The latest report of the Economic Advisory Council, or EAC, to the Prime Minister is a wake-up call, because it presents the macroeconomic quandary more clearly than has been done in the past. While headline attention in the media has focused on the expectation of faster economic growth next year (between 7.5 per cent and eight per cent), that is the relatively unimportant part of the Council’s report — not least because the Council has been consistently behind the curve in anticipating and tracking the slowdown. The meat of the report is in what it says on the trade deficit and the fiscal deficit. For the first time in an official document, the dangers on the external front are spelt out clearly, without pressing panic buttons. The current account deficit, at 3.6 per cent of GDP, is unsustainable and should ideally be capped at two per cent. With oil prices rising, and export markets sluggish, a correction to that extent is unlikely. The danger is that capital flow surpluses, which pay for the current account deficit, may be affected if the external account is seen to be in difficulty. This would point to a fall in the rupee’s external value and, as the Council points out, could hit companies with forex exposure. One way to ward off trouble is to keep the foreign investment flowing, but after the way in which foreign investors have been treated (Qualcomm, Vedanta, Telenor, Etisalat, perhaps even Vodafone) and policy flip-flops, who can be sure of this? What the Council does not say is that the external risk needs to be warded off with precautionary steps, such as the issue in the past of Resurgent India Bonds and Millennium Bonds, which were designed to shore up forex reserves and build confidence in the country’s external viability.
The fiscal deficit is no less a worry. The Council does not go as far as to say that it could climb to six per cent of GDP this year, up from a budgeted 4.6 per cent, but that is what the numbers suggest. Direct tax collection is short by Rs 40,000 crore, and disinvestment by Rs 27,000 crore. On the spending side, the subsidy bill has gone up massively. Even with some savings on expenditure, the overall gap could increase by Rs 1.25 lakh crore, or 1.4 per cent of GDP. The tax collectors have responded with pressure on companies to pay more on corporation tax (the largest source of revenue) even though corporate profits have fallen short. Absurd orders are being issued on transfer pricing in a further desperate effort to collect more tax. This has contributed to the general anti-business mood engendered by the government. Among other things, the Council notes the role being played by a surge in demand for gold, and it wants financial savings to become more attractive. But the decline in the mutual fund business and in insurance premiums this past year is the direct fallout of regulatory action.
The Council says the fiscal problem is not structural, but it notes that controlling the deficit will involve raising politically sensitive prices for fuel, food and fertiliser. And if the government goes ahead, it will take the inflation numbers back up the charts, and create challenges for monetary policy when the slowdown requires a dropping of interest rates. Then there are the new spending commitments being pressed on the government by the Congress leadership — for a food security programme and an expanded health programme. Investment is desperately needed in the infrastructure sector, including in a cash-strapped Railways, and defence spending may have to go up too. Even if the finance minister increases the scope of the service tax, and takes excise duties back to the pre-crisis levels of 2008, it is hard to see the deficit being reined in significantly. As for financing growth, the Council notes the steady fall since 2007-08 in the savings rate, the ratio of tax to GDP, the sharp fall in corporate investment and the general fall in fixed capital investment rates (by 3.6 per cent of GDP). Reversing these will take time. If the monsoon this year is sub-normal, as some early-bird forecasts suggest, the chances of a post-harvest recovery would dim. Therein lie the reasons for lowering growth expectations, for this year and for the medium term.