The first thing the new government has to do is to spell out its plan to deal with the mounting fiscal deficit.
Thanks to the global financial crisis, the fiscal monster has once again raised its ugly head. Like plummeting growth, the fiscal worsening is also synchronised across the globe. Slowing growth has shrunk revenues while the unprecedented size of discretionary fiscal stimulus has bloated expenditures in most major economies. The deterioration in government finances is more marked and expected to be more prolonged in advanced economies in comparison with emerging countries (IMF, 2009). High deficit and debt levels can crowd out private investment, reduce the fiscal latitude for investment in human development and infrastructure and create difficulties for the implementation of monetary policies. Once economies across the globe begin to recover, the increased size of the government is bound to crowd out private investment.
India embarked on a fiscal consolidation programme in the early nineties and strengthened it through the Fiscal Responsibility and Budget Management Act (FRBM). The success of the fiscal reforms programme has been mixed. In the current decade, the easing of fiscal stress since 2003-04 coincided with India’s transition to a high growth trajectory. Despite the lack of expenditure reforms, the sharp rise in revenue buoyancy (aided by high growth, excellent corporate performance and tax reforms) was enough to trigger a phase of steadily improving fiscal balances after 2003-04. Indeed, the central government achieved the FRBM target of a 3 per cent fiscal deficit in 2007-08, a year ahead of the mandated date. The more critical parameter — the revenue deficit — however could not be trimmed to zero and the debt-to-GDP ratio continued to remain high.
All this got decisively reversed in 2008-09. The fiscal deficit of the central government (including off budget liabilities) touched 7.8 per cent of GDP as against the initial target of 2.5 per cent. The sharp and sudden worsening of India’s public finances can be attributed to domestic developments as well as external shocks.
On the domestic front, the implementation of the Sixth Pay Commission Report, the National Rural Employment Guarantee Act, the farm loan waiver and various subsidies has fuelled government expenditure. The impact of global developments can be categorised in two parts. The first was the commodity price shocks in the first half of 2008-09. It resulted in a ballooning of the oil, fertiliser and food subsidy bills. The second shock came from the global financial crisis. As the crisis deepened, and started affecting India’s real economy, the government provided some fiscal stimulus by reducing different taxes and duties and also by raising expenditures. The FRBM targets were postponed to ensure the economy didn’t have a very sharp contraction in growth.
The key issue is whether the current fiscal worsening will be temporary in nature or whether it is structural and will pressure government finances over the medium-term. This distinction is important as transitory factors will correct themselves, but structural factors will have a lasting impact on fiscal sustainability. The fiscal stress due to the sharp global slowdown and its impact on economic growth (and hence on revenue buoyancy), the subsidy shock from high oil and commodity prices and the additional spending on the fiscal stimulus can all be broadly classified as transitory in nature — they will self-correct when the cycle turns.
On the structural side, the key positive developments in the last few years have been the disciplining impact of the FRBM and the widening coverage of the services sector tax. But the unreformed subsidy regime and the persistence of populist measures like the farm loan waiver are structural factors which accentuate the impact of cyclical factors, and make the fiscal situation vulnerable.
We have analysed the short and medium-term fiscal scenarios for India using a fairly disaggregated fiscal model. The revenue performance of the government is not linked to the aggregate growth performance but depends on its sectoral dynamics. While the buoyancy in industry leads to buoyant revenues, the buoyancy in agriculture has no impact on revenue performance. Recognising this, government revenues have been linked to the appropriate GDP base. The revenue buoyancy itself has been found to be sensitive to the growth rate — it is higher in an upturn and lower in a downturn. The model captures this non-linearity in the response of revenue collections to the economic cycle. For 2009-10, we have assumed the major expenditure categories will grow as projected in the interim budget. We have assumed that expenditure growth will revert back to its normal trend once the stimulus is stopped. It has been assumed the arrears to central government employees will not continue beyond 2009-10. The expenditure on the farm loan waiver has been distributed over five years (till 2011-12). The interest payment component of the expenditure is linked to changes in debt stock and interest rates.
Last but not the least, is the assumption on the future growth trajectory of the economy. For purposes of this exercise, we assume that the growth rate will be 6.1 per cent in 2009-10. It will increase to 7.2 per cent in 2010-11 and to 8 per cent thereafter.
The model’s simulations indicate that fiscal stress is likely to continue with only moderate corrections in the fiscal deficit-to-GDP and revenue deficit-to-GDP after 2009-10. The fiscal deficit comes down from 6 per cent of GDP in 2008-09 to 3.5 per cent by 2013-14.
Fiscal projections over the medium-term clearly indicate that unless concerted efforts are made to curb expenditures and/or raise revenues, reducing the revenue deficit to zero will remain an elusive target over the medium-term.
Under the current set of assumptions, the debt-to-GDP ratio is unlikely to explode. The debt dynamics can be understood in terms of the growth, interest rates and primary deficits. As long as the growth remains higher than the cost of borrowing (interest rates), the debt ratio can be kept stable even by running a primary deficit. The current downturn notwithstanding, the structural upward shift in growth rates and a downward shift in interest rates will help in ensuring debt levels do not explode. If however, growth slips further and/or expenditures do not revert to their normal trend, India will face a rising debt ratio. The task before the new government would be to clearly lay out its medium term fiscal strategy. This would be critical to ensure India doesn’t fall on the slippery fiscal path.
The authors are, respectively, Principal Economist and Economist at CRISIL. A fuller version appears in Crisil’s April EcoView.
