First budgets are as much about signalling as they are about action. What finance minister Nirmala Sitharaman says on 5 July will thus be as important as what she does. It will set the tone for India’s fiscal policy over the next five years.

Sitharaman has taken charge of the finance ministry in the midst of a sharp economic slowdown. The most pressing challenge is to regain the economic momentum that has been lost over the past three quarters, which seems likely to persist into at least the first two quarters of the current financial year.

Her core message should thus be about economic growth.

The canons of modern economics tell us that governments should spend more when private sector demand is weak. Sitharaman will obviously be under pressure to open the spending spigots, given the weakness in private sector demand. However, the new finance minister will have to do a careful balancing act.

The second Narendra Modi government does not have enough fiscal space to stimulate economic activity, because of a combined borrowing programme of the Union and state governments that is sucking up most of the stock of household financial savings in the economy. A sharp increase in government spending at this juncture could once again unsettle the bond market. On the other hand, a sharp cut in the fiscal deficit this year will worsen the growth slowdown.

Budgets should ideally be counter-cyclical. Indian fiscal policy has too often broken this sensible rule. It has been expansionary in good times and restrictive in difficult times. The latter is often because governments do not save in good times. This is exactly the opposite of what the doctor ordered.

Such pro-cyclicality of Indian fiscal policy needs to be addressed through institutional change. Sitharaman should use her pulpit to make the case for a new fiscal policy framework. It can have three elements.

First, India needs a new fiscal law to replace the landmark Fiscal Responsibility and Budget Management Act (FRBMA), 2003. Fiscal policy should ideally be designed so that the ratio of public debt to gross domestic product (GDP) is stabilized at a particular level. It need not be focused solely on annual targets, though that also matters. One possibility is to fix the fiscal deficit target as a proportion of potential GDP rather than the actual GDP. Such a cyclically-adjusted fiscal deficit target will provide greater flexibility compared to the current approach.

Second, the tricky issue of estimating the trajectory of sustainable public debt over the medium term, as well as the level of potential GDP, should not be left to the government of the day alone. India needs a fiscal council such as the bipartisan Congressional Budget Office in the US that will independently analyse these issues. For example, the trajectory of public debt depends on the underlying estimates of real GDP growth, inflation and nominal interest rates over the medium term. A fiscal council could also deal with the more immediate challenge of checking the sanctity of budget numbers, so that finance ministers do not get away with impractical tax collection estimates in their budget statements.

Third, the government does not bear the full cost of fiscal profligacy because it impounds nearly one-fifth of bank deposits through the statutory liquidity ratio. This is thankfully half of what is allowed by law and has been brought down after years of financial sector reforms. The captive market for government borrowing is still very large. The past few years have seen an important change, as bond markets have begun to be more sensitive to fiscal borrowing patterns. The steepening of the yield curve in the first few months of 2019 was a clear sign that bond investors were worried about the consequences of high fiscal deficits.

These three changes—a new fiscal law that provides flexibility, a fiscal council reporting to Parliament, and reducing the size of the captive market for government bonds—should be part of the fiscal reforms agenda of the second Narendra Modi government, which has to its credit run an overall tight fiscal ship. The FRBM review committee headed by N.K. Singh has already given several important suggestions on fiscal policy. The report needs a fresh airing.

The tricky problem remains: How should the government stimulate economic activity in this downturn? Using the fiscal lever is risky. There are two immediate policy options.

One, the government can go for an aggressive programme of asset sales and use the proceeds to build new infrastructure. So privatisation should be seen as an asset swap rather than a financial trick to balance the budget numbers.

Two, the monetary policy lever can be used more aggressively as long as inflation continues to remain below the central point of the target given by the government to the central bank’s monetary policy committee. There is scope for two more rate cuts of 25 basis points each, but that is possible only if the government does not blow public finances apart through a large fiscal expansion.

Niranjan Rajadhyaksha is member of the academic board of Meghnad Desai Academy of Economics. Read his previous Mint columns at