Select thoughts on the FRBM report
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The reports of the N.K. Singh Committee on the revision of Fiscal Responsibility and Budget Management (FRBM) Act were published on 12 April. Find all the four volumes here.
I went through the summary of recommendations, the annexures, the dissent note by Arvind Subramanian, the chief economic advisor (CEA) to the government of India, and the reply by other members of the committee. The exchange between the dissenter and the rest of the committee does not seem to have been marked by civility. Funny though that Business Standard and The Indian Express had mentioned the dissent note in January itself, although the report was released officially only in April. That is curious.
The committee (ex-CEA) has not answered the question why there is a jump in targeted reduction from 3.5% to 3% for the fiscal deficit and then a steady state and then again a reduction. It deserves a response. At the same time, the CEA is inconsistent himself. One of his inconsistencies has been caught by the committee and they had mentioned it too, in their response.
One minor disappointment is that the committee has not pruned the list of three reports that the government tables in the Parliament as part of budget documents.
The Fiscal Policy Statement;
The Medium-Term Fiscal Policy Strategy Statement;
The Macro-Economic Framework Policy Statement
Anyone who has gone through them—as I have, over the years—will be left confused as to what the distinct message of each of them is. Most of the time, they are repetitive, overlapping and confusing. They are badly drafted too. They could have been combined into one single document with a greater clarity and structure given to it, by the committee.
Detailed comments on the mathematics of the deficit and debt targets (or is it a ceiling or an anchor, in the case of the latter?) have been made by Pronob Sen, Indira Rajaraman and the CEA himself. In addition, there is a comment by Montek Singh Ahluwalia and an edit by Mint. Whether the path of deficit reduction envisaged under assumptions about interest rates and nominal gross domestic product (GDP) growth would lead to an eventual stable debt ratio of under 50% of GDP is hotly debated.
Fiscal deficit over primary deficit
Should there be a primary deficit target instead of a fiscal deficit target? The CEA bats for a primary deficit. Rajaraman supports him. I beg to differ. Primary deficit is fiscal deficit minus interest payments. Interest payments are a function of the market borrowing and other borrowings that the government makes such as by issuing bonds to the small savings fund and borrowing from it.
For the financial year 2017-18, the government could reduce its market borrowings by an order of magnitude of more than Rs1 trillion because it issued 10-year bonds to the small savings fund at a coupon of 9.5% per annum when the government bond yield was around 7%. The government does this because it pays a higher interest rate to depositors in small savings schemes. The latter widens unfunded obligations in small savings schemes. That number too is rising although somewhat more slowly in recent years.
The accumulated unfunded liabilities is of the order of around Rs1.14 trillion. Hence, to offset the higher interest payment to depositors, the government borrows at a higher rate from the small savings fund. That undercuts the banking system in the country, the bulk of which is in government hands. At the same time, the government would argue that the reduced market borrowing put less upward pressure on government bond yields and thus avoided a ‘mark to market’ hit to government bonds held by banks. What a tangled web!
However, the long and short of it is that the government must be held responsible for interest payments too, since its policy decisions do affect the overall interest burden on the government. It is not as though the government is a helpless spectator as the market determines the interest rates on government borrowings and hence the overall interest burden on the government. Therefore, the appropriate measure of fiscal responsibility must be the overall fiscal deficit and not the primary deficit. The principle here is not that of economics but management. If someone is in control of the outcomes, then they must be held accountable for it.
The revenue deficit target can be done away with. On that topic, the arguments made by the CEA in his dissent note are valid. It is not necessarily correct that all revenue expenditure is bad and that all capital expenditure is good. Therefore, there is no need for an incremental focus on revenue deficit. The overall fiscal deficit would do.
