Hopefully this week a new government will take office in New Delhi, ending the nearly three-month-long policy hiatus. Signs that the adjustment to the financial carnage of 2008 is nearing its end have been emerging in the data flow over the last few weeks. And although it is too early to claim that a full-fledged recovery has taken root, chances are that the second half of the year will see much stronger growth than the first half. This is also true in several countries across the globe, although in many parts, the adjustment will require more time and pain. But helped by the positive feedback among the recovering economies, the likelihood of a global recovery in the next six months appears high.
So when the new government takes office, it will need to focus much less on managing the adjustment and much more on managing the recovery. And if not done right, questions will be raised about the durability of the recovery. Given the long time lag between implementation and impact, what is expected from the new government is policy support now to sustain activity in 2010.
Illustration: Jayachandran / Mint
The first order of business for the new government of any hue will be the full-year fiscal 2010 budget. And this is a good example of how policies aimed at managing the adjustment need to be different from those focused on managing the recovery. Prior to calling elections, the government, through tax cuts, refinancing facilities and higher spending, provided 1.5-2% of gross domestic product (GDP) in fiscal support for the first two quarters of 2009. More importantly, it did not interfere in the price adjustment to the global shock. One can quibble with the size, form and timing of policy support, but the principle was broadly right—offset the decline in the quantity of private demand but let the price correction complete itself, painful though it may be.
However, policies to manage the recovery are different. By the time the government will be ready to present the budget, say in June, the data flow is unlikely to contain sufficient evidence that a recovery has taken firm root. It will likely be happening in the economy, but won’t show up in the data, which would still be telling the adjustment story of the earlier months. Additional fiscal support will thus be demanded and provided. But the fiscal space is limited. Lower oil and fertilizer subsidies allow for about 2% of GDP in additional fiscal space that will need to accommodate both lower taxes and higher spending. Even so, the overall deficit (Central and state) will likely breach 11% of GDP, the same as in fiscal 2009.
This will raise two concerns: one about near-term liquidity and the other about medium-term debt sustainability. The outsized government borrowing since the start of this year has already spiked longer-term interest rates. But it is unclear whether this was because of the lack of liquidity or oversupply of longer-term bonds. Given falling credit growth, large open market purchases by the Reserve Bank of India (RBI) and continued short-term excess liquidity, the spike in rates probably had more to do with the latter than the former. Indeed, if RBI continues to supply liquidity through its open market operations, then despite the anticipated revival in credit growth as the economy rebounds in the second half of the year, overall liquidity should be adequate. The oversupply of longer-term bonds, however, will continue to push rates up at the long end. This, too, is not an insurmountable problem. A combination of increased issuance of shorter-term government papers, perhaps even by borrowing abroad through NRI (non-resident Indian) bonds, and raising the limits on foreign holdings of rupee government securities should be able to limit the rise in rates to modest levels.
The bigger issue is with debt sustainability. Two straight years of double-digit deficit will raise interest cost and the debt burden. While investors empathize with the need to provide short-term fiscal support, the concern over debt sustainability rests on the lack of a credible medium-term consolidation plan. Such a plan requires a combination of four elements: (i) revising the policy on food, fertilizer and fuel subsidies to limit overall subsidy spending; (ii) enacting a new Fiscal Responsibility and Budget Management (FRBM) Act mandating debt and deficit targets, perhaps along with a cap on spending and a broadened definition of the FRBM-relevant deficit to include outlays such as oil and fertilizer bonds; (iii) improving tax efficiency and revenue potential by implementing the nationwide goods and services tax (GST) and (iv) a credible commitment to divestment.
The first three are neither technically difficult nor politically unattainable. Revising the subsidy programme has been on the agenda of various government and the current soft global prices provide a favourable environment to launch the reforms. The 13th Finance Commission is well on its way with a new FRBM Act and preparatory work for the GST has long been completed and a general consensus reached.
This brings us to divestment. Waiting for political consensus is futile, and it rarely takes place in any country. Instead, agreement is typically forced by circumstances. The present cash crunch is one of the best opportunities to bring the asset side of the government’s balance sheet into play, which can alter the debt dynamic markedly. The government does not have to go down the difficult route of selling unlisted entities or seeking strategic partners. Instead, it could simply dilute part of its holdings of listed companies. True, the equity market may remain too soft in the near term to absorb a large increase in supply. But this concern can be mitigated by the listed public sector undertakings issuing two-three-year convertible bonds, buying out equivalent shares from the government, and then letting the market decide whether or not to convert after the recovery has firmed up. This way, the government gets its funding, cuts its debt, and the divestment is left to the market, assuring credibility.
There are many other areas that need government attention, but a credible budget is half the battle. How likely is it that we will get one? Not sure, but chances are that the economic realities of June will not allow space for policy adventurism. Instead, the government will have to walk the straight and narrow path of conventional policies. For once, being uninteresting will be a virtue.
Jahangir Aziz is chief economist India, JPMorgan Chase. Views are personal. Comment at firstname.lastname@example.org