?

MISHRA: One is the most salient feature of this whole fiscal framework during the last decade, is that fiscal consolidation has remained the primary focus. We gave a stimulus during COVID, but much smaller than advanced economies gave. Importantly, the stimulus did not last long and we started normalizing very quickly. We’ve had about 200 basis points of tightening since FY21. That’s why we’ve seen some of the growth slowdown, cyclical slowdown attributable to that. 

Second is that budget after budget, the commitment to fiscal consolidation has really been underpinned by conservative assumptions. For example, in the most recent budget, we have a projected nominal GDP growth of 10% and tax buoyancy assumptions, which are also reasonable.

Third is the quality of spending has improved because the ratio of capital to current spending has increased a lot. I think if you compare over the last couple of years, we’ve gone from 20% to 30%. In fact, a lot of commentators were saying that central capex has really hit the ceiling in this budget. But actually, the budget, if you look at some of the details is freeing fiscal space by cutting some of the inefficient revenue expenditure items.

That said, I think there is still many challenges. India’s sovereign debt situation still remains a concern. Sovereign debt to GDP is about 84%. An outcome of this is the high burden of interest payments. For the central government, it’s 37% of revenues which is very high. If you look at interest payments, how much they constitute the fiscal deficit. If you exclude interest payments, India’s primary deficit is actually quite small. It’s only 0.8% of GDP.

We spend a lot of our resources in actually making interest payments on existing debt. Therefore, I think this requires, again, careful deleveraging, and also to improve sovereign ratings. If you have deleveraging that can improve sovereign ratings and create space for development initiatives. 

Let me just digress a little bit to this topic of credit rating agencies, because also I’ve been working on a research project on sovereign credit rating agencies. The fact of the matter is, even if it’s not fully clear how they decide their ratings, their ratings still strongly influence how much foreign money flows into a country and how likely a country is to repay its debt. Stock of debt as a fraction of GDP remains an important ingredient of its rating models. I’ve been looking at it with co-authors, Olivier Blanchard and Daniel Lee, where we are looking at future fiscal prospects.

For example, India is committed to a path of fiscal consolidation versus the stock of debt. It turns out that rating agencies put much more weight on your existing stock, accumulation of past deficits compared to future fiscal prospects. I think it is important to engage with them and understand why they give more weight and what that implies for rating agencies itself. I think if you want a fuller picture of sovereign risk as well as a more accurate predictor of foreign inflows into an economy, if I’m fully committed to fiscal consolidation going forward, why is it that rating agencies do not weight it as much?

RAJAGOPALAN: I want to connect your work, both on fiscal consolidation and sovereign credit ratings. One way to think about it is they don’t weight it quite as much because interest payments keep ballooning, and that is not changing unless someone just writes that off, which is also not ideal for sovereign credit ratings.

Is that the big part of it, or is it because they want to see a very strong track record of durability in fiscal consolidation before that informs the credit rating? In your other work with co-authors, you find that this discretionary fiscal consolidation, which countries do in a one-off way, either by dramatically reducing spending in a particular part of the business cycle, or by selling off assets that may bring down the debt to GDP ratio for a small fraction in time and so on.

You find that that doesn’t seem to matter as much as a more slow, steady approach, which gives you much better durable reduction in debt to GDP. Are these two things connected, or am I just connecting them because you’ve just written both these papers?

MISHRA: Actually the first one is work in progress. I think you raised an important question, why is it that? This is what we are struggling with, why is it that rating agencies give so much more weight to your past sins, so to say, than to your future fiscal prospects?

Remember that this is controlling for your accumulated stock of debt. They don’t give as much weight. It’s not because that the interest payments are what you’re saying, that interest payments are going to—because you’re controlling for that.

RAJAGOPALAN: You’re controlling for that, fair.

MISHRA: Controlling for your past stock of debt, they don’t value it as much. Interestingly, they don’t value it compared to what markets do, compared to what a theoretical model is suggesting, a simple theoretical model. I think compared to what markets—we look at spreads as well. We look at sovereign spreads across a large number of countries and they don’t give as much weight. Rating agencies don’t give as much weight to future fiscal performance compared to the theoretical model, but also compared to what markets tend to weigh future fiscal prospects, weigh more. If a country is committed to future path of fiscal consolidation, markets tend to weigh more. I don’t have an answer for why this is the case, but I think what is puzzling is that’s not a theoretical construct because it’s also relative to what the markets are suggesting. 

Coming to a second question on discretionary fiscal consolidation, why that might not always reduce debt to GDP, is debt to GDP is, debt in the numerator, GDP in the denominator. While discretionary fiscal consolidation is, you are cutting transfers, you’re cutting unnecessary expenditures, et cetera, normally you would reduce the numerator, the stock of debt would reduce, but generally macroeconomic sense, you also reduce aggregate demand. GDP would also reduce. It’s not always true that the ratio discretion fiscal consolidation always reduces debt to GDP. It’s not always true. You have to do it in the right condition. Globally right conditions, domestically right conditions, when the world is doing better, when the domestic economy is doing better, when there’s less volatility, that’s the time to consolidate. That’s the time to build buffers. I think that’s what the paper’s about.

RAJAGOPALAN: Also, the signal sent through consistency. If you very systematically embrace fiscal consolidation, then presumably the rest of the world also responds to that, the market responds to that, and the denominator will increase.

MISHRA: Right. Exactly. I think so. Of course, credible fiscal consolidation can increase confidence, and actually increase GDP. This effect could outweigh the standard macroeconomic channel that you cut aggregate demand and you reduce GDP.

RAJAGOPALAN: That’s how I read the paper. 

MISHRA: That can take time.

RAJAGOPALAN: That takes time basically. Again, Prachi, it’s so late for you. We haven’t covered even half your academic research. I really hope you will come back to talk about all your work on monetary policy and other countries and so on, and even fiscal policy. Actually, we barely scratched the tip of the iceberg. Thank you so much for doing this. This was a real pleasure. I really enjoyed speaking with you.

MISHRA: My pleasure, Shruti. I look forward to interacting with you in the future.