Regaining Fiscal Credibility in India
Editor’s Note: An abridged version of this commentary was published as an op-ed in Mint on February 13, 2012.
The challenge of reining in large fiscal deficits has re-emerged in diverse parts of the world. In India doubts over sustaining a high growth performance have morphed to reservations on broad stability issues. There are two macroeconomic drivers that have changed the state of affairs. First was a sharp depreciation of the Indian rupee towards the end of last year to the extent of it being the worst performing currency among emerging market peers, despite hikes in policy rates. Notwithstanding official foreign exchange reserves of $293 billion, India’s external position is no longer felt to be impregnable; for example, the ratio of short term debt on a residual maturity basis to reserves has more than doubled since 2006/07 to 40 percent in 2010/11. The second factor is that the stream of poor, mainly self inflicted, trends for the expected budget outturn in 2011/12 have turned into an avalanche for the government’s fiscal balance (after correctly accounting for off-budget items). Most components of the budget have gone awry, viz., lower than projected tax revenues, negligible privatization receipts, and subsidies reaching stratospheric levels, especially those related to energy. At present, India’s fiscal position, as measured by such common indicators as the general government budget deficit and the general government gross debt (as shares of GDP) puts it in the same camp as recognized fiscally stretched economies. India has had a run of four years of general government deficit of about 10 percent of GDP, of which the central government’s share is two-thirds. Against this background, it is difficult to reject claims that recent growth performance has been propped up by unsustainable aggregate demand policies.
For the most part, the disquiet over India’s fiscal stance stems not so much from impending external debt service problems as doubts over maneuverability. To start with, a virtual exhaustion of fiscal “insurance cover” to counter cyclically deal with prospective shocks emanating as backwash from serious crisis elsewhere like the euro zone, or, Iran, not to mention the task of recapitalizing government-owned banks as non-performing assets rise. The fiscal situation also severely circumscribes exchange rate management by the Reserve Bank of India as an instrument of strategic commercial policy. Even more worrisome, and a source of considerable uncertainty for the nation’s public finance, is the impending expansion of entitlements, both explicitly for food and implicitly for petroleum products. Furthermore, there has been an excessive reliance on monetary policy in the absence of the requisite fiscal retrenchment in the fight against inflation.
It is important to observe that the adverse evolution in the central government’s fiscal balances in recent times has not wholly been on account of the operation of automatic stabilizers during a cyclical slowdown. On the contrary, the central government’s revenues have been buoyant – the gross tax-GDP ratio increased from 9.7 percent in 2004/05 to 12.6 percent in 2007/08 – on the back of an almost 9 percent average annual real growth rate. The profligacy of the central government has its primary driver in populist spending policies initiated in early 2008 by the ruling coalition leading up to national elections in May 2009; three stimulus packages (including a reduction in indirect tax rates) starting in late 2008 to counter the global recessionary headwinds only accentuated matters.
The challenge of addressing the parlous fiscal situation was squarely faced by the 13th Finance Commission (TFC). Quantitative signposts for general government consolidation were recommended. The TFC called for general government deficits to shrink by 4 percentage points of GDP between 2009/10 and 2014/15 and for public debt to fall from 79 to 68 percent of GDP. The TFC also sought to impart integrity to the budgetary process of the central government by drawing attention to off-budget liabilities that had been accumulated since 2005/06.
It is natural at this juncture to examine the broad possibilities to obtain the quantum of consolidation envisaged by the TFC. On the revenue side, the decline in indirect taxes on account of excise duty reduction in 2008/09 presents a natural point for efforts to reverse the trend. In addition, removing exemptions on the direct tax side will add to the revenue kitty without upward tinkering of tax rates. Even more importantly, implementing a comprehensive Goods and Service Tax (GST), which encompasses the petroleum sector, should not be delayed. Rationalization of coal prices in tandem with its inclusion in GST is desirable, viz., mitigating distortion between hydrocarbon fuels and although coal has a share of one-half in commercial primary energy consumption its share in revenue is negligible at 0.1 percent of GDP.
The expenditure side, where the government’s credibility is at its lowest, presents the toughest challenge. India has painted itself in a corner in this regard. Analogous to old-age and health related commitments in mature economies, the implementation of schemes for the poor in India (inter alia comprising of sector subsidies) have been mangled into unconditional, uncapped and open-ended entitlements. In political economy terms, all non-merit subsidies are considered part of social spending, hence a holy cow. A widening of the food security net combined with the inability to adjust petroleum product prices has engendered a backdrop to India’s fiscal challenge that almost seems overwhelming, especially since the large number of stakeholders who benefit from the schemes are perceived, rightly or wrongly, to vote against political dispensations that seek to downsize outlays.
One form of expenditure growth mitigation could be a phased expansion in entitlement coverage so that the impact on the budget is spread over several years. Over time, Aadhar – under implementation by the Unique Identification Authority of India – through better targeting should help to plug leakages and assist expenditure control. However in the near term, on balance, given the constraints on the expenditure side, viz., interest payments, defense and education, disproportionate adjustment on the fiscal balance is likely to come from revenue enhancements.
The difficult path of consolidation is further challenged along other dimensions. Growth is faltering, and even as headline inflation finally shows sign of declining, an important caveat is in order. Energy prices, comprising petroleum and power, have not yet been adjusted to the requisite levels by some distance, with concomitant pass through implications. Core inflation is still above the comfort zone and, therefore, the down cycle in interest rate reduction could be delayed. There has been procrastination in reorienting growth drivers towards eliciting supply and productivity responses in key sectors, and away from government sponsored aggregate demand. Lastly, investing in macroeconomic management credibility means that the Indian government cannot postpone matters; easy options have been exhausted for some time.