The interim budget that was announced by the UPA government on 16 February revealed that the Centre’s fiscal deficit is expected to rise to 6% of GDP in fiscal 2009 and 5.5% in fiscal 2010. Adding off-balance sheet items and state governments’ fiscal deficit, the consolidated gross fiscal deficit is expected to be close to 10-11% in both these years. This is the highest ever fiscal deficit recorded by India since independence.
The current fiscal deficit levels are comparable with the period between 1999-2000 and 2001-2002, when the gross fiscal deficit had increased to 9.5-10% due to the adverse effect of the Fifth Pay Commission awards. This article tries to draw some lessons from the previous cycle of high fiscal deficits and endeavours to throw some light on how the present high levels of fiscal deficit will affect the real economy in the coming years.
Also See Learning From The Past (Graphic)
As shown in the adjoining table, fiscal deficit between 1999-2000 and 2001-2002 remained sticky at about 9.5-10%. Higher fiscal deficit meant a rise in public dissavings, which rose from -0.8% of GDP in 1999-2000 to -2% of GDP. On the other hand, corporate savings declined from 4.5% of GDP in 1999-2000 to 3.4% of GDP by 2001-02. The household savings component, however, increased in this three-year period from 21.1% to 22.1% as households preferred to save more than spend in an uncertain economic scenario. But the steep fall in corporate savings and a sharp rise in public dissavings led to a fall in the overall gross domestic savings from 24.8% in fiscal 2000 to 23.5% in 2001-02.
On the gross domestic capital formation (GDCF) front, public investments held up pretty well, consistently around 7% of GDP while private investments came down from 17.9% in fiscal 2000 to 16.7% in 2001-02 (due to crowding out effect), thereby dragging the overall GDCF down from 25.9% to 22.8% by the end of 2001-02.
The current account balance, which bridges the gap between domestic savings and investment turned from a deficit of -1% of GDP in fiscal 2000 to a surplus of 0.7% of GDP by 2001-02. This effectively meant that India turned from a net savings importing country to a net savings exporting country. In other words, domestic investment activity remained extremely weak during this period to even absorb the domestic savings fully, which led India to export part of its domestic savings abroad.
Weak investment sentiments were reflected in capital goods growth turning negative 3.5% by 2001-02 from a rise of 15.6% in fiscal 2000. Consumer goods growth, on the other hand, remained strong in this three-year period due to fiscal pump-priming. This is typical in an economic down cycle where the more volatile investment sector takes a bigger hit than the consumption sector as most of the government policies in an economic downturn are aimed at boosting consumer spending.
The overall impact of a higher fiscal deficit between fiscal years 2000 and 2002 was a sizable reduction in gross domestic savings and investment, which pulled down the real GDP growth from 6.4% in 1999-2000 to 4.4% in 2000-01 and 5.8% in 2001-02.
The visible negative effects of the previous high deficit period forced the government to pass the Fiscal Responsibility and Budget Management Bill in 2003, which later helped bring the Centre’s fiscal deficit as a percentage of GDP down to 3.1% in FY08 from a peak of 6.1% in 2001-02. But most of this improvement was just on paper, brought about by a rapid growth in the nominal GDP during the FY03-08 period. On an absolute scale, India’s fiscal deficit did not shrink at all and remained virtually unchanged in FY06, FY07 and FY08.
So how will the present high levels of fiscal deficit impact the real economy in the coming years?
First, a sustained high fiscal deficit will gradually lead to a steepening of the yield curve once the rate cut cycle is over and result in crowding out of private investments. Capital goods sector growth has already fallen to 2.3% in December 2008 (the lowest since April 2002) on a three-month moving average basis from a peak of 24.2% in October 2007. With investment activity deteriorating rapidly, capital goods growth may even head towards negative territory in the next fiscal. Contra-cyclical fiscal and monetary policy will, however, help support consumption growth. But, as investment growth plays a bigger role in maintaining the growth momentum in the economy, as witnessed in the last five-year boom period, the real GDP growth would take a bigger hit as investments growth falls sharply, even as consumption growth holds up.
Second, a shrinking investment demand will need lesser foreign savings to fund the investment growth. This will result in the current account deficit turning into a surplus over the next few years.
Third, a higher fiscal deficit may also result in a sovereign rating downgrade by international credit rating agencies, leading to more capital outflows and depreciation of the rupee.
And lastly, a high fiscal deficit and excessive monetary stimulus to prop up growth is bound to result in higher inflation pressures in 2010.
After the last economic down cycle, Indian economic growth revived primarily because of the global lax monetary policy that was followed between 2003 and 2006, which led to a humongous amount of capital flows coming into the Indian economy, thus helping to prop up investment demand. This time round, despite the various fiscal and monetary stimulus policies adopted by most developed nations, the global economy would not revive at least in the next five years. What it means for India is that it might get stuck in a low growth trajectory in the coming years with added pressures of an unsustainably high fiscal deficit and the spectre of a high inflation. Could it get any worse?
Kaushik Das is an economist with Kotak Mahindra Bank. These are his personal views. Comment at email@example.com
Graphics by Ahmed Raza Khan / Mint