Hopefully, in the Budget on February 28, the government will see the driver of current inflation for what it really is: an unsurprising consequence of loose monetary and fiscal policies stretching the economy beyond its capacity. If it does that and gives up the misplaced faith in miracle harvests and base effects, it will also do the right thing: pull back the massive fiscal stimulus that has been in play since the global economic crisis.
Why is this important? Think back to January 25. The market had fully priced in a 25 basis point rate hike by the Reserve Bank of India (RBI) and some were bracing for a higher increase. The RBI delivered a 25 basis point hike. But instead of a relief rally, the equity market has bled relentlessly since then.
Not tightening is not always pro- growth or pro-investment. Investors are turning shy today owing to a loss of confidence rather than the high cost of funds. Since the crisis, investment outside of infrastructure has been dormant despite capacity being stretched. At first, what held back investment was the fear of a global double-dip. When this passed, India-specific concerns about regulatory uncertainties and corruption surfaced. And now questions about the ability of macroeconomic policies to rein in inflation have emerged.
To restore confidence, the government and the central bank need to assure investors that they plan to get ahead of the curve rather than stay behind. By letting food inflation fester, the government has allowed inflationary expectations to harden, which are now threatening to ignite a generalised inflation. In December, the monthly momentum of core inflation – which excludes food and fuel – was running at over 11 per cent and that of the narrower non-food manufacturing inflation at 8 per cent, having risen from 1 per cent six months ago!
Remaining behind the curve doesn’t help investment. Instead, it deters investment owing to a heightened fear of a hard landing. To minimise this eventuality, inflationary expectations need to be brought under control and that means sacrificing near-term growth. So we are left with just one choice: sacrifice a little now or a lot later.
Although there are several things the government can do to rebuild investor confidence, my guess is that these will be parsed over the course of the year as and when politically feasible.
More From This Section
The Budget will be an accounting exercise with minimal policy changes. On the surface, the Budget 2011 numbers will look good aided by the spectrum sales revenue and higher taxes collected. The deficit should be 5.2 to 5.3 per cent of GDP, much better than the budgeted 5.5 per cent. If the government runs oil subsidy arrears as it did last year, the cash balance could also be sizeable. Also, chances are that a significant portion of the two supplementary Budgets will not be spent. The government will parade that it brought the deficit down from 6.8 per cent of GDP in the financial year 2010 by 1.5 percentage points while still keeping growth at 8.5 per cent.
But beware of claims that are cosmetic. The spectrum sale was a one-off. Exclude this and the deficit will barely decline from 6.8 to 6.7 per cent of GDP. If the government fully compensates oil companies this year, the adjusted FY11 deficit will be even higher.
And this is where the problem lies. It was one thing to provide stimulus in the financial year 2010 when the economy was staring at the possibility of 6 to 7 per cent growth, but to continue doing so when growth was touching 9 per cent in FY11 questions macroeconomic judgment.
The FY12 Budget gives the government an opportunity to correct this. The FY12 deficit target is likely to be 4.8 per cent of GDP. But achieving this will be a tall order, since it will mean bringing down the deficit from its underlying level of 6.7 per cent of GDP by an unprecedented 1.5 percentage points.
The government will try several options. Some tax bases (direct and indirect) are likely to be expanded such as those for education, health and new properties. Income tax exemption may be raised in line with the next year’s Direct Taxes Code, but this won’t be a major revenue drag. Disinvestment targets will be set higher since the unfinished initial public offerings of this year will be added. And a partial rollback of the excise tax cuts during the crisis may be on the agenda.
On spending, the Budget will use the space provided by the unspent supplementary budget to show only a modest increase. Oil subsidies will again be severely underestimated and the new big subsidy item, the Right to Food Security, will not be budgeted since it has not been passed by Parliament. It will likely be added through a supplementary budget later in the year. The gross borrowing will amount around the same level as this year, but with lower redemptions the net borrowing will be higher. This won’t upset the market much since the cash surplus will be seen as a buffer.
Separately, the government may lower the withholding tax on bonds to develop the corporate bond market to help investment in infrastructure. The Budget will also set a new date for the implementation of the unified Goods and Services Tax (GST) — probably April 2012. But don’t hold your breath. Nothing fundamental is holding up GST, it is just political obstinacy and that isn’t going away anytime soon. Oh! I nearly forgot. There will be lots of sound and fury signifying nearly nothing about black money.
Will these be enough to restore investor confidence? Not really, but the tightening will be a big first step and it will buy the government time to reform the agricultural sector and address regulatory uncertainties and corruption. But the market won’t be patient for too long. In a world awash with liquidity, there are many other places to fish.
The writer is India Chief Economist, JP Morgan The views expressed are personal