There are two perspectives that can be justified from the Union Budget of India for 2011/12 delivered in parliament on February 28. First, it was largely an agnostic event and did not make major headway for key reforms (i.e., opening up new sectors for foreign direct investment). Simultaneously, the government maintained restraint by eschewing additional (populist) schemes to gratify sections of the population, considering that there are a few state elections due this year. The stress has been on existing programmes.
Second, for the first time since 2007/08, India’s finance minister may just have convinced investors that the country is making a serious attempt to put its fiscal house in order in a bid to restore macroeconomic stability; the fiscal deficit of the central government is budgeted to decline from 5.1 percent of GDP in 2010/11 to 4.6 percent of GDP in 2011/12. This has been overdue against the backdrop of three successive years of virtually double-digit consumer inflation; strong persistence strongly suggests that this has not been due to food and energy, much as government macroeconomic managers dissemble on the subject. In addition, the emphasis in the budget to pass outstanding economic legislation will be more effective than any major efforts on innovative issues.
Both inflation and interest rates are influenced by expectations. Therefore, the proximate goal of bringing down government-induced aggregate demand in the budget proposals (to moderate inflation expectations and reverse the extant upward pressure on market interest rates) will be well served for driving private investment in the medium term.
A potentially decisive break of substituting indirect (highly distortionary) subsidies for cash transfers in lieu of kerosene, cooking gas (LPG) and fertiliser subsidies is probably the most far-reaching announcement in decades for delivering targeted benefits to the poor. But in these key expenditure categories there are non-trivial risks in the projections made in the budget, in particular the compression of one-half percent of GDP in subsidies envisaged in 2011/12:
- The elevated oil prices, if they persist, will need to be passed through to the final consumer to achieve the fiscal targets, although the budget estimate for 2011/12 shows a decrease from the level for the current year. Without adjustment in retail fuel prices, a one percent of GDP fiscal hole is a distinct possibility. Either the finance minister will have to be lucky so that oil prices moderate soon or his recalcitrant colleagues will have to support him in revising prices of all liquid hydrocarbon fuels.
- An increase in the food subsidy on account of imminent right-to-food legislation does not seem to have been budgeted for. If the universal scheme is not postponed to 2012/13, food subsidy expenditure will increase by an estimated Rs.100-150 billion in the coming year.
- Inflation indexation of the rural employment guarantee payments can add as much as Rs. 100 billion to overall expenditure.
It is noteworthy that during the transition to cash transfers, overall expenditure need not (automatically) decline (and may actually increase). There is compelling, albeit indirect, evidence: the rural income support scheme – a form of dole – that has now been in operation for several years has not led to a reduction in myriad subsidy payments made in the name of the poor in India. It is also pertinent to note that cash transfers per se need not translate into better targeting. The supporting administrative “ecosystem” needs to fall into place (information technology-centric work on this is taking place). Expenditure overrun in entitlements may have to be met by savings elsewhere. The much respected and experienced Indian finance minister will have to actively manage the expenditure compression; it cannot be left on autopilot.
On the tax side of the budget, although revenues slated to increase by 18.5 percent next year may come across as optimistic, the much-delayed removal of tax breaks for the information technology & IT-enabled service providers, and a minimum alternate tax on special economic zones, has justifiable upside potential for enhancing the government’s revenues.
The government’s (and the Reserve Bank of India’s) concern on financing the external current account deficit has forced the finance minister’s hand into liberalising capital inflows, namely, allowing foreign retail investors directly into Indian mutual funds, raising limit for foreign funds in infrastructure debt to US$ 25 billion, and raising the overall cap for foreign institutional investment in corporate debt to US$ 40 billion. Analysts would put these in the category of “fair weather” capital, hence prone to dry up if global risk aversion were to come back into vogue. However, if the requisite legislations are passed to allow higher foreign investment in insurance companies in India and lift voting rights of foreign investors in Indian banks, then more stable and durable inward investment can be expected.
If investment does not respond positively to the finance minister’s “invitation” of a larger “financial space” for the private sector, then growth next year will be considerably lower than the 9 percent (a best-case scenario) that has been assumed by the government. Interest rates have already hardened and are unlikely to reverse quickly, which will impact private corporate investment. Furthermore, in the coming year, the fiscal multiplier will work in reverse as fiscal consolidation is pursued. The fiscal deficit outcome for 2010/11 at 5.1 percent of GDP comprised 1.3 percent of GDP in (non-tax) one-time telecommunications spectrum auction proceeds and 0.3 percent of GDP in disinvestment in government-sponsored enterprises (GSEs). If these are excluded, the fiscal deficit is 6.7 percent of GDP. Now, the 2011/12 budget projects a deficit of 4.6 percent of GDP, which contains 0.4 percent of GDP in GSE disinvestment. In essence, the planned deficit reduction is from 6.7 percent of GDP to 5 percent of GDP – 1.7 percent of GDP in one year – which is unprecedented since the crisis-driven consolidation in 1991/92. A modest fiscal multiplier of 0.5 means that the implied reduction in GDP growth due to aggregate demand compression is about 0.9 of a percentage point. Therefore, because of this and other reasons, overall growth in 2011/12 will be lower than the 8.6 percent achieved in 2010/11 unless private and inward foreign investment in India spikes up considerably on account of, say, greater confidence in the government’s ability to manage affairs, including recent governance challenges at the highest levels which have roiled the country. A potential upside to the “growth calculus” is strong global growth helping to further accelerate the already impressive Indian export earnings rebound in 2010/11.
The table below provides a quick summary of the evolution of some important macroeconomic variables.
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Jonathan D. Pollack will moderate a discussion with Ambassador Frank Wisner on potential nuclear conflicts in Asia and shifting U.S. nuclear policy on April 1.