The sudden turn in India’s optimistic macroeconomic outlook, triggered by high structural inflation and the twin fiscal and current account deficits, is only the backdrop to today’s budget. What lies ahead is worse: the threat of imported inflation as commodity prices dance northward with gay abandon. Given the sensitivity of our economy to oil prices, this alone is capable of sending off the two deficits and inflation into a tizzy. How should these risks inform budgetary decisions in balancing growth and inflation for 2011-12?
There’s little doubt that inflation should carry a larger weight for policymakers. On the one hand, the expected gross domestic product (GDP) outturn for 2010-11 is 8.6%, indicating that output growth is close to, or even above, potential. On the other, demand-side pressures have made the current inflationary cycle, sparked originally by temporary supply disruptions due to a drought in 2009, a persistent phenomenon. In this scenario, the risk of inflation getting out of control in the presence of global uncertainty is very real.
Moreover, some elements of the current high-inflation-high growth configuration bear resemblance to the 2007-08 cycle, when accelerating food and commodity prices abroad supplemented overheating pressures at home. This repetition has turned what was only speculation in 2007 into a fact now: India is incapable of sustaining an 8%-plus growth rate—capacity or supply constraints quickly lead to inflation, resulting in the application of monetary brakes that in turn slow growth.
In terms of policy-mix and timing too, fiscal measures now need to share the burden of economic adjustment, and complement the monetary action taken so far to limit the risks to both inflation and growth.
A fiscal contraction now will affect inflation by cooling overall demand, which in turn will moderate the current account deficit. Then again, rising interest rates, in conjunction with the falling savings rates of the past two years, will lead to lower investment rates and slower economic growth.
A big increase in nominal GDP and buoyant tax and non-tax revenue receipts resulted in an unexpected outcome in 2010-11—a deficit of 4.8% of GDP against the targeted 5.5% (according to the just-released Economic Survey). This should now pave the way for further consolidation in the 2011-12 Budget. An improvement on the 4.8% deficit target recommended in the 13th Finance Commission’s fiscal reform path for 2011-12 —perhaps 4.5% of GDP— would be a signal countercyclical effort matching the above-potential growth rate of 9% that the Economic Survey projects in 2011-12.
Further, concerted action on precise pressure points in the economy can demonstrate the shift of policy focus to inflation. This action could, for instance, include reorienting subsidy expenditure towards capital expenditure in agriculture to specifically address investment deficits in the farm-to-customer chain; and measures to remove market imperfections that contribute to the widening gap in wholesale and retail prices, such as removing inter-state restrictions on marketing and movement of farm goods, eliminating local taxes on these, and so on. The budget should lead with such reforms, even though individual states have to eventually do some of these. A display of strong determination to tackle food inflation upfront through a comprehensive policy package of short- and long-term measures will effectively counter the “strong growth-inflation-monetary speed-breaker” limit to India’s growth.
Two, fiscal consolidation will signify a return to macroeconomic discipline, which is important for markets, investors and the overall business environment. The huge resources raised via spectrum and asset sales in 2010-11 without any offsetting cuts in market borrowings have sent a rather adverse signal of fiscal profligacy that ought to be addressed.
Policies must also be forward looking. The increase in global macro-financial risk—reflected in spiraling oil, food and commodity prices—suggests it is time to make the economy resilient once more. With inflation, current account and the fiscal gap overshooting limits, the room to manoeuvre policies to respond to any external shock has been sharply squeezed. It’s important to remember that in 2008, India entered the crisis on a very strong footing; sound macro fundamentals allowed fiscal responses that helped support domestic demand and enabled the economy to ride over the crisis shock. This could happen only because of the room created by four successive years of fiscal consolidation. It is again time to rebuild fiscal coffers and increase policy space, else an adverse scenario catches India on the wrong foot.
Finally, it’s important to be realistic. Historically, India’s growth dynamics alone have led to improvements in its public balances. It’s best then to sustain growth by engineering supportive conditions—higher savings and investment rates with lowered interest rates and inflation—through macroeconomic policies. The cover page of the Economic Survey 2010-11 is telling in this context. It has the familiar IS-LM curve, the intersection of which determines interest rates and real output in the economy. If this is a herald, then a budgetary effort towards lower interest rates can be expected.
Renu Kohli is a macroeconomic consultant and a former staff member at the International Monetary Fund and the Reserve Bank of India.
Comments are welcome at firstname.lastname@example.org