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India’s fiscal challenges

India’s fiscal challenges
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First Published: Thu, Jan 27 2011. 10 21 PM IST
Updated: Thu, Jan 27 2011. 10 21 PM IST
The Reserve Bank of India’s (RBI) third quarter review has clearly brought out the limitations of monetary policy. The central bank has said that it can, at best, contain the rise in food and energy prices spilling over into inflationary expectations. It has said that effectively managing inflation through monetary policy is a challenge due to the persistence of a large fiscal deficit.
Apart from supply-side pressures, today’s high inflation is often attributed to high growth. The fact remains, however, that the economy was growing much faster in 2005-06 and 2006-07, though inflation was much lower. One simple explanation for this is that the fiscal deficit in those years was much less. It did make sense for the government to go in for a stimulus in the aftermath of the financial crisis, but now that the economy has recovered there’s no justification for having such a high level of fiscal deficit. To illustrate, the deficit in 2007-08, just before the downturn, was as low as 2.7%. With the gross domestic product (GDP) growth projected at 8.5% for 2010-11, there is no reason at all why the deficit should be as high as 5.5%.
In fact, conditions in 2010-11 were ideal for curtailing the deficit, because of the windfall from the auction of telecom spectrum and other asset sales. But the government instead used the funds to push expenditure.
This fiscal, higher-than- expected nominal growth in GDP has helped boost tax collections and it’s likely that the deficit will be lower than budgeted. The problem, however, is that the government may not be able to stick to the deficit target of 4.8% of GDP for FY12. That is because inflows from asset sales will be much less and because higher oil and food prices will push up subsidies. A delay in implementation of the goods and services tax, uncertainty on the direct tax code, the indexation of the wages paid under the Mahatma Gandhi National Rural Employment Guarantee Scheme and the adoption of the food security Bill are also factors that will keep the deficit high. Add to that the fears, recently expressed by RBI, that high inflation could lead to lower consumption and investment, that in turn could affect growth and delay fiscal consolidation.
It’s not going to be easy. The central bank, for instance, points out that if oil prices go up and the government restricts the pass-through to consumers, it will lead to a higher deficit. If it does not, fiscal credibility could be undermined. Interestingly, the International Monetary Fund in its latest Fiscal Monitor Update also warns emerging markets of relapsing into procyclical policies that will undermine fiscal credibility. In short, pruning the deficit can no longer be put off.
What are the dangers that confront the Indian economy? Tell us at views@livemint.com
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First Published: Thu, Jan 27 2011. 10 21 PM IST