Revising the fiscal consolidation road map is tempting but self-defeating
Addressing the joint session of Parliament on Tuesday, President Pranab Mukherjee termed India a haven of stability in an increasingly turbulent global economy, as macroeconomic indicators such as growth, inflation, current account and fiscal deficit have improved in the past few years. However, the challenge now is to preserve this hard-won stability and build on it to achieve higher growth on a sustainable basis. This will require policy thrust in multiple areas—and the upcoming Union budget to be presented on 29 February, the third by the present government, will be expected to take the process forward.
Various stakeholders in the economy will look forward to announcements regarding their respective sectors. But at the macro level, how the government intends to manage its own finances in the coming year and its road map for the medium term will be keenly watched. Ratings firm Moody’s Investors Service, for example, in a report this week said that the budget’s importance will lie in the fiscal consolidation plans of the government. It also pointed out that fiscal metrics will continue to remain weak in the near term for India compared with its peers even if consolidation continues because of higher deficit and debt.
As things stands today, there are multiple areas that will need the government’s attention and can complicate its fiscal calculations. For instance, at a time when private consumption and investment demand continue to remain tepid, the government is expected to push capital expenditure in order to bridge the gap and sustain economic momentum. Further, after two successive years of below-par rainfall, the agriculture sector is in stress and the government has indicated in favour of increasing budgetary allocation. And asset quality in public sector banks is deteriorating at a significant pace, which will require the reassessment of capital infusion plan of the government.
All this will need budgetary resources at a time when the government has to implement the Seventh Pay Commission’s recommendations, while reducing the fiscal deficit to 3.5% of the gross domestic product (GDP) in the next financial year from a target of 3.9% of GDP in the current year. This will be a big challenge—and there is a good chance that the government may again modify the medium-term fiscal consolidation road map as was argued in its mid-year economic analysis, published last December.
Allowing some slippage in deficit targets may seem compelling at this stage and might, in fact, lead to some short-term benefits in terms of higher output. But it will affect credibility and increase macroeconomic vulnerability in the medium to long term as has been argued in this space before. The combined deficit is still at higher levels compared with India’s peers. According to International Monetary Fund estimates, it is expected to have gone up to 7.2% of GDP in 2015 compared with 7% in the previous year.
Further, since state governments will partially take over the debt of power distribution companies and will possibly not be in a position to reduce deficit in the next fiscal, the central government will need to make the necessary adjustment to keep the combined deficit in check. Meanwhile, the news from the bond market is that investors are demanding higher yields on state government bonds as supply is expected to increase in the near term. A higