Mint readers may well feel they have had enough of pre-budget commentary and it is time to suspend reading and wait to savour whatever is unveiled on 29 February. For those who still have an appetite left for commentary, here are some thoughts on the key issues the budget should address.
The global environment
We are now a more open economy and the global environment, therefore, matters. The signals at present are mixed with significant downside risks. The fall in oil prices is clearly a bonanza. However, global growth is weaker than expected a year ago and world trade has slowed massively. Many emerging market countries, including Russia, Brazil and South Africa, face serious difficulties. China, traditionally the best performing emerging market, may be headed for a “hard landing" and this could cause contagion for other emerging markets. We look good at present, and the International Monetary Fund (IMF) has projected our growth at 7.5% for 2016 and 2017, compared with 6.3% and 6%, respectively, for China. Since these projections are conditioned on continuing progress on reforms, we should make sure we have enough on that front.
The fiscal deficit
The fiscal deficit target adopted in the budget will come in for much scrutiny given the public debate that has occurred on this subject. The governor of the Reserve Bank of India (RBI) has made the case for reaffirming the target of 3.5% of gross domestic product (GDP) announced last year. His argument is based primarily on the view that modifying a target set only a year ago will undermine the credibility of government commitments, especially because there is no special factor that justifies the departure. Had oil prices shot up unexpectedly, it would have been different. The 7th Pay Commission report cannot really be called unexpected. The report was expected and its impact could also have been reasonably anticipated a year ago.
The case for enlarging the deficit is simply that export demand has fallen and investment demand is weak. But the Central Statistics Office’s (CSO’s) estimate of 7.6% growth in 2015-16—which is close to the 12-year average of 7.7%—suggests that a stimulus to aggregate demand is not needed. Of course, we would be better off with more public investment in infrastructure than government consumption, but that is an argument for changing the composition of government expenditure, not increasing the deficit. This is particularly important in an environment where risk perceptions about emerging market countries are fragile and countries with a weak macro balance will be particularly vulnerable. We are doing well on growth, if the CSO is to be believed, but unfortunately, we qualify as having a weak macro balance. Our combined fiscal deficit (centre and states) is around 7% of GDP, much higher than in most other emerging markets.
Will market perceptions turn adverse? One cannot be sure, but if it affects confidence, it can impose a high cost. As was said at the time of the East Asia crisis in 1997, “Confidence grows at the rate a coconut tree grows, but it falls at the rate a coconut falls!" On balance, I believe the finance minister would be better off staying with the fiscal deficit target he announced last year, but doing other things to stimulate investment. Fortunately, there are things we can do.
Two important areas where investment in infrastructure can be increased without an immediate impact on the fiscal deficit are highways and the railways. The hybrid annuity development model for national highways recently unveiled by the government enables the private sector to bid for all “shovel-ready" projects with payments falling due only later. The railways have announced an ambitious investment programme for the next five years, based on borrowed funds and new public-private partnership (PPP) initiatives. We should make all efforts to ensure that investment in these areas fructifies. A similar approach can be taken for ports.
Stressed corporate balance sheets and NPAs
A parallel effort is also needed to revive private corporate investment and this requires action on the inter-related problems of stressed corporate balance sheets and rising non-performing assets (NPAs) of banks. When projects run into financial difficulties, promoters typically look for assistance from the banks, but the banks quite rightly expect them to bring in more equity, either on their own account, or from other investors. If the promoters cannot bring additional equity, banks are being encouraged to convert their loans into equity and take over ownership under the RBI’s strategic debt restructuring (SDR) scheme.
The companies thus taken over cannot be managed by the banks. They have to be handed over to credible managers who can run them while looking for investors willing to bring in equity and take over the companies and hopefully turn them round. However, this may require the banks also to take a ‘haircut’ by writing off a part of the debt. Since the haircut needed may differ in different cases, banks will have to take a call in each case. Given the constraints under which public sector bank managers have to operate, it is not easy for them to adopt a case-by-case approach, especially if a consortium of banks is involved.
A better alternative would be to hive off existing NPAs into separate asset reconstruction companies, which could then specialize in organizing new managements for the taken-over companies and devise special procedures to handle difficult decisions. If the bad assets are taken off the books of the banks at low prices, as they should be, the public sector banks will take a hit upfront and will then need to be capitalized adequately. RBI regulations will have to be tailored to ensure that such companies can function effectively. If they are seen to be effective, they could even attract private capital.
