In about two weeks, Union finance minister Arun Jaitley will present his fourth, and possibly most important, budget so far. The presentation of the budget has been advanced by about a month so that the government is in a position to start spending from the beginning of the financial year. Apart from the changing global economic order, Jaitley will have to account for domestic factors such as the impact of the currency swap on economic output and the implementation of the goods and services tax (GST). Given this context, Reserve Bank of India governor Urjit Patel’s remark last week that good policy housekeeping should be the cornerstone for India gains importance.
It must be considered against the backdrop of global developments. For one, significant policy changes are expected in the US as the incoming Donald Trump administration is likely to opt for an expansionary fiscal policy which can lead to higher interest rates and tightening of financial conditions in global markets. Bond yields have gone up in the US after the November election and the Federal Reserve is now expected to tighten rates at a faster pace this year. These changes will affect capital flows as money managers may get more selective in deciding fund allocation.
Second, financial conditions can also be affected by the ongoing rebalancing in China. Chinese policymakers are now dealing with capital outflows more aggressively, though the falling foreign exchange reserves suggest that the pressure on the renminbi is likely to continue.
The best policy defence for a country like India in this uncertain global environment is to keep its own house in order to minimize the impact. However, economic uncertainty in the Indian economy has risen after the government’s decision to withdraw high-denomination currency notes. While the first advance estimate by the Central Statistics Office (CSO) showed that the economy is expected to grow at 7.1% in the current fiscal, it did not account for the possible impact of the currency swap on economic activity. Incoming forecasts, including that by the International Monetary Fund, suggest that growth could be considerably lower in the current year and output might suffer in the next year as well.
As a result, a view is emerging that the government should give a demand push to the economy by delaying fiscal consolidation. According to a report published in Mint on Wednesday, unlike last year, there is near unanimity in the government over the need for fiscal stimulus. The government would be well advised to avoid taking such a decision for several reasons.
First, the initial assumption was that the impact of the currency swap would be temporary, so fiscal intervention would not be warranted. Second, as economist Sajjid Z. Chinoy of JP Morgan argued in these pages earlier this week, a positive demand shock is not the perfect response to a negative supply shock and could lead to price pressures. Also, a monetary stimulus is already under way as lending rates have come down significantly after the currency ban, which will help output to recover. Third, postponing consolidation on the fiscal front will affect the government’s credibility and keep the combined fiscal deficit at higher levels. As Patel noted in his above-mentioned speech, and this paper has highlighted on several occasions in the past, India’s consolidated budget deficit is one of the highest among its peers. This affects credit ratings and capital flows. According to the fiscal consolidation road map, the government will need to bring down the fiscal deficit to 3% of gross domestic product (GDP) in the next financial year from the current year’s target of 3.5% of GDP.
Furthermore, since the revised estimates and the budget estimates are likely to be prepared on the basis of the CSO’s advance estimate, it would be prudent on the part of the government to plan more conservatively, which will help keep the fiscal deficit close to the target even if actual output deviates from current estimates. Put differently, the government will have to work carefully to avoid any divergence from the fiscal consolidation road map as it will not only affect credibility but will also add to economic uncertainty after the currency swap.
To be sure, this will complicate the budget exercise as the government needs to push capital expenditure since private-sector investment continues to remain weak. But higher allocation for capital expenditure should not come at the cost of fiscal prudence. The government will also have to move forward on bank recapitalization. Although the fall in bond yields due to policy accommodation and liquidity gush will boost profits in the banking sector, it is unlikely to significantly reduce the need for capital infusion.
The 2017 budget should be a part of the ongoing process of creating the necessary conditions for sustainable growth while maintaining fiscal discipline. Last year, Jaitley took a prudent decision to adhere to the fiscal target. There is no compelling reason why he should not be moving forward on the same path.
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