India has had its steepest annual fall in the fiscal deficit in 20 years, down 1.54 percentage points as a proportion of gross domestic product (GDP) in FY11. The brutal compression of demand in the 1991 budget presented by Manmohan Singh in the midst of the economic crisis had almost sent the economy spinning into recession. Pranab Mukherjee has seemingly been able to reduce the yawning gap in government accounts while leaving growth intact. But this is a testimony to the underlying strength of the economy rather than skilled economic management.
Also See Staying the course (PDF)
The actual gap between government revenue and spending overshot budgeted targets. Yet, the ratio of the fiscal deficit to nominal GDP fell because the denominator expanded on the back of high inflation. Nominal GDP is the sum of real economic growth and inflation. India will end this fiscal year with the highest rate of nominal GDP growth since FY89. The government has actually exceeded almost all its spending targets, led by an excess Rs50,000 crore of subsidies.
Most economists agree that staying on course will be more difficult in FY12, especially since windfalls from one-time events such as the wildly successful auction of 3G airwaves will not be around in FY12. It seems the finance ministry has made brave assumptions about food and fuel prices to allow them to forecast a Rs20,000 crore drop in subsidies in the next fiscal year. Tax revenues are expected to grow around three percentage points faster than the nominal GDP growth rate (14%) assumed in the budget while expenditure growth is to be around 11 percentage points lower (at 3.4%). Watch this space!
The revenue deficit is still too high, which means that the government continues to borrow to meet its current expenditure. Ideally, current spending should be out of current revenue, and the government should borrow only for capital expenditure. Further, India still has a primary deficit; a primary surplus is usually a good indication of the strength of a fiscal correction. That said, the forecast of a lower fiscal deficit and borrowing plan should release resources for the private sector.
The most pressing need at this stage of the Indian business cycle is to get private sector investment back on track so that companies do not hit capacity constraints. Indian companies had put off capital spending plans 2008 and 2009 in the aftermath of the crisis. Gross domestic capital formation has bounced back since then (see chart), but recent swings in the capital goods component of the (admittedly imperfect) Index of Industrial Production (IIP) and a slowdown in non-oil imports do not bode well for the economy.
The biggest disappointment in the new budget is the lack of policy direction. The Prime Minister’s Economic Advisory Council was quite correct when it pointed out in its latest report: “The principal challenge is to ease the various sectoral bottlenecks that continue to exist, whether it be in electricity and other infrastructure availability or slow-growing farm productivity and inadequate logistics for farm produce.”
In recent years, demand management has been the main tool to manage the economy in general and inflation in particular. What India needs right now is supply-side economics so that the higher demand for goods from a more prosperous country does not necessarily translate into higher inflation, as is the case right now. In other words, India needs a fresh dose of reforms to boost investment.The five most relevant reforms on the table right now are: clearing the way for a goods and services tax, the direct tax code, foreign investment in multi-brand retail, licenses to new private sector banks and getting more capital into insurance companies. Pranab Mukherjee did not provide any direction of these important reforms that will help make the economy more productive and efficient.
Graphic by Ahmed Raza Khan/Mint