Going beyond the idea of fiscal stimulus
The government of India is working on a plan to revive the economy after growth slipped to a modest rate of 5.7% in the first quarter of the current fiscal compared with 7.9% in the same quarter last year. Media reports suggest that it is mulling a fiscal stimulus to boost growth, which could increase the fiscal deficit. The idea is that in the absence of sufficient investment demand from the private sector, higher government expenditure will help boost gross domestic product (GDP) growth. It makes political sense. The Narendra Modi government will present its last full budget in February and the Bharatiya Janata Party will be facing a number of crucial assembly elections before the 2019 general election. However, there are sound economic reasons why the government should adhere to its fiscal commitments.
First, the deceleration in growth is partly being explained by the lingering impact of demonetisation and destocking before the implementation of the goods and services tax (GST). The impact will peter out and output affected by these events doesn’t need fiscal support. But since growth started decelerating before these shocks, policy intervention needs to go beyond fiscal stimulus. Opening the fiscal tap at the moment would mean that crucial reforms in areas such as improving the ease of doing business might get postponed.
Second, there is no guarantee that expanding the deficit will take India to a higher sustainable growth path. In fact, the economy already has a fair amount of fiscal support with the combined fiscal deficit running in excess of 6% of GDP. Expanding the deficit by another half a percentage point, for instance, is unlikely to change things materially on the ground. Furthermore, the government has exhausted over 90% of the estimated fiscal deficit for the year in the first four months, but it has not resulted in the desired level of growth. All this shows that increasing government spending may not be sufficient to boost growth in a sustainable manner.
Third, expanding the deficit can complicate policy choices for the Reserve Bank of India (RBI). It can affect RBI’s target of keeping inflation around 4% on a durable basis. The Indian central bank has been extremely sensitive about fiscal discipline and the latest minutes of the meeting of the monetary policy committee (MPC) show that members continue to remain watchful. Governor Urjit Patel, in his remarks, for instance, said: “…the implementation of farm debt waivers by the state governments has significantly increased the fiscal risks and poses an upside risk to the inflation outlook.” Similarly, another member, Chetan Ghate, noted: “...both farm loan waivers and proximity to the 2019 election year suggest that fiscal impulses could contribute to inflationary pressures.” Clearly, fiscal expansion is not something that the MPC will be comfortable with and it will reduce the chances of monetary accommodation in the foreseeable future.
Fourth, even though it has deviated from fiscal commitments in the past, macroeconomic stability is one of the biggest achievements of the Modi government. It should not do anything that will compromise this. If the government decides to expand the deficit in the current year, a reversal will be unlikely in the next fiscal, as it will end close to the general election. This means that the deficit will remain elevated for a considerable period and would affect investor sentiment. It is often suggested that the government should not pay much attention to international investors and rating agencies. This is a mistaken view. It is in India’s own interest to keep its house in order and minimize risk from external shocks. Also, if India needs fiscal support at a time when the global economy is recovering and financial markets are relatively stable, what will happen if some of the economic or geopolitical risks actually materialize? This option should only be used in extreme circumstances.
Economic growth has slowed considerably and the economy needs policy intervention that goes beyond running a bigger deficit. Also, as India learned the hard way a few years ago, it is never easy to cut the budget deficit. What the economy needs is deeper and broader structural reforms that will help attain sustainable higher growth in the medium to long run. To be fair, the government has implemented big-ticket reforms like GST and the bankruptcy code. But it needs to keep moving. For example, factor markets such as for land and labour, and public sector banks need immediate attention.
On the fiscal front, government should address all the issues in the functioning of GST. If revenue gets affected because of operational issues, fiscal management will become extremely difficult. Higher tax revenue from GST will help push public expenditure. The government should also aggressively pursue disinvestment and privatization, which will help augment resources. Irrespective of the slowdown, the Indian economy needs higher public investment, but it need not come at the cost of fiscal discipline.
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