Twenty years ago, India was hurtling towards an unprecedented economic crisis that took it close to an international default.

The famous budget presented by Manmohan Singh in July 1991 was a turning point in economic management, but the first clear warnings on the coming crisis and the need for radical reform were sounded by Yashwant Sinha, in the course of the interim budget he presented in March 1991 as finance minister in the short-lived Chandra Shekhar government. Pointing to the noxious combination of elevated fiscal deficits, a high current account deficit and double-digit inflation, Sinha had said: “I need hardly stress that neither the government nor the economy can live beyond its means for long. The room for manoeuvre, to live on borrowed money or time, has been used up completely. The soft options have been exhausted."

Priming the demand engine through an expansionary fiscal policy is no longer a rational option. The Reserve Bank of India (RBI) has already begun to compress private demand by increasing interest rates seven times since March 2010. A more disciplined budget in February should help keep a lid on government demand. Economic growth is already close to the trend rate and does not require short-term policy support through negative real interest rates and a fiscal deficit that is far higher than in comparable countries such as China and Brazil (see chart).

To be sure, there is a fiscal correction on. The government will very likely meet its deficit target for the year—welcome news even though the improvement in the budgetary balance could have been far better given the tailwinds. The one-time bonanzas from the auction of telecom spectrum and successful disinvestments have been frittered away to fund higher subsidies and populist programmes. In effect, capital has been sold to fund current requirements.

RBI governor D. Subbarao has already mentioned these issues in the monetary policy review of 25 January. “The recent improvement in the fiscal situation has been mainly the result of one-off revenue generated from spectrum auctions. The government also had the benefit of disinvestment proceeds, which may continue to occur for some more time. However, fiscal consolidation based on one-off receipts is not sustainable…fiscal consolidation is important for several reasons, including the fact that monetary policy works most efficiently while dealing with an inflationary situation when the fiscal situation is under control," he said.

Following the recommendations of the 13th Finance Commission headed by Vijay Kelkar, the United Progressive Alliance government has committed itself to a stiff programme of fiscal correction (see chart). The fiscal deficit as a proportion of gross domestic product (GDP) has to be brought down by 1.4 percentage points over the next two years. This projection assumes that government spending is cut to 14.6% of GDP and the tax-to-GDP ratio is increased to 11.8% of GDP.

It’s a tall task. The government has traditionally been more successful in cutting its deficit because of higher revenues rather than lower spending. High nominal economic growth (thanks to soaring inflation) in the current fiscal has helped keep tax collections on course and the telecom auctions have added an unexpected Rs65,000 crore extra to the kitty. Next year could be tougher, given that economic growth could slow, there will be fewer one-time bonanzas such as spectrum auctions, and higher fuel and food prices will keep the subsidy bill high.

As Sinha pointed out 20 years ago, we are running out of soft options. The government needs to push through the direct taxes code, and the goods and services tax to increase the tax-to-GDP ratio. It also needs to prioritize its spending plans; the recent decision to peg wages in the Mahatma Gandhi National Rural Employment Guarantee Scheme to inflation is a worry in this context. And important reforms in areas such as modern retail, insurance and land markets are necessary to remove obstacles to private investment.

There is no need to hit the panic button. This is not 1991. But the new Union budget is being framed against the backdrop of a stuttering world economy, and signs of domestic pressures. There are ample indicators of the key risks in the year ahead. The fiscal deficit is being funded by domestic savings and there are signs that it is crowding out private investment; the current account deficit is funded with foreign capital, but the worrisome drop in foreign direct investment in recent quarters means that India is increasingly dependent on volatile portfolio and short-term debt flows; and high inflation is a clear sign that the lack of meaningful reforms since 2004 has made the economy structurally constrained to increase aggregate supply, with the output gap shrinking too early in the business cycle.

If India continues on its current policy path, 2011 could be the year of living dangerously.

Graphics by Ahmed Raza Khan