Bracing for external headwinds by minding our weak spots
Since the fiscal deficit is generally regarded as a critical measure of macroeconomic stability, we can assume that our fiscal deficit will come under intense scrutiny
The favourable external environment of the past few years has changed to one that is very challenging. Oil prices have shot up and global interest rates are set to increase, raising the prospects of capital flowing back from emerging markets to safer havens. The possibility of trade war between the US and China, and the nervousness in Europe about whether the ongoing Italian crisis will prove a threat to the euro, add to the air of uncertainty. Past experience suggests that countries that are seen to be well managed do better than others. Since the fiscal deficit is generally regarded as a critical measure of macroeconomic stability, we can assume that our fiscal deficit will come under intense scrutiny. It makes sense in this situation to prepare for the worst, while hoping for the best.
Is the fiscal deficit too high?
Although most of the discussion in India focuses on the central government’s fiscal deficit, the relevant parameter is the general government deficit or the combined deficit of the Centre and the states. This is currently about 6.6% of gross domestic product (GDP), which is more than twice the average of comparable emerging market countries. High fiscal deficits lead to high debt levels and our government debt-to-GDP ratio is 69%, much higher than most emerging market countries. It is lower than in the industrialized countries because fiscal expansion, after the financial crisis of 2008, led to sharp increases in their debt ratios. The UK, for example, has a debt ratio of 88% and the US, 100%. However, we will be compared with other emerging markets, and won’t perform well on this comparison. This is the reason Fitch gave recently to explain why they decided not to upgrade India.
There are two reasons why a high fiscal deficit is felt to be bad. One is that it pre-empts a large portion of the available pool of financial savings for the government. When the fiscal deficit is effectively financing government consumption, this has the effect of raising consumption at the cost of investment which has an adverse impact on growth. When the fiscal deficit is used to finance government investment, the story is a little different. The deficit changes the composition of investment towards public investment. Opinions vary on whether this necessarily hurts growth. It obviously depends on the relative productivity of public vs private investment.
The second reason why a high fiscal deficit is frowned upon is that it adds to public debt, and a rise in public debt can be destabilizing. However, this is less of a worry when the economy is growing rapidly because high growth allows a country to run a higher fiscal deficit and still reduce the debt-to-GDP ratio over time. Since India’s growth rate has been much higher than most other countries, this counts in our favour. Many sins are forgiven to those who grow fast and we must do everything we can to maintain this reputation.
The pace of growth
The average growth rate of gross value added in the 10 years of the United Progressive Alliance (UPA) was 7.8%, including the slowdown in the last three years. In 2015, the National Democratic Alliance (NDA) government’s first Economic Survey triumphantly announced that double-digit growth was round the corner. That has proved to be over-optimistic as the average growth rate in the four years of the NDA was about 7.2%. In the current year, growth is expected to pick up to 7.4%. This will not be enough to generate the kind of expansion in employment we need, but it will be good enough to retain the confidence of foreign investors.
Ensuring 7.4% growth will not be easy. It calls for action on some specific areas: a reversal of the decline in private investment in the economy; an improvement in agricultural performance based on improved productivity; a continuing thrust on infrastructure development; an early resolution of the implementation problems of the goods and services tax; and a resolution of the problems of the public sector banks. Policymakers need to focus on these critical areas and not be distracted by the many other initiatives that are being called reforms, though they are essentially an exercise in renaming, and perhaps even strengthening, schemes that were underway earlier.
Fiscal performance of the centre
What does our performance look like? A fair assessment would be that it is lacklustre. The government inherited a target set by the UPA, of reducing the Centre’s fiscal deficit to 3% of GDP by 2016-17. Finance minister Arun Jaitley announced that he would retain this target, and was widely commended for it. But slippages have occurred year after year. The current year’s budget projects a deficit of 3.3% of GDP, and the 3% target has been postponed to 2020-21.
