This year’s Budget is a demonstration of the discipline that global integration imposes upon countries. The modest contraction in the fiscal stance displays a responsible coordination of macroeconomic policies. Its overall message—serious effort at consolidating public finances—manages fiscal expectations positively. Both were necessary to contain rating hawks and reassure markets and investors—the new watchdogs of open India.
Photo: Raj K Raj / Hindustan Times
This remarkable development owes significantly to the pressures of growing economic openness. The fiscal retrenchment—through a 1.2 percentage points reduction in the fiscal deficit—rebuilds sovereign credibility, severely damaged when fiscal rules were violated in a populist splurge. This it does by extending last year’s flexible policies: If counter-cyclical responses demanded loosening strings despite an already strained financial position, the case for a contraction with an upswing in the cycle was equally strong. Anything less than a retreat, however modest, would have been interpreted as the bad old habit of extravagance.
Openness demands policy restraint; profligacy becomes costlier than before. The past year singularly demonstrates how these costs are impinging upon policies.
Markets—now deeper and globally interlinked—have reinforced the adverse impact of large fiscal deficits. Bond market vigilantes—fortunately only local (things would have been much worse if public debt was significantly foreign-held, for example in Greece now, or in Hungary and Indonesia in end-2008)— pushed long-term bond yields from a low of 5.37% in December 2008 to above 7.8% in February 2010. Consequently, the average interest cost on government debt has risen from an average 6.2% in 2008-09 to 7.1% in 2009-10. With public debt levels at 80% of the gross domestic product (GDP), the increasing costs of debt-financing have virtually forced the deficit-interest rates trade-off to settle for the former.
Rating overseers, fed upon debt indicators and market signals, were equally punishing. They reacted quickly, as Standard and Poor’s did, by lowering the country outlook to negative in February 2009. Being assigned the lowest investment grade—also the lowest among the Bric (Brazil, Russia, India and China) countries—is not merely an embarrassment, but has real economic costs when a country is financially integrated. The cost of foreign capital, which now meets nearly one-third of the funding requirements of Indian companies, is determined by these risk ratings. In the last year, borrowers have faced high interest rates domestically and high risk premium abroad, reflecting fiscal vulnerability, among other risks. The pressure upon fiscal policy to be reworked to enable private investments thus doubled.
Rating agencies demand orderly policies on the external account, too. A negative confidence shift, triggered by a downgrade, can set off an outflow of foreign capital, now integral in financing the savings-investment gap. The threat of disrupting trade financing (inching towards normalcy) and deterring foreign investments at a time when raising investment levels is a core thrust of economic policy, through any further downgrades, has elicited a conscientious effort to repair public finances. This the Budget does through a commitment to a future path of debt reduction by accepting the 13th Finance Commission recommendations to bring down its debt-GDP ratio to 48% by 2014-15. The promise of fiscal rectitude is backed by intent—reduction and reorientation of subsidies, taxation reforms, and so on—and supplemented with honesty, by bringing on board the off-budget liabilities.
Finally, the pressure of a liberalized capital account is imposing policy discipline. In the current macroeconomic environment—upswing in the business cycle, inflation and a positive capital flow outlook—were policymakers not to opt for a fiscal restraint-looser monetary policy combination, the deficit-induced pressure on interest rates would further add to the existing bias towards monetary tightening. The complications arising from a widening domestic-foreign interest rate gap—attracting disproportionate volumes of arbitrage capital, often carry-trade related, encouraging investors to take short positions in anticipation of an appreciating domestic currency—are a real threat to stability. A taste of the negative spillovers—exchange rate appreciation, monetary expansion, sterilization, and so on—from managing a capital inflow boom was had in 2007. The destabilization threat from volatile capital movements has now been factored into policymaking. In responding correctly to the macroeconomic situation, the Budget sends out a mature message of responsible policymaking.
An unintended but welcome consequence of liberalization, the trend towards responsive and disciplined policies, will likely become the future norm with deepening economic integration. This implies two things. One, as reinforced by market responses to the post-crisis fiscal expansion, the government will have to create fiscal room to enable expansion to combat adverse shocks or a downswing. It follows, two, that a contractionary stance in an upswing should lead to savings. For markets will assess sovereign credibility on improvement in public finances and whether surpluses are utilized for payouts in a downswing in the future.
India loosened its monetary and fiscal policies in synchronization with the world to counter the global financial crisis. Ironically, the synchronization has also brought domestic macro policies into greater international focus. Emerging from the crisis to become the second fastest growing economy in the world has made it the cynosure of international attention. The Budget shows that you behave yourself when in the big league.
Renu Kohli was until recently with the International Monetary Fund. Comments are welcome at email@example.com