The Indian economy could be headed for a huge fiscal mess.
The committee headed by Vijay Kelkar has done well to pull no punches in its report on fiscal consolidation that was released on Friday.
The report opens with a bang: “The Indian economy is presently poised at the edge of a fiscal precipice”—a reminder of the current debates about a fiscal cliff in some other countries. The massive hole in government finances has not only left policymakers with few options to defend the economy in case there is another global shock, but is also the core reason for a host of other problems in the Indian economy.
To understand how much India has veered away from fiscal good health, take a look at three road maps. The Fiscal Responsibility and Budget Management (FRBM) Act of 2003 expected the government to eliminate its revenue deficit by 2009 and reduce the fiscal deficit to 3% of gross domestic product. It is well known that India made rapid progress towards these targets till the global crisis intervened.
The 13th Finance Commission then suggested a new fiscal road map, where the original FRBM targets for fiscal and revenue deficits should be met in 2013-14. The second United Progressive Alliance government then used the work done by the 13th Finance Commission to promise the nation in its medium-term fiscal strategy announced in 2010 that the fiscal deficit would be down to 3.5% of gross domestic product (GDP) in 2013-14 and the revenue deficit would be 2.1% of GDP.
Kelkar was an important figure in the framing of the FRBM and he was chairman of the 13th Finance Commission. His latest report gives us some idea about how far India is from meeting the more recent fiscal targets, with the anticipated fiscal deficit of 4.6% of GDP in 2013-14 and a revenue deficit of 2.8% of GDP.
The current government has fallen way behind both the targets suggested by the 13th Finance Commission as well as its own commitments made in 2010.
The core fiscal consolidation strategy outlined by the Kelkar committee is based on “a frontal attack on inequitable subsidies”. That will test the commitment of Prime Minister Manmohan Singh and his team in the months leading to the next national election. It is undoubtedly true that political pressures in a heterogeneous country such as India lead to higher claims on public finances by various powerful interest groups, but the politics of the ruling alliance has been particularly damaging, including providing an inflationary stimulus to consumption spending while destroying the investment climate.
The severity of the fiscal problem means that it is time for tough decisions now. The Kelkar committee has done well to send out a clear warning. “High fiscal deficits tend to heighten inflation, reduce room for monetary policy stimulus, increase the risk of external sector imbalances and dampen private sector investment, growth and employment.”
Not only is there a threat of a sovereign ratings downgrade, but the fiscal problem will eventually spill over into a macroeconomic crisis unless the government grits its teeth and sticks with its newly discovered zeal for hard economic measures.