Opinion | A good budget this year would take the skill of a trapeze artist4 min read . Updated: 07 Jan 2020, 10:32 PM IST
This may not be a bad time to take a policy risk on fiscal expansion so long as it goes with adequate safeguards and reforms
Budget 2020 promises to be a high-wire act for finance minister Nirmala Sitharaman.
On one side is the need to respond to the economic slowdown with a fiscal stimulus. On the other is the limited fiscal capacity to do so. It will require skill to strike a balance between the two.
India has been hit by an aggregate demand shock. Export growth is tepid, the corporate investment drought continues, and consumer spending shows signs of buckling under pressure. The economy has lost momentum for five quarters in a row. The anticipated cyclical recovery in the second half of this financial year will only be a mild one, at best.
There are other signs of weak domestic demand. Core inflation is below target (though the recent spike in food prices will likely push headline inflation close to the upper bound of the inflation target in the coming months). The current account deficit has shrunk. Not only is the economy growing two percentage points below its potential, the latest quarterly nominal growth rate is close to the cost of government borrowing, which is never good news for macroeconomic stability.
This sets up the textbook case for higher government spending to support aggregate demand until private sector activity recovers. The problem is that there is limited space for an expansionary fiscal policy right now. It is well known that borrowing at all levels of government is sucking up the net financial savings of Indian households. The financial resources to support extra borrowing are thus limited. That is one reason why bond markets continue to be on the edge despite the interest rate reductions by the Reserve Bank of India (RBI). One source of uncertainty is the fact that the government has not yet announced an extra borrowing programme, even though there are clear indications of a fiscal slippage.
The fiscal deficit will most likely overshoot the target set last year. In the current financial year, the fiscal deficit of the central government plus the borrowing by agencies such as Food Corporation of India is likely to be anywhere between 5.5% and 6% of gross domestic product. An “involuntary fiscal expansion" is a given, which is how automatic fiscal stabilizers are supposed to operate during a slowdown. The question is whether there will be a “voluntary fiscal expansion" on top of that.
Beyond the headline fiscal deficit, a number that needs greater attention will be the revised primary deficit estimate for fiscal 2019-20. It will be a good indicator of the direction of the fiscal future. The International Monetary Fund estimates that the primary deficit will nearly double to 2.3% of gross domestic product in the ongoing financial year. The primary deficit does not include the cost of past borrowing, so its deterioration tells us a lot about what is happening to the government budget right now.
There continues to be a good case for an expansionary fiscal policy, especially with core inflation under control, a comfortable balance of payments situation, and the fact that global macro policy is also in an easing mode. If a policy risk has to be taken, this is not a bad time to do so. However, there are three additional points to be kept in mind.
First, market concerns about fiscal profligacy will have to be assuaged with credible commitments. The fiscal arithmetic presented last year was dodgy. The budget for 2020-21 should be more realistic. Estimates of tax collections should reflect the underlying reality that nominal growth is in single digits. This is a good time to reiterate an old theme of this column, that India needs a fiscal council on the lines of the Congressional Budget Office in the US to provide an independent parliamentary assessment of budget estimates.
There should also be a credible strategy to exit fiscal expansion once private sector demand is back on track. That is easier said than done. The lessons from the delayed withdrawal of fiscal stimulus in the 2011-2013 period, culminating in the run on the rupee in July 2013, are hopefully still fresh in public memory.
Second, a meaningful reforms package can boost confidence. The goods and services tax (GST) is a good place to start. The finance minister would do well to signal that the government has recognized the flaws of GST 1.0, and that she is committed to replacing it with a GST 2.0 that is closer to sound economic principles. The 2009 report written by a committee headed by Arbind Modi and the report of the Thirteenth Finance Commission headed by Vijay Kelkar are good starting points to begin a rethink of the GST structure. A new direct tax code is also overdue.
Third, a lot depends on how RBI responds to a fiscal expansion. It has been extraordinarily supportive in recent months. In the year to 28 December 2019, the central bank has already expanded its balance sheet around twice as fast as the nominal growth in the underlying economy. This has been done through a combination of domestic bond sales ( ₹3.5 trillion) plus two foreign exchange swaps ($10 billion). The velocity of base money has fallen, a sign of fragile confidence.
Arvind Chari of Quantum Advisors has noted in a recent Bloomberg Quint article that RBI supported almost 80% of the net government borrowing in 2019, an unprecedented level of fiscal support. The excess liquidity in the money market is now around ₹2.5 trillion, which means risk-averse banks are happy parking money with the central bank at the reverse repo rate, making it the effective policy rate. That tells us a lot about the state of the economy.
Niranjan Rajadhyaksha is a member of the academic board of the Meghnad Desai Academy of Economics