While the scale of the problem is new, concerns were voiced even at Budget time about the so-called off-Budget liabilities that were the oil and fertiliser bonds. The concerns were motivated in equal measure by uncertainty about the financial magnitudes and, consequently, their impact on the fiscal situation, and by the likelihood that market conditions in these two commodities would tempt the government to persist with an essentially short-term measure for longer than it should. In an attempt to allay the first of these concerns, Mr Chidambaram provided estimates of the magnitudes involved in the Budget papers. They were large, but, against the backdrop of significant revenue buoyancy, did not appear particularly intimidating at the time. The Budget estimate for the fiscal deficit, 2.5 per cent, in fact improved on the target of 3 per cent set by the Fiscal Responsibility and Budget Management (FRBM) Act. Mr Chidambaram viewed this as a cushion to absorb the impact of the recommendations of the Sixth Pay Commission, which were subsequently revealed about a month later.
In less than two months since the Budget was presented, the economic environment has changed quite dramatically. The global scenario, already turbulent then, has got worse since. Closer home, the slowdown in industrial production that was already on the cards is clearly visible. Under normal circumstances, repo rate cuts by the Reserve Bank of India (RBI) would have very likely countered the deceleration. However, what has made macroeconomic policy-making difficult is the surge in inflation that has hit not just India but many countries. Domestic inflation has accelerated after the Budget and crossed the 7 per cent mark. While this is driven primarily by sharp increases in food and commodity prices, forces that monetary policy does not have a very good handle on, the RBI cannot conceivably take an expansionary stance in the face of such high inflation rates. Consequently, it signalled its position with the hike in the cash reserve ratio announced last week. This stance, other things remaining equal, will reinforce the deceleration in industrial production, which in turn will undermine the revenue projections that the Budget made. Both direct and indirect tax collections will be adversely affected by the slower pace of growth.
Meanwhile, a government that is looking for every possible way to contain inflation in a pre-election year will simply not dare to raise now the prices of these two commodities. It will continue instead to issue more bonds to the hapless companies who produce and market oil and fertiliser. Since the average price is forecast to remain around the $100 per barrel mark over the medium term, the accumulation of oil bonds (if they continue to be issued over a long time frame) will be enormous. Similarly, as international fertiliser prices climb to unprecedented levels, so will the subsidy bill for a government that will not pass on the cost increases. Indeed, the fertiliser subsidy has already ballooned to a level that is provoking suspicious glances from the relevant Parliamentary committee.
These developments, coming on the back of an already anticipated hike in government salaries, pose the hard choice of controlling either the fiscal deficit or inflation. The preference so far has been to tackle prices. But the temporary measure used for this (ie the oil and fertilizer bonds) has turned into an apparently uncontrollable expansion of financial obligations as the measure entrenches itself into permanence. To add insult to injury, the companies which receive these bonds, as a substitute for a cash subsidy, find themselves unable to sell these bonds in order to raise cash. There are few takers for these special-purpose bonds, which cannot be used by banks to meet the statutory liquidity requirement (SLR), so no bank wants to touch them.
No one should underestimate the seriousness of the inflationary threat and the hard choices before the government. At the same time, today's policies are lulling the country into inaction. It is important for everyone to get a true picture of the situation, which will facilitate fact-based debate and, perhaps, a more efficient solution. So the finance ministry should provide, with as small a lag as possible, information on the magnitudes and increments in its liabilities on account of these and similar bonds. It should grant SLR eligibility to these bonds; companies, particularly if they are at least partly owned by private shareholders, cannot be used as an instrument of policy indefinitely, if this hurts the interests of these shareholders, for it is a gross violation of corporate governance norms. Even if the issue of such bonds is an escape route that has to be used at the moment, companies can be spared the burdens of illiquidity by making the bonds more tradable. Finally, the ministry must recognise that this short-term approach cannot go on indefinitely. The government has to start raising the selling prices of these commodities, with a clear explanation to consumers about the inevitability of doing so. Ideally, this would be done within the ambit of a broad political consensus, in which all parties would accept that the government of the day has no choice. This is highly unlikely, even impossible, in the current political scenario. And therein lies the great danger, that an unsustainable policy will be sustained for far too long--causing severe price distortions (and therefore wrong price signals to producers and consumers alike), equally serious fiscal damage, and of course considerable risk to external confidence in the management of an economy that is slowing down despite all the cushioning being provided by soft pricing policies.