BackThe Union budget must address the risk of stagflation
The Union budget must address the risk of stagflation
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While the stock market continues to be weak in the final lap before the Union budget, it hasn’t done too badly in relative terms. The MSCI India index is marginally in positive territory this month (as on 22 February) while the Emerging Markets Asia index is down 3.3%. Very likely it’s merely a correction from the earlier steep fall and not the result of any firming up of expectations ahead of the budget. Nevertheless, a look at the bond market shows that yields have been declining. Indeed, the yield on the most traded 2022 bond is at a six-month low. Is that due to the market’s anticipation that government borrowing next year may not be very much higher than in the current year? Or it could also be due to near-term technical factors, such as buying by the central bank and absence of further auctions. But the markets do seem to believe the government is likely to stick to its fiscal deficit target of 4.8% of gross domestic product (GDP) for FY12 in the budget. Needless to add, a disappointment would be greeted with a sell-off.
The government’s borrowing requirement is very important this time, because interest rates are high, liquidity is tight and there is some evidence that capital expenditure is being postponed. High government borrowings is therefore likely to crowd out the private sector, which will mean less capacity addition and more upward pressure on inflation in manufactured goods. However, it’s very likely that there will be some unspent cash balances held by the government at the end of March which can be used in the next fiscal and therefore reduce borrowing.
The projected deficit depends, of course, on the budget’s growth estimates for FY12. The Prime Minister’s economic advisory council (EAC) has provided a lot of comfort by keeping its GDP forecast for FY12 pegged at 9%, higher than this year’s 8.5%. Most estimates, however, forecast a moderation in GDP growth next fiscal. That is not surprising given that interest rates have been moving up while inflation continues to be high. So how is the EAC forecasting higher growth? It pins its hopes on a sharp increase in growth in the construction segment and on “community and personal services". It also forecasts a sharp increase in government capital expenditure. It’s likely, therefore, that the outlay for capital expenditure will be stepped up in the budget. That would be a big positive, as it would mean that government spending is directed towards an increase in the productive power of the economy, rather than to consumption.
The EAC report also shows the buoyancy in the growth of services. For instance, even during the worst days of the financial crisis, in 2008-09, the growth rate in the services sector was an excellent 10.1%. It does seem that in the services sector we have a source of growth that will remain resilient. The problem is that the tax potential of this sector has not been exploited, which is why the markets expect more services to be brought into the tax net. There’s also a view that the government would roll back the excise duty exemptions, but that would lead to the excise rate going higher than the 10% provided in the proposed goods and services tax (GST). The government may also take the opportunity to align tax rates with the direct taxes code, which would mean an increase in the minimum alternate tax. A high disinvestment target is also expected.
There are concerns over whether the government will be able to rein in expenditure, especially expenditure on social services, given the state elections ahead. The government may consider that incomes are being eroded by high inflation to give some tax relief, while spending more on social programmes. However, while Mahatma Gandhi National Rural Employment Guarantee Scheme outlays have been linked to the Consumer Price Index, it’s very likely that utilization under the programme will be well below the budgeted amount, which means that there may be little in the way of additional allocations. It’s true, of course, that amounts spent on subsidies will go up because of higher oil and food prices. It’s also true that the food subsidy bill will rise substantially if the guaranteed foodgrain scheme comes into effect. But that is unlikely to be budgeted for, just as the rise in oil subsidies is unlikely to be reflected in the budget. In other words, while the budget may show a fiscal deficit of 4.8% of GDP in accordance with the road map, the risks of fiscal slippage during the year are large.
In view of the crisis the government finds itself in, the best way to deflect attention would be to announce some reform measures. It’s doubtful whether the government’s definition of reform is the same as the market’s, but it can at least announce progress on the GST, infrastructure projects, land acquisition policy and, though this may be a stretch, some relaxation in foreign direct investment. Hopes have been buoyed recently by the environmental clearances for several projects.
The premium the Indian markets commanded after the United Progressive Alliance government came to power for the second time sans Left support has been eroded, partly because of the lack of reforms and partly because of the concerns over high inflation. This time, the stakes are high, because a refusal to tackle core issues could result in low growth combined with high inflation, or stagflation.
Manas Chakravarty looks at trends and issues in the financial markets. Comment at capitalaccount@livemint.com
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