The budgetary prudence that Pranab Mukherjee has promised in the coming fiscal year should create the space needed for a new round of economic expansion driven by private sector investment --- just what India needs at this point of the business cycle.
The government hopes that public spending will grow at a slower pace than the growth in the nominal gross domestic product. This along with an estimated Rs75,000 crore that it plans to collect from the sale of equity in public sector firms as well as the auction of spectrum for third generation should help it keep its net market borrowings to Rs3.45 trillion, a level that the financial markets seem very comfortable with.
Higher market borrowings because of a higher fiscal deficit would have pushed up interest rates and put a spoke in the capital spending plans of companies. Such crowding out did not happen last year because corporate demand for funds was low and the Reserve Bank of India could conduct open market operations and desequester Market Stabilization Scheme (MSS) bonds to ensure that the Rs4 trillion borrowing programme for 2009-10 did not unsettle the money markets. This is not possible now: private demand for funds is picking up and the MSS bonds have been used up. The fiscal correction is thus timely.
To understand why it is important for private sector investment to drive growth at this stage of the economic cycle, it would be useful to step back a bit and take a look at what has happened in these two manic years. Economic growth over the past two years has been propped up by a rise in private and government consumption spending, thanks to the fiscal stimulus, increase in funds for select schemes such as the National Rural Employment Guarantee Scheme and the salary increases given to public sector employees. The brutal import compression in the worst months of the downturn also contributed to economic growth.
However, the contribution from investment was negative as companies held back investment plans amid all the uncertainty. Capital spending by the government too has been weak. But there can be no doubts that a fast- growing economy such as ours needs more investments to create capacity and rebuild our tattered infrastructure. The government will help the investment cycle turn if it keeps its borrowings within the budgeted limits, though the decision to increase the minimum alternate tax is a bit puzzling in these circumstances.
The Union budget is just one part of a policy tango so a lot also depends on what the Reserve Bank of India does in the months ahead. The central bank is widely expected to increase policy interest rates in April. A useful thumb rule is that a tighter fiscal policy will allow the central bank to conduct a relatively looser monetary policy. In other words: interest rates would have had to be pushed up more aggressively in case the finance minister had not announced such a deep cut in the fiscal deficit and market borrowings.
Global experience clearly shows that countries that have well-managed public finances can maintain a regime of low interest rates to boost private sector activity. The 13th Finance Commission chaired by economist Vijay Kelkar has quite rightly called for a sharp decrease in the fiscal deficit in the next five years, a rise in capital spending by the government and a cut in the stock of public debt to less hazardous levels.
India needs investment-led growth right now. The sort of fiscal discipline that the finance minister has promised in the coming years should help keep down government borrowings and interest rates, creating incentives for companies to build new capacity.
In that sense, the broad macroeconomic strategy implicit in Budget 2010 is laudable.