The finance minister should attempt to quickly get back to a path of fiscal consolidation.
With the Budget just a couple of weeks away, Delhi’s lobbying machines and rumour mills are working overtime. The forecaster community appears to be divided — the pessimists believe that that the new Budget will show a larger fiscal deficit than the Interim Budget target (5.5 per cent of GDP) and perhaps even higher than actual deficit in 2008-09 (6.1 per cent GDP). Implicit in this is the view that the government will continue with a ‘stimulus’, ie it will increase spending on a wide range of social sector and infrastructure projects without reversing some of the cuts in indirect taxes that were introduced in the second half of the last fiscal. This camp also believes that divestment will be a damp squib and all sorts of political and operational barriers will get in the way of the government’s efforts to lighten its stake in state-owned companies.
I belong to the other camp that believes that the Budget will be driven by the need for fiscal consolidation. Hard macroeconomic logic will force the finance minister to increase the average rate of excise and service tax though some sectors that are still in down in the dumps (textile and trucks, for instance) could be exempted. Second, the disinvestment programme will be driven entirely by fiscal imperatives and will get the government enough cash to fund increases in budgetary support without necessarily enlarging the fiscal hole.
There are two associated assumptions. First, the government might find it difficult to divest large fractions of its stake in companies (its allies that face state elections soon seem dead against the idea) but will produce a large enough list of companies in which minor dilution of stake adds up to a relatively large sum (say, Rs 25,000-30,000 crore). The other assumption is that a significant fraction of the allocations to flagship programmes like NREG made last year is yet to be spent. Thus if it chooses to, the government could ramp up spending on these schemes without necessarily increasing allocations sharply. Thus our assumption is that the increase in Budget support to plan spending could be in the region of Rs 40,000-50,000 crore, not more. If you do the arithmetic, the fiscal deficit targeted in the current Budget comes close to 5.5 per cent of GDP — I would not be surprised if it is slightly lower.
The key difference between the two views seems to hinge on how quickly the government can get out of ‘fire-fighting’ mode and turn its attention to chalking out a long-term strategy. The conflict between short-term expansion and long-term sustainability lies in the funding constraint. Fiscal deficits are known to be self-sustaining and as the spiral of greater borrowing and higher interest costs builds up, it becomes increasingly difficult to tame. Someone compared (very appropriately, I think) fiscal deficits to Hotel California — ‘you can check out but never leave’.
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If private demand for credit starts picking up in the presence of high Budget gaps, it can drive a sharp spurt in interest rates that can quickly poop the party. The local bond market has been quick to price in this risk — despite a glut of short-term liquidity, the benchmark ten-year bond yield is trading close to 7 per cent. It is difficult to argue that the new finance minister will indeed see the power of this logic. In his earlier avatar as finance minister, he is known to have followed what could euphemistically be termed an eclectic approach to Budget-making. The general impression is that he does indeed tend to focus more on the minutiae of tax and spend rather than on an underpinning macro-strategy. Those of us who believe that we are likely to see a new avatar on the sixth of July can only point out that Pranab Mukherjee is too astute a politician and policymaker to ignore the obvious difference between the fiscal regime of the early eighties and today. The RBI, for one, is no longer an appendage of the exchequer that would willingly fund fiscal excesses by printing more money. Both the bond and credit markets have been liberalised and interest rates are driven more by profit margins than by government fiat.
I am not trying to make a case for fiscal fundamentalism or the need to chase numerical targets at any cost. Instead I am trying to highlight a couple of somewhat obvious things. First, we have enough experience of the problems that high and unbridled deficits can breed. This is not to suggest that we did not need a fiscal stimulus last year and should have stuck to our deficit targets at all cost. However, it might be sensible to get back to a path of fiscal discipline as quickly as possible. Second, unlike most other economies that are still contracting or are extremely sluggish, India seems to be faring better than even what the most optimistic projections had suggested. This is perhaps because of the unexpected resilience in domestic consumption. The challenge now is to get investments going.
The only way to do this is to ensure that funds are available at a reasonable cost in the long term. An attempt to quickly get back to a path of fiscal consolidation will help in two ways. Foreign investors tend to lay a lot of emphasis on the state of the domestic fiscal situation. Thus a renewed commitment to fiscal rectitude is likely to add to the bullishness on India that seems to be returning and ensure a flow of external capital.
Second, it will ensure that that in long term, the government does not crowd out investment-related private borrowing. Thus India is somewhat uniquely positioned to shift from short-term imperatives to long-term ones. And, no — we are not all dead in the long term.
The author is chief economist, HDFC Bank. The views here are personal