Beyond complacency

Next finance minister must address real concerns of the economy

Speaking at a briefing at Congress party headquarters on Saturday, Finance Minister P Chidambaram painted a rosy picture of the economy that he was handing over to the next finance minister. The current account deficit, which had risen to a dangerous level of $88 billion, or 4.8 per cent of gross domestic product in 2012-13, had been controlled and was expected to decline to $32 billion, or 1.7 per cent of GDP, he argued. And the full financial year's fiscal deficit, he added, would be within the "red line" that he had drawn for himself some time ago. He insisted that the target of 4.6 per cent of GDP for the fiscal deficit that he had set would be met. Mr Chidambaram may be right on the broad numbers. It is certainly true that the current account deficit has shown a sharp decline and spending has been almost brutally curtailed, preventing the fiscal deficit from rising. And he is also right to argue that the turnaround in the headline numbers is a major reason for continuing flow of funds into the Indian economy.

But the larger story is somewhat different. In fact, the next finance minister will have to deal with the fact that this is a false calm, brought about by draconian measures fixed on the short term - not by long-term solutions. Take the current account deficit. The proximate cause of the sharp increase in the current account deficit was the rise in gold imports. This is not surprising, given the low rates of return on savings accounts, and growing middle-class distrust of the equity markets. The United Progressive Alliance halted the current account deficit's slide by, essentially, reintroducing 1970s-style controls on gold imports. The duty on gold was hiked steeply. This will, of course, make it more difficult to import gold; however, over time, unless it is withdrawn, a black economy will grow around smuggling and illegality. The next finance minister will have to withdraw this measure - and then the problem might well recur, making the Indian economy more vulnerable to volatile international capital flows. The only way structural improvement in the current account deficit can be assured is through growing exports. And that will involve painful reform at home, revival of the manufacturing sector and boosting investment in infrastructure projects, as well as a depreciated rupee.

In other words, there is no room for complacency such as Mr Chidambaram displayed. The fiscal deficit numbers for last year were achieved by postponing some spending to the current financial year. The government is also in arrears in terms of subsidy payments, whether to oil marketing firms or to fertiliser companies. It would be wise for the next finance minister, when presenting the Budget in July, to take advantage of the short honeymoon available to the new management of any enterprise and genuinely account for this spending to reflect the actual fiscal deficit. There are other major expenses also on the horizon. The most worrying is the need to recapitalise the financial sector. The banking system is severely stressed; non-performing assets have grown out of control. In addition, many loans to the power and infrastructure sectors might as well be considered delinquent. This comes on top of the need to meet Basel III capitalisation requirements. All told, this will cost the government a significant slice of GDP in the next few years. According to official estimates, the additional capitalisation requirement for public sector banks alone would be Rs 8 lakh crore over the next five years, assuming average annual growth of 20 per cent in their risk-weighted assets. The Budget in July should be frank about the coming expenses and how they should be paid for. Most importantly, it would be necessary to raise revenue through tax reforms. Passing the direct taxes code and the goods and services tax on a priority basis, along with expediting stalled tax administration reforms, would increase compliance and revenue.