Surjit S Bhalla & Rohit Chawdhry: Bye Bye Fiscal Deficit

IT DOESN'T MATTER

There is increasing evidence that the RBI may well have overreacted in its monetary tightening in 2006, not unlike the 1995 monetary fiasco.

It is very likely that the Indian economy entered a structurally different phase starting in 2003. GDP growth will exceed 8 per cent for the fourth year in a row. However, there are many who see this growth pattern as a blip. Just last month, the RBI somewhat surprisingly raised credit requirements to cause nominal interest rates to rise by 50 basis points. Given that inflation is likely to fall by at least half per cent over the next few months (oil prices have declined significantly, manufactured goods prices are stable and wholesale food prices have actually declined since September), this means that the RBI has through its policy raised real interest rates by a minimum of 1 percentage point.

The RBI has embarked on this course because it feels that the economy has entered a significant "overheating" mode. It clearly does not buy the analysis of several economists (including this author) that the Indian economy has shifted gear to an 8 per cent plus growth path. Nor does the RBI put much weight behind the Planning Commission projections of a sustained 8 per cent growth profile. And obviously, the RBI believes that the PM is just being a politician, and not a respected economist, when he talks about the realistic possibility of a 10 per cent growth profile in the near future.

The last time the RBI went significantly against the grain, and against growth, was in 1995 when, at least ex-post, it tightened way too much and brought the economy crashing down to a GDP growth rate below 5 per cent. The stock market also crashed, declining by over a third in a short space of two years (and well before the onset of the Asian financial crisis). Will history repeat itself in the near future?

That remains to be seen but if the RBI wants counter-cyclical policy, it should be very pleased with the figures on the fiscal deficit for this year. In November this year, as part of the IIC Mid-Year Review of the economy, I had offered some evidence to suggest that a large part of the "extra" growth that India had achieved over the last few years had gone into investment and not consumption. The investment rate (share of investment in GDP) had, according to my calculations, jumped to around 38-40 per cent in the current fiscal year, up some 8 to 10 percentage points from the 30 per cent level prevailing in 2004-05.

The question raised by this forecast""where is the extra investment coming from? Answer""from domestic savings and most emphatically not from foreign savings (current account deficit). In 2005-06, the share of financial savings in GDP had already increased by 2.6 percentage points""from 14 per cent to 16.6 per cent of GDP (RBI Annual Report). Going by "historical" relationships between financial and total household savings, this implies that the household savings rate would have increased by at least 4 percentage points (ppt) in 2005-06, and most likely by an additional 2 ppt in 2006-07. This means that almost a 6 ppt increase in investment would have come about from just household savings. 
 

PUBLIC FINANCES IN INDIA, 2004-2006                                                                                       (All figs as % of GDP)
	Revenue			Expenditure			Deficit
	Centre	State	Total	Centre	State	Total	Centre	State	Total
2004	9.8	11.9	21.7	15.9	13.9	29.8	4.0	3.5	7.5
2005	10.0	12.9	22.9	14.1	16.1	30.2	4.1	3.2	7.3
2006 (BE)	10.1	12.8	22.9	13.8	15.4	29.2	3.7	2.6	6.3
2006 (Oxus)	11.4	13.5	24.9	13.8	15.4	29.2	2.4	1.9	4.3
Source: Oxus Investments, Mid Year Review of the Indian Economy, 2006/7  Note: BE refers to budgeted figures while last row contains estimates by Oxus

The forecast for increase in the investment rate in just 2 years""8 to 10 ppt. The real surprise is most likely going to be in the form of a significantly lower fiscal deficit (of both the Centre and the states). The consolidated fiscal deficit for the last three years as percentage of GDP: 7.5, 7.3 and 6.3 per cent (budgeted, 2006-07). If the 6.3 per cent target is achieved, then the savings rate in 2006-07 would be approximately 37 per cent""forecast achieved and with no help from the rapidly increasing corporate savings!

How likely is it that the combined centre and state fiscal deficit will be below 5 per cent this year, well below the budgeted 6.3 per cent? Very likely. The Budget deficit is an outcome of two variables""expenditures and revenue. Expenditures are budgeted, passed by Parliament, and frozen, at least until Parliament authorises additional expenditures. It is not unknown for expenditures to be increased during the year; on average over the last seven years, central expenditures have overshot the Budget by about 3 per cent. Assuming the same overshooting for state expenditures, it is possible that government expenditures will be higher by 3 per cent than budgeted, or about 1 per cent of GDP.

The other side of the story, tax revenue, has exceeded all budgets, and expectations. By November end, revenue was up 32 per cent over last year (April-November). There is little reason to think that the full year revenue growth would be less than this number. The budgeted revenue increase is 19 per cent. Tax revenue this year is likely to be higher by 2 per cent of GDP; if expenditure growth stays as planned (see table) then the fiscal deficit this year is likely to be well below 5 per cent of GDP and the lowest in the last 30 years. Even with some expenditure leakage, the budget target will be exceeded. So the worst-case scenario is for the central and state fiscal deficit to be close to 5 per cent of GDP, i.e. an approximate increase in government savings of 2.5 percentage points since 2004-05.

If a small increase in the corporate savings rate is expected, then, in all likelihood, the savings rate in India in 2006-07 will be very close to 38 per cent of GDP; and an investment rate somewhere between 38 and 40 per cent. India has gone on an investment spree, not a consumption real estate binge as presumed by some. This is a structural change of a fairly robust magnitude. A decline in fiscal deficit of this magnitude (2 to 3 per cent of GDP) is counter-cyclical and contractionary.

This raises the obvious question: was a drastic real interest hike of 100 basis points, as engineered by the RBI, really necessary? The RBI should worry that its wishes may come true""the joint impact of a world economic slowdown and a very tight monetary policy may move the Indian economy from misperceived overheating to being undercooked.

ssbhalla@gmail.com