On Monday, the government asked Parliament for approval to spend an additional Rs1.05 trillion. With this, the fiscal deficit, or the gross borrowings of the government for the year, will be well off target.

There is reason to believe that this will eventually crowd out investments and drain some of the liquidity from the system, undoing the initiative undertaken by the central bank.

Illustration: Jayachandran / Mint

The government is calculating that a big step-up in demand thanks to higher government spending will help start an upturn in the growth cycle. Its implicit assumption is that inflation, though still in double digits, has peaked, and there’s little risk of it being stoked afresh by this infusion of liquidity.

Some policy planners have pointed to the sharp decline in international commodity prices, especially oil, as international demand turns sluggish, as reason enough to go slow on fighting inflation. Given that domestic consumers are protected by controlled pricing, this has no direct impact on inflation levels. Some political sections have even asked that since the average bill of India’s oil imports has dropped, the consumer be rewarded by a cut in domestic fuel prices. This is nothing but populist opportunism and deserves to be condemned. It will only increase losses for oil companies and put a further burden on the exchequer and thus the fisc.

Even by conservative estimates, the deficit is likely to touch 4% of the gross domestic product, or GDP, and not the 2.5% targeted in the Union Budget for 2008-09. Independent assessments have, after including the slew of off-balance sheet liabilities, pegged the combined state and Central fiscal deficit at 8% of GDP, if not more, against 6.2% in 2007-08.

So far, the overall policy response has been to help the market with liquidity — Rs1 trillion has been infused by cutting banks’ cash reserve ratio — and, at the same time, continue big-ticket government spending together with a cut in interest rates to stimulate retail demand. On Monday, just four days before its credit policy review, the Reserve Bank of India effected a 100 basis points cut in the key policy rate. It did so for the first time in five years.

This is a calculated risk with the premise that inflation, which is still in double digits, is a lesser risk than slowing growth. We are still not sure whether this will endure in the medium term.

Will the additional government spending boost demand? Write to us at views@livemint.com