Cross-country experience shows that if bank losses are recognized early, and the banks suitably recapitalized, they can get on with fresh lending and stimulate economic recovery. Where this is not done, banks are locked into zombie-like behaviour, effectively greening bad loans, but doing little fresh lending. This is a serious problem, given the rising level of NPAs. There is urgent need for a big clean-up, followed by substantial injection of additional capital into the banks, combined with changes in governance and management that would reduce the danger of the same thing recurring. In some ways, this is the most important reform to be attempted at present.
The fiscal burden of recapitalization should not hold up bold action. It is well accepted internationally (and sanctified by the IMF) that capital transactions of a financial nature, such as injecting capital into the public sector banks, need not be treated as “above-the-line transactions" that increase the fiscal deficit. However, if we follow this approach, we would symmetrically have to give up treating disinvestment receipts as above-the-line revenues. Given the huge requirements for bank capitalization, and the somewhat uncertain revenues from disinvestment, this should be an attractive package allowing the government to recapitalize the banks quickly, without presenting a negative picture of the fiscal situation.
Rewriting the FRBM
Looking ahead, if we want to evolve a credible medium-term strategy for fiscal consolidation, we need to replace the existing Fiscal Responsibility and Budget Management (FRBM) Act, which is seriously flawed, with a more modern legislation. Four changes are particularly important. First, the fiscal deficit target of 3% of GDP enshrined in the Act has no clear economic rationale. We should move to a system in which a fiscal trajectory is chosen that reduces the debt/GDP ratio of the general government (i.e. centre plus states) to some desired level within a period of five years. For any given growth of GDP and inflation (as measured by the GDP deflator), we could define a trajectory for the central government fiscal deficit and a separate trajectory for state government deficits over the next five years, which brings the debt ratio of the centre and states combined to the target level. The aggregate deficit target for the states needs to be specified in the new FRBM and the central government must determine a transparent way of apportioning the available borrowing space across states.
Second, the concept of the “revenue deficit", presently enshrined in the Act, has no economic rationale whatsoever and should be jettisoned. It is not, as many suppose, a measure of borrowing to finance consumption, since the revenue deficit treats interest payments as an expenditure, whereas they are really transfers. The relevant concept for debt sustainability analysis is the primary deficit/surplus and we should switch to that.
Third, annual fiscal targets should be monitored not in terms of the actual fiscal deficit, but a “structurally adjusted" fiscal deficit. This would ensure that an unexpected reduction in output may justify the actual deficit exceeding the target, as long as the structurally adjusted deficit is on target.
Finally, the deficit in the FRBM should be redefined so that the treatment of capital transactions is aligned with international practice.
Exports have been a weak spot in our performance, having fallen in dollar terms month over month for the past year. This has not presented a problem for the balance of payments in the current year because low oil prices reduced the import bill but, as the finance ministry’s mid-term review points out, they are a “missing engine" in the growth story. It should be our objective in the coming year to reverse the trend. It may seem, given our very small share of world markets in almost all of our exports, that we should be able to raise our market share, but this will be difficult in conditions of weak global demand because our competitors, who are more dependent on exports, will fight to retain their market share.
We need to improve our export competitiveness, and in the longer run, this depends upon improving productivity, especially in the manufacturing sector and logistics. In the short run, the only instrument available is the exchange rate. Exporters interacting with the commerce ministry typically lobby for export incentives because these are directly under the ministry’s control. The fact is that even if all their demands were accepted, it would do less for export profitability than a 2% depreciation! The Real Effective Exchange Rate Index prepared by the RBI, using the currencies of 34 of our main trading partners (adjusting for relative rates of inflation), shows that the rupee has appreciated in real terms by as much as 12% compared with the position in 2004-05. There is a strong case for letting the exchange rate depreciate to reverse some of the real appreciation that has occurred. This will help get the export engine humming, or at least not misfiring. It will also help keep protectionist lobbying—such as the recent successful effort by steel producers—at bay.
Montek Singh Ahluwalia is the former deputy chairman of the Planning Commission.