FINANCIAL SCENE
Fiscal deficit, the biggest challenge
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Borrowing from the RBI has its risks; it will increase money supply and stoke inflation
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It is not just the size of the budgeted fiscal deficit — at 6.8 per cent of the GDP — but the high probability of not being able to check it even over the next two years that is causing concern.
— Photo: AFP
BORROW AND SPEND: Currency notes stacked up at the Reserve Bank of India.
Arguably the biggest challenge before the Finance Minister, and almost certainly his successors as well, will lie in the area of containing the government’s fiscal deficit. The announcement of a 6.8 per cent fiscal deficit has made headlines and has, along with other factors, caused a stock market decline which continued well into the following week. If the deficits of the States and off-budget liabilities (such as petroleum and fertilizer bonds) are taken into account, the combined fiscal deficit will be almost 11 per cent of the GDP.
An immediate consequence of the large deficit will be a big jump in government borrowing. In fact, fiscal deficit is really government’s net borrowing needs. A 6.8 per cent Central government deficit translates into Rs. 400,000 crore of borrowing during 2009-10. That will be roughly four times the amount envisaged in the 2008-09 budget. The States may have to borrow around Rs. 15, 000 crore.
A public borrowing programme of such magnitude will definitely crowd out private investment and push up interest rates.
On budget day, yields on long-dated bonds shot up indicating the market’s unease with the proposed borrowing plan. Borrowing from the RBI has its risks. It will increase money supply and stoke inflation.
A big gamble
There can be no doubt that Finance Minister Pranab Mukherjee has chosen a huge gamble. From the government’s point of view, the only way a calculated risk of this magnitude can pay off, and restore fiscal balance, will be for economic growth to accelerate to its earlier 8.5 per cent to 9 per cent levels, so that tax revenues increase substantially. At the same time, unproductive expenditure will have to be pared down and the heavy social sector spending better targeted.
Governments around the world have incurred deficits to finance their contra cyclical stimulus packages. Some, like the U.K and the U.S., have incurred much larger deficits and consequently borrowed more. Everywhere the expectation is that growth, so badly affected by the global economic crisis, will resume.
However, there is a qualitative difference between India’s economic story and that of developed and most other developing countries except China.
India and China are among the few that are forecast to post positive growth while most others will witness a contraction in their economies.
China’s economy grew by 7.9 per cent in the second quarter this year, due to an ambitious stimulus package and aggressive bank lending.
The Finance Minister is right in proceeding with the stimulus packages, temporarily relaxing the fiscal discipline as mandated by the FRBM legislation, until the negative effects of the global crisis on India are overcome. After all, all countries have agreed — at the G20 meeting in London to undertake a synchronised public spending — to lift the global economy out of the recession.
The additional reason why India has loosened its purse strings is that the emphasis on social sector programmes including the NREGA has delivered rich returns politically. In any case growth with equity is the central theme of the budget.
The real culprit
Between 2007-08 and 2009-10, revenue deficit has gone up more than four times from 1.1 per cent to 4.8 per cent of the GDP and .fiscal deficit from 2.7 per cent to 6.8 per cent. Revenue expenditure has increased by more than Rs. 300,000 crore while tax revenues have risen by just Rs. 35,000 crore. The massive increase is due to interest payments, defence, subsidies, salaries as well as major social programmes such as the NREGA and Bharat Nirman.
Replying to the budget debate, the Finance Minister laid stress on economic reforms and promised action on public sector disinvestment. The fiscal deficit will be brought down to 5.5 per cent by 2010-11 and to 4 per cent by 2011-12, as stated in the Medium Term Policy Statement.
There are sceptics who feel that the government is being overambitious in aiming for a 2.8 per cent reduction in fiscal deficit from the budgeted 6.8 per cent (2009-10) to 4 per cent of the GDP by 2011-12.
Flawed assumption
They have argued that such a large improvement in government finances over a short time has never occurred before in India.
Implicit in the government’s calculations is the assumption that buoyant tax collections will make up for half of the 2.8 per cent fiscal correction. But tax revenues depend on economic growth and India’s growth rate, though impressive in comparison with most other countries, will not be that robust to deliver outsized tax revenues.
It is also felt that economic reform and the introduction of GST cannot be counted upon to improve government finances so dramatically. Aspects of reform such as disinvestment cannot proceed at a brisk pace even if there is no strident political opposition. Despite the best intentions, the government may not be able to introduce GST by April 1, 2010, as announced. A number of important steps including constitutional amendments need to be taken before the new tax can become a reality.
The factors that have driven up revenue expenditure — defence spending, interest payments and outlays on social sector programmes cannot be curtailed even when the need for a fiscal stimulus is not there.
C. R. L. NARASIMHAN
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