The government needs to plan for the benign assumptions underlying the Budget turning sour, says Subir Gokarn
The Union Budget for 2009-10 estimated that the fiscal deficit for the current year would be 6.8 per cent of GDP, 1.3 percentage points higher than the interim budget had projected. Of this, 4.8 per cent of GDP is attributable to the revenue deficit, which was supposed to have been eliminated under the original roadmap laid out by the Fiscal Responsibility and Budget Management (FRBM) Act. In a macroeconomic environment in which the bottom was falling out, such a large deviation from fiscal rules would have been justified as an emergency response to a crisis. Without a massive fiscal transfusion, consequences be damned, there might have been nothing left to save.
However, in the context of “green shoots”, the perception that the worst is behind us and stabilisation and recovery are under way, the crisis response argument is weakened somewhat. If the patient is out of emergency care, the collateral consequences of different courses of treatment must be taken into account while making a decision. It is from this perspective that one has to ask the following questions about the Budget. First, in what scenario will it deliver its promise of growth with fiscal consolidation? Second, what features of this scenario are most likely to change for the worse, threatening to derail the already delicate fiscal balance?
The ‘Plan A’ is straightforward. The recovery that many people think has begun will enable tax revenues to grow more robustly than the rather conservative estimates made by the Budget. Global liquidity is high and will continue to flow into the relatively better-performing emerging economies, India certainly being one of these. This should help the financial system absorb the very large borrowing requirement of government without too much upward pressure on interest rates.
Importantly, in light of the benign inflationary situation, the dollar inflow will not create the kind of liquidity pressures in did during 2004-07. The Reserve Bank of India can absorb the inflows with the twin objectives of replenishing its reserves and managing rupee appreciation in the short term, without worrying about the increase in domestic liquidity that this will create. In fact the central bank has a significant amount of headroom to lower its benchmark repo rate to help contain lending rates to a reasonable level. This, in turn, will spur lending, particularly at the retail level, which will combine with the personal tax reductions to stimulate consumer spending. We can thus visualise a virtuous cycle of expansionary fiscal and accommodative monetary policies taking advantage of low inflation to offset the slowdown in the economy.
This process will help contain the fiscal deficit, particularly its revenue component as stronger growth generates larger revenues. The government can, of course, supplement tax revenues with larger realisations from disinvestment. Very little credit was taken for this in the Budget, but the move to have a minimum of 25 per cent of the equity of listed companies outside the control of the promoter is one way to enhance this. Substantial dilution of the government’s stake in public enterprises will have to take place to comply with this requirement.
In short, even though the estimated fiscal deficit is a cause for concern, there is a plausible scenario in which it effectively sets an upper bound. In the Plan A scenario, the probabilities of deviation appear to be loaded towards improvement rather than deterioration.
But, let’s look at ways in which the Plan A scenario can break down. First, global liquidity may be plentiful, but there is no guarantee that it will continue to flow into India at the rate at which it has over the past few months. If, for any reason, investors stay away from India, one source of liquidity that would have helped to keep domestic interest rates down will disappear. Further upward pressure on interest rates will deter borrowing and lending; if consumers do not borrow, the macroeconomic benefits of the personal tax changes will be diluted. Growth will not be as fast as anticipated, which will, by way of revenue slippages, put additional pressure on the fiscal deficit.
The same global liquidity that the economy is counting on could actually turn out to hurt it. After a break of some months, it is finding its way back into oil and commodity markets, causing prices to rise beyond levels that would be explicable purely in terms of demand and supply conditions. In other words, oil and commodities are re-emerging as asset classes. Although the intensity of this source of pressure on prices is currently far less than was seen during late 2007 and early 2008, it could build up to a point where it has significant policy implications.
As in early 2008, central banks including the Reserve Bank of India will have to confront the potential inflationary consequences of these developments. If the pressure on prices mounts, central banks may be forced into, at best, a neutral stance, but, quite likely, into an anti-inflation position in which they will have to raise their benchmark rates and curb liquidity to offset the inflationary impact of high oil and commodity prices. If this were to happen before the recovery were to take hold, it could take the global, including the Indian, economy into a double-dip or W-shaped recession. For India, one of the implications is that revenue collections may fall short of even the conservative budget estimates, widening the deficit further.
Rising oil prices and their concomitant impact on fertiliser prices pose a huge dilemma for the government in the current macroeconomic environment. If the higher prices are passed on, the impact on inflation and the chances of a monetary response will be higher. As far as fertilisers are concerned, the uncertainties surrounding the performance of the monsoons make it difficult enough to raise issue prices. On both fronts, if price increases are not passed on, the subsidy bill will obviously increase, completely upsetting budgetary calculations. Devices like oil bonds will not help to mitigate concerns about these developments.
One can hope that the assumptions underlying the Plan A scenario do not turn out to be false. But, given that the risk exists, it is necessary to have a Plan B to deal with the alternative and far less benign scenario. At the fiscal level, this will have to identify sources of significant amounts of new revenue and non-priority expenditures, which can be postponed or cancelled. Good fiscal policy is as much about mitigating risk as it is about stimulating growth.
The author is Chief Economist, Standard & Poor’s Asia-Pacific. Views are personal.
