The great Indian fiscal dilemma
The state of the economy and the possibility that the government will miss the current year’s fiscal deficit target of 3.2% of gross domestic product (GDP) has put the spotlight on how it manages its finances. The details, of course, will be known when Union finance minister Arun Jaitley presents the last full budget of this government in about a fortnight. The debate on whether it should stick to fiscal consolidation or run a higher deficit to push growth is likely to intensify as we get closer to the budget.
To be sure, there are strong arguments on both sides, as economists Deepak Nayyar (goo.gl/a3zktn) and Vivek Dehejia (goo.gl/u9bnQy) have shown in these pages. Decision making will not be easy for the government; naturally, it will want economic growth to pick up before crucial assembly elections later in the year and the general election next year. But it would be well advised to remain on the path of fiscal prudence for a number of reasons.
First, it is correct that economic growth has been weak and in the current fiscal, the economy is expected to grow at its slowest annual rate since this government assumed office. However, the first advance estimate of gross domestic product for the current year and recent high-frequency data, such as Manufacturing Purchasing Managers’ Index, suggest that economic activity has bottomed out and is likely to pick up in the coming quarters.
Further, the slowdown in the economy can partly be explained by the twin policy shocks of demonetization and the implementation of the goods and services tax (GST). The government is actively working to stabilize the GST system and is likely to continue to work in this direction. It is also working on the bank recapitalization plan. Adequately capitalized banks and progress on resolving bankruptcies in large non-performing accounts should help bring the capex cycle back on track, as the twin balance sheet problem also contributed to the slowdown. Swift movement in these areas will be more useful than pushing expenditure by running a higher deficit.
Second, it is likely that a higher than expected deficit will do more harm than good. The possibility of fiscal slippage and higher borrowing has pushed the benchmark 10-year government bond yield up by about 30 basis points since the beginning of December. The bond market is clearly indicating that it is not comfortable with the idea of increasing the supply of government paper. Higher yield on government bonds will push up the cost of money and can neutralize the intended benefit of higher government spending on economic growth.
Third, a significant deviation from the path of fiscal prudence will also complicate things on the monetary policy front. A higher deficit will increase inflation risks and reduce the possibility of monetary accommodation. In fact, it is possible that with an increase in crude prices, fiscal slippage will add to the possibility of monetary tightening in coming quarters. This would further push bond yields and increase the cost of money.
Fourth, the combined deficit is already on the higher side and is likely to be around 6.5% of GDP in the current year. The government should have extremely compelling reasons for keeping it at higher levels. It would do well to be more conservative in its approach so that it is in a position to absorb shocks. For example, the rise in crude prices has surprised most people. It has been reported that oil companies are now reluctant to pass higher prices on to the consumer. This could affect government finances as lower profits for public sector oil companies would mean lower dividend payments. Any reduction in taxes to protect the consumer will directly affect revenue generation. Besides, it is not clear how much time the GST will take to stabilize. The government should account for these uncertainties in its budget calculations.
The Narendra Modi government has done well on the fiscal front so far. It should carry this process forward. India needs to create jobs and invest in the infrastructure sector—but experience shows that running a higher deficit is not the solution. On the contrary, it has the potential to create more problems as India learned the hard way, most recently in 2013. The economy is now in a much better position, but India needs continued fiscal discipline to preserve the hard-won macroeconomic stability.
Should the government increase the fiscal deficit to push growth? Tell us at email@example.com
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