The fiscal-monetary mix is an important aspect of how an economic cycle is managed. In fact, a lopsided mix has been an underappreciated contributor to the crippling of the India story. This in no way downplays the painful fallout of the corruption scandals. However, even today the suboptimal fiscal-monetary mix remains a critical risk to the strength and sustainability of economic recovery. This is mainly because the quality of India's fiscal correction remains poor, never mind the make-believe assumptions of the interim Budget 2014-15.
Contrary to fashionable thinking, the issue with India's fiscal stimulus in the aftermath of the global financial crisis in 2008 was not that it was excessive, but that it was not withdrawn adequately or in a timely manner. Most people become better analysts ex-post. But policymaking is a real-time process and there was little protest against the fiscal boost at that time. It was also a fashionable policy initiative globally then, and, of course, it was politically convenient locally. After all, few politicians resist the temptation to have more funds to spend.
To be sure, the 2010-11 Budget speech acknowledged the efficacy of the aggressive fiscal and monetary stimulus in facilitating a quick recovery. However, it went on to emphasise the need to "…quickly revert to the high-GDP growth path of nine per cent and then find the means to cross the 'double-digit growth barrier'". And to achieve this, the then finance minister called for "…imparting a fresh momentum to the impressive recovery in growth witnessed in the past few months".
To be fair, the government did talk about the importance of fiscal consolidation after the Centre's fiscal deficit averaged 6.2 per cent of GDP in the two previous fiscal years. And it even began a gradual rollback of the earlier excise duty reduction. But the overall approach remained more lax than it should have been. In fact, a windfall from the 3G spectrum auction - counted as a revenue item, as is typically done in India, rather than as a financing item, as should be done under higher standards of fiscal transparency - made the actual fiscal deficit of 4.8 per cent of GDP (Budget forecast: 5.5 per cent) appear better than it really was.
Indeed, in 2011-12, the fiscal deficit turned out to be 5.7 per cent of GDP compared with the Budget target of 4.6 per cent of GDP. That Budget also announced rolling targets for the fiscal deficit at 4.1 per cent for 2012-13 and 3.5 per cent for 2013-14. What went wrong with the Budget's calculations? Well, the same issue that also plagued the subsequent two Budgets and the recently announced interim Budget for 2014-15: revenue assumptions were optimistic, while expenditure assumptions were conservative. These willingly fathered fiscal mishaps should further undermine whatever little fiscal credibility that exists.
Optically, the government can always claim that the fiscal deficit has been improving and that the government's debt-to-GDP ratio has been declining. Unfortunately, there are three problems with these arguments. First, India's reliance on financial repression and the Reserve Bank of India's (RBI's) large-heartedness in recent years, which saw it keep on buying government paper, kept the nominal cost of borrowing artificially low. It was also lower than nominal GDP growth, resulting in a declining debt-to-GDP ratio. In fact, thanks to uncomfortably high consumer price inflation, the real borrowing cost to the government has actually been negative!
Second, the size of the fiscal deficit is understated even if there is some directional improvement. This is because India habitually includes one-off intakes from telecom auction, divestment and disinvestment as revenues instead of financing items. Thus, the fiscal deficit for 2014-15 is 4.7 per cent of GDP, instead of the official 4.1 per cent. This is more than a definitional quibble. Indeed, by including these one-off financing items as revenue, the government is underestimating the fiscal injection into the economy.
Finally, for two consecutive years, last-minute spending cuts were needed to salvage the fiscal position after it was allowed to run amok for most of the year. This approach is unsustainable. It is also unwelcome from the standpoint of mapping an appropriate monetary response function.
It is a foregone conclusion that the new government will have to rework the fiscal arithmetic. The new government can still deliver the same fiscal deficit, but certainly not with the existing assumptions for revenue and spending.
If India's fiscal dynamics leave a lot to be desired, monetary policy has become more transparent and consistent. This is despite the RBI engineering a tectonic shift towards using the consumer price index to set benchmark policy rates. The shift to targeting retail inflation will be the single biggest of positive developments, since it will play a critical role in managing households' inflation expectations. For the first time, the RBI will explicitly target the inflation metric that better captures households' inflation outlook.
Unfortunately, there are still some misguided apprehensions about the RBI's new proposed policy framework, including thinking of it as anti-growth. These stem from incorrectly thinking of the new approach as fanatically and narrowly focused on inflation at the expense of other indicators, which supposedly were adequately covered in the prior multiple indicators approach. Political pro-growth rhetoric also irresponsibly put pressure on the RBI to be less stern in its fight against inflation. Indian politicians fail to realise that low and stable inflation is a prerequisite for a sustained acceleration in economic growth. Whether it'll also be a sufficient condition will really be up to the government's response in tackling the supply-side impediments.
India's fiscal-monetary mix continues to be terribly lopsided. The quality and pace of fiscal correction are far from what they should be. And monetary policy is understandably tighter as the RBI has undertaken a welcome transition to also think about depositors along with the typically overwhelming pro-growth interest of the business lobby groups and their pressure on politicians.
Inflation has been higher than real GDP growth for five consecutive years, and that pattern will likely remain in place for another couple of years, though the gap will narrow. India's recent macro stabilisation, including in the rupee, owes a lot to the efforts of the RBI under Governor Raghuram Rajan. Hopefully, the next government will spend less time and effort in undermining the central bank and, instead, do more of what it should do. That approach will facilitate more degrees of freedom for the central bank, and, in time, result in lower interest rates as retail inflation eases.
The writer is senior economist at CLSA, Singapore.
These views are his own
Disclaimer: These are personal views of the writer. They do not necessarily reflect the opinion of www.business-standard.com or the Business Standard newspaper