Cyclically adjusted deficit target
The committee had given its reasons as to why it is not able to recommend targeting a cyclically adjusted fiscal deficit. Timely and quality macro data is usually a problem in India. Of course, that is not the reason why the committee had not developed a cyclically adjusted fiscal deficit framework. The state of Indian public finances—an excellent statistical compendium—is available up to 2015-16 and the data for 2016-17 will be updated only by the middle of the current financial year 2017-18. That is not a bad timeline. However, the problem is that several state governments have not published their fiscal numbers for 2015-16.
That said, the failure to agree on a cyclically adjusted fiscal deficit formula has also left the committee vulnerable to criticism that its escalation clause in the event of a growth slowdown could still result in pro-cyclical tightening. In the event of a growth slowdown, tax revenues will automatically be lower. Hence, there will be a natural slippage in the deficit target.
On top of that, the committee has recommended that the fiscal deficit target could be expanded up to 0.5% of GDP if there was a “sharp decline in real output growth of at least 3 percentage points below the average for the previous four quarters” provided there was a “clear commitment to return to the original fiscal target in the ensuing fiscal year.” That would amount to a sudden fiscal contraction. Such a sharp growth slump, were it to occur, would not be reversed so soon. The government may have to run a higher fiscal deficit for more than a year.
Higher household financial savings can result in a higher deficit target
The committee’s formula for arriving at a resting fiscal deficit ratio of 2.5% for the Union government and 2.5% for the states is somewhat simple. They took the total pool of available financial savings from within the country and outside at 10% of GDP, household financial savings of 7.6% and a current account deficit of 2.3%. They divided it equally between the state and the private sector. Then, the State’s share was divided between the Union and state governments. Seems simple enough. I am not going to go into whether this method makes sense. I do not know if other methods would have yielded ‘superior’ results. A ‘superior’ result is usually the one that conforms to our priors or prejudices.
However, what this method tells us is that there is scope for raising the fiscal deficit target above 2.5% if the pool of available savings increases, especially if household financial savings rise. The trick will be in judging its sustainability. Of course, in the aggregate, households save more if they earn more and if they are taxed reasonably. Unreasonably stiff fiscal targets make the State overzealous in collecting taxes. That is actually a dampener on economic activity more than it is on household savings. Hence, any fiscal deficit target should take into account its impact on India’s tax administration.
The relevance of norms
Finally, there is a general feeling that these deficit targets are ritualistic and that they do not serve any useful purpose. In democracies, they do not deter governments from spending when they wish to and how much they wish to. The proof for this cynicism exists. Western governments have splurged since the 1970s no matter how often and how eloquently economists and central bankers stressed fiscal prudence to the sage nodding of heads from politicians. That is why the overall government debt/GDP ratio has had its longest peacetime expansion in more than 130 years.
However, there is a counter-argument to that. Without these norms and periodic verbal warnings, the situation might have been worse. Norms do have a restraining influence even when they are not followed up with penal action against violations of norms. Therefore, we cannot know the counterfactual outcome—fiscal deficits and debt—in the absence of norms on fiscal deficit and debt.
T.C.A. Srinivasa Raghavan, a learned commentator who has questioned the need for externally imposed norms, had conceded that fiscal deficits matter in a financially globalised world. Unfortunately, it is still a financially globalised world. India has also been allowing its firms to raise money overseas, although increasingly in Indian rupees. If that continues, India’s credit rating will matter and for that, fiscal deficits and debt levels will matter. Whether rational or not, 3% for fiscal deficit and 60% for the gross public debt are etched in the collective memory of financial markets. None of this might be fair or reasonable but they are part of the reality in global financial markets that India has chosen to embrace.
On the topic of credit ratings, we concede that the CEA is absolutely right that the Indian sovereign credit rating is arbitrarily low and unfair. The intense debate around the recommendations of the FRBM Committee is proof enough that India takes it more seriously than many other governments do. The oligopolistic credit rating agencies owe an explanation. Indeed, the above chart is proof of their signal failure to rein in fiscal imprudence and in judging it as such.
V. Anantha Nageswaran is senior adjunct fellow (geoeconomics studies) at Gateway House: Indian Council on Global Relations, Mumbai. There are his personal views.