Fiscal adventure, monetary dilemma4 min read . Updated: 04 Feb 2016, 11:53 AM IST
The government is missing the game plan that can facilitate sustained and aggressive monetary easing
The forthcoming 2016-17 Union budget will, more likely than not, settle for a higher fiscal deficit than the 3.5% of gross domestic product (GDP) announced in February 2015. Admittedly, there is still some sensible resistance to easing the fiscal constraint. However, some government officials have already made a case for easing to avoid a pro-cyclical fiscal policy. Consequently, the government will be on the defensive if it sticks to its fiscal deficit reduction schedule despite its concerns about growth revival.
The current focus on the fiscal deficit target masks some underlying misadventures that still affect India’s fiscal dynamics. These ultimately also adversely impact monetary policy dynamics.
In his budget speech in February 2015, finance minister Arun Jaitley said: “…I will complete the journey to a fiscal deficit of 3% in three years, rather than the two years envisaged previously. Thus, for the next three years, my targets are: 3.9% for 2015-16, 3.5% for 2016-17 and 3% for 2017-18." This followed a reminder in the speech that “Rushing into, or insisting on, a preset time table for fiscal consolidation pro-cyclically would, in my opinion, not be pro-growth."
Frankly, the approach begs the following question: How can investors take the pace of India’s fiscal consolidation to be credible when the government appears to think of it as only a fair-weather outcome?
The revised trajectory of the fiscal deficit announced in February last year was around 0.3 percentage points of GDP higher annually than what had been indicated by the outgoing United Progressive Alliance (UPA) government. A similar magnitude of slippage is possible in the new trajectory likely to be announced later this month. The government will again tom-tom the importance of fiscal discipline while possibly indicating that the fiscal deficit target of 3% of GDP will now be met one year later, in financial year (FY) 2018-19. If that goalpost is announced, the government, in the nearly two years of being in power, would have pushed out that target twice.
The forthcoming budget will probably aim for a fiscal deficit of around 3.8% of GDP in 2016-17. While higher than 3.5% for FY17 in the prior trajectory, this target will still be lower than the current fiscal year’s 3.9%. The government could thus claim being “responsible" as the fiscal deficit will still be shrinking, though at a slower pace. I feel this, along with some fiscal reform initiatives would—perhaps grudgingly—also satisfy the Reserve Bank of India (RBI).
In the Asian context, the calls for slipping on the fiscal red line are the most pronounced in India. This is intriguing because India has among the lowest export-to-GDP ratio in Asia, though it has increased over time. Also, India is one of the biggest beneficiaries of the collapse in crude oil prices. But where is the additional stimulus from the oil windfall?
It isn’t that the windfall has prompted the government to step up public capex significantly more than what was budgeted. The answer lies in one of the most chronic weaknesses of the Indian budget-making process that cuts across political lines—unrealistic and irresponsibly opportunistic fiscal arithmetic. Essentially, the huge boost from the collapse in international oil prices plus higher post-budget cess and fuel excise increases covered the massive shortfall on divestment and tax collection.
India tends to under-report its fiscal deficit because it counts divestment and other asset sales as revenue rather than a financing item, as is practised by the International Monetary Fund (IMF). Thus, the FY16 budget deficit target—adjusted for divestment—was actually 4.4% of GDP, not 3.9% as officially reported.
Rating agencies remain strangely silent on this self-serving approach. However, it was reassuring that RBI governor Raghuram Rajan recently cited the consolidated (centre plus states) fiscal deficit as reported by the IMF, not by the Union government. The difference isn’t academic and highlights that the fiscal support already being provided is more than what is being acknowledged.
For a brief period after it came to power, the Narendra Modi government appeared to hint at a path-breaking focus on recalibrating the fiscal-monetary mix. The hope was that a credible and lasting shrinkage in the fiscal deficit would widen the scope for significant monetary easing. That, of course, would be possible only if the fiscal healing was complemented with the government undertaking measures to address the chronic demand-supply imbalances in some sectors (food, healthcare and education, for example) that are keeping inflation, especially core components, high.
However, the government’s actions on institutional and structural changes to achieve low medium-term inflation have been disappointing. Such a focus would have ensured a significantly higher probability of the RBI meeting its medium-term consumer price inflation target of 4%. That, in turn, would have set the stage for financial markets firmly discounting an aggressive and long-lasting monetary easing, the multiplier impact of which would have been just what is needed.
Jaitley should be well apprised about the local bond market’s indigestion from the anticipated rise in consolidated government borrowing. He should also appreciate that raising taxes—like cutting spending—to meet a fiscal deficit target is inimical to growth.
Finally, sticking to the existing fiscal deficit forecast by relying on fuzzy math is worse than a slight slippage accompanied with creative and reformist measures in the budget, in my opinion. All the best!
Rajeev Malik is a senior economist at CLSA, Singapore. These are his personal views.
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