The fiscal deficit for the current year is not only above the original target, it also lacks credibility because many government programmes seem underfunded. These include the new health insurance scheme, the recapitalization of public sector banks, and the promise to make up the difference if farmers receive prices below the promised formula of cost plus 50%. The revenues from disinvestment also seem uncertain with the absence of any bids for Air India.
Much has been made of the Fiscal Responsibility and Budget Management (FRBM) Act as an institutional reform that encourages fiscal prudence. However, its effectiveness is limited. There are no penalties for non-compliance, and a government that has a majority can always revise its targets. This has happened in the past. In 2008-09 and 2009-10, the fiscal deficit overshot the target massively, because of the need to impart a fiscal stimulus. This was justifiable to begin with, but should have been reversed in 2010-11. Instead, the FRBM was simply suspended, with no protest from Parliament.
The best way of strengthening fiscal discipline would be to accept the FRBM (N.K. Singh) committee’s recommendation to establish an independent fiscal council to monitor the government’s performance on fiscal targets and inform parliament regularly. A similar recommendation was made by the Fourteenth Finance Commission. These have yet to be accepted.
Controlling the states’ deficit
The second component of India’s fiscal performance is the performance of the states. This has been disappointing, with fiscal deficits rising over the past few years. The N.K. Singh committee had recommended that state fiscal deficits should be calibrated to ensure that the outstanding debt of the states falls from 21% of GDP in 2017 to 20% by 2022-23. The Fifteenth Finance Commission has been tasked with recommending ways of achieving this objective.
Since the states cannot borrow without the permission of the Centre, this is an area where firmness on the part of the Centre will help create fiscal credibility. The finance commission should consider recommending a departure from the past practice of determining the borrowing limit for each state by applying a uniform ratio of the fiscal deficit to gross state domestic product (GSDP). Some states have debt ratios that are much higher than the average and it is reasonable to expect that they must do more by way of fiscal correction. Faster growing states can also tolerate a higher fiscal deficit and still achieve the target debt to GSDP ratio.
Suggesting different fiscal deficit ratios for different states will be controversial, but the finance commission is best placed to consider the case on merits. Ideally, the commission should also prescribe exactly how such a path should be calculated for each state, based on a target debt to GSDP ratio for each state, consistent with converging towards an aggregate debt/GDP ratio for all states of 20% by 2022-23. States are much more likely to accept a formula coming from the finance commission, which hears the states’ views and takes these into account, than one proposed by the finance ministry.
Ideally, fiscally stressed states should face higher interest rates when they borrow. This would create incentives to reduce fiscal stress. Instead, studies show that debt-stressed states are able to borrow at rates that are only marginally higher than that of better performing states. Banks are clearly working on the assumption that differences in the fiscal health of the states don’t matter. The Reserve Bank of India should ensure that the bank managements take credit worthiness of different states into account while subscribing to state government bonds. Similar discipline is needed for insurance companies.
Borrowing by state government entities should also be subjected to full credit risk assessment. Otherwise there is a real danger of states borrowing excessively through their entities, with or without explicit state government guarantees. Uncontrolled sub sovereign borrowing can be a source of fiscal stress.
The logic of cooperative federalism is that states should get more untied funds, which they can use to address their developmental challenges. The Fourteenth Finance Commission has already moved the needle in this direction and the Fifteenth Finance Commission will be under pressure to do more. These are desirable developments, but the flip side is that states should then live within their enhanced means.
Fiscal discipline will become more important if the current account deficit (CAD) deteriorates. It has already increased from 0.7% of GDP in 2016-17 to 1.9% in 2017-18 and could rise further to say 2.5%, if oil prices remain at current levels. It could get worse if oil prices go higher, because of uncertainty about Iran. If the CAD goes up to 3% of GDP, it may become necessary to rein in the fiscal deficit, even in the current election year, to retain investor confidence. Difficult, but no one said macroeconomic management is easy.
Montek Singh Ahluwalia was the deputy chairman of the erstwhile Planning Commission.
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