Budget 2018: This could be the best time for Modi to honour fiscal pledges

With elections in sight, India's government is under pressure to loosen fiscal policy in its budget on Thursday. Tempting as this may seem, it would be a mistake.

Chief economic adviser Arvind Subramanian has made the most candid argument for relaxing the country's tough fiscal stance: Given the political calendar, promises to honor the targets simply wouldn't be believed. He has a point -- but the answer is to do a better job of explaining why the targets make sense.

The Indian economy was jolted by the overnight withdrawal of high-value currency notes in November 2016 and last July's introduction of a complicated goods-and-services tax. Plummeting crop prices have caused widespread distress in the rural areas where most Indians live. Facing upcoming state polls, as well as another general election in 2019, Prime Minister Narendra Modi is expected to loosen the purse strings. Indeed, many investors seem to want him to, because they'd like to see him reelected.

Nonetheless, the government ought to stick to its goal of reducing the deficit to 3 percent of the gross domestic product next year. The target for this financial year is likely to be exceeded regardless. Overshooting it again would dent the hard-won confidence that earned India its first debt-ratings upgrade in years last November.

The most recent fiscal numbers have already contributed to a rout in sovereign bonds - lately the worst-performing in Asia. Benchmark 10-year yields rose again after Subramanian's comments and are up almost 40 basis points since the beginning of December. A budget that raises the cost of borrowing any further will undercut any benefit that additional public spending might bring. 

Crude-oil prices compound the problem: They're climbing, which threatens both to worsen the government's subsidy bill and to push up inflation, already at a 17-month high. The government has often expressed its frustration with the Reserve Bank of India for failing to cut rates faster. A populist budget would threaten further increases in inflation and could even force the RBI to raise rates, choking off any potential expansion.

Even without a fiscal boost, the economy is likely to do somewhat better next year. On current policy, the government predicts growth will rise from 6.5 percent to somewhere between 7 percent and 7.5 percent. Exports are up and supply chains have begun to recover from the shock of demonetization. As businesses adjust and the new goods-and-services tax is further streamlined, tax receipts should rise as well.

The best way to support this improvement is not with fiscal indiscipline but by addressing India's bad-loan problem, which would free up banks to lend and companies to invest. The government has made a good start on this and needs to keep at it.

More than any Indian leader in recent memory, Modi has the political space to do the right thing. He faces a weak opposition that's unlikely to pose much threat even in 2019. Voters have shown that they're willing to tolerate pain so long as they see the prime minister as acting in their long-term interests. Even the fallout from demonetization and the new GST haven't seriously dented Modi's astronomical approval ratings.

By insisting that the government honors its fiscal pledges, Modi could burnish his image as a special kind of politician while maintaining India's fiscal credibility. That's the best course for his government and his country.