It needs to take into account the permanent and transitory components of the deficit.
The debate on the need for additional fiscal stimulus in 2009-10 is overshadowed by apprehensions about the rapid deterioration in India’s fiscal balances. A projected deficit of 5.5 per cent of GDP in the interim budget for 2009-10 and an 80 per cent public debt-level make it obvious there is no fiscal room to run a countercyclical fiscal policy.
Given that two key drivers of economic growth in the past five years, investment and exports, are sharply hit, it is consumption and domestic demand that will have to support growth until the external environment improves sufficiently. These two developments will lop off 2-3 percentage points of economic growth over the next two years. So, assuming a 7-8 per cent potential GDP growth, this ‘output gap’ justifies the need for a fiscal boost.
The lack-of-fiscal-room concerns stem from the fact that the combined deficit of the centre and the states, at 8.9 per cent of GDP in 2008-09 and projected at 8.8 per cent of GDP in 2009-10, is already above its historical average of 7.9 per cent for the first seven years of this decade. Inclusive of the off-budget items, the augmented, consolidated deficit is at least 3 percentage points higher. This build-up has now led to the questioning of debt sustainability, conflict between debt-financing and monetary policy and worries of macroeconomic instability driven by the public-debt dynamics.
It is doubtful if debt sustainability would be an issue in the current scenario had ‘credibility’ been there; one has only to look at Japan, with debt levels touching 200 per cent of GDP and no sustainability concerns. Or the ease with which the US and the UK can run up big budget deficits without adversely affecting market sentiment.
There are two aspects to this problem: the need for stimulus and a plan for assuaging market confidence. First, the need for further fiscal support must be derived squarely from the estimated output gap in 2009-10, making it clear that no extra spending but that justified by growth-concerns is being undertaken. Second, the impact of major fiscal measures taken in 2008-09 must be quantified to establish government spending and outcome linkages. Three, the distribution between taxation and spending components must be based upon observed fiscal multipliers to direct stimulus measures at the most effective components. Lastly, there should be a clear time-frame for withdrawal of these measures; for example, an exit plan could be linked to growth, investment revival, exports, or any other indicator.
The second aspect of this problem is to reassert commitment to fiscal discipline in the medium term. The Fiscal Responsibility and Budget Management (FRBM) Act, as it stands, does not make any allowances for the state of the economy. Violations of rules under the act are permitted only in the event of national calamity, national security or any exceptional grounds that the government may specify. So when the economy was hit by the sudden but very steep and sustained spike in oil prices, the government responded to the supply shock by issuing oil bonds that were kept off the Budget in order to meet its targets, but eroded its reputation and commitment to fiscal reform. Likewise, the surpluses earned during the economic boom were squandered in a burst of generosity in 2008-09, violating the key precept of the FRBM Act. And now, in the face of a severe downturn, an institutionally-constrained government has responded by setting aside the fiscal rules to run a countercyclical fiscal stance.
The FRBM Act does not distinguish between what is structural and what is cyclical. These rules now also constitute the benchmark for fiscal appraisal. Such an assessment has prompted at least one rating agency to downgrade the country’s long-term sovereign credit rating outlook from ‘stable’ to ‘negative’, cautioning foreign investors and likely raising the risk-premium for domestic borrowers in overseas markets and thus worsening the already bleak external financing environment. There is, therefore, a need to modify the FRBM Act; allowing for a countercyclical fiscal stance will not only bind the government to use cyclical surpluses to offset deficits, but also communicate its near-term fiscal stance to the markets.
But this would still leave the historical fiscal gap, which typically takes longer to adjust, as cyclical surpluses are likely to be consumed during a downturn. Let’s use a simple rule of thumb that every percentage point of less growth leads automatically (via tax and transfers) to an increase in the deficit of a little less than 0.5 per cent of GDP. If potential output is 8 per cent (though this is debatable), there would be a budget surplus of 0.9 per cent of GDP (0.5 into the difference between the actual and the potential growth) at the peak of the business cycle in 2006-07. Adjusting for a contributable surplus, the reduced deficit would be 4.5 per cent of GDP (against actual deficit of 5.3 per cent). Likewise, there would be a fiscal surplus of 0.7 per cent of GDP and an adjusted deficit of 4.9 per cent of GDP. And in 2008-09, when actual growth is expected to be around 6.5 per cent, the cyclical shortfall would be 0.8 per cent of GDP, followed by a cyclical deficit of at least 1 per cent of GDP in 2009-10 (assuming real GDP growth of 6 per cent). So what is gained on the swings would be lost on the roundabouts, leaving the persistent deficit almost intact, albeit slowly correcting with rising tax levels and expenditure reform.
In other words, cyclical surpluses can usefully offset cyclical deficits, but are less than adequate in addressing persistent, historical deficits that can only be eliminated over longer periods of time. Therefore, the countercyclical fiscal stance needs to be combined with a credible plan for fiscal consolidation to reiterate commitment to policy discipline. The plan for achieving this goal should be realistic and believable. It can even incorporate creation of a political space to carry forth structural fiscal reforms regardless of the nature of the government (majority or coalition) or its duration, so that politicians of all hues are committed to fiscal consolidation. Illustratively, the implementation of VAT would have been impossible without the evolution of political consensus via the Empowered Committee of State Finance Ministers; a political vehicle for restoration of government finances to good health could similarly be thought of. Consider, for example, a one-time adjustment through divestment, a matter that can only be resolved politically. There is a need to recognise that structural, fiscal reforms are as much a matter of economics as politics and they take a long time.
Just as the current crisis emphasises the need for counter-cyclical fiscal policy as India integrates more with the global economy, it also reinforces the need for policymakers to realise that they cannot become more globalised and also desire to keep domestic prices out of line. Broader economic convergence will eventually bind them to policy discipline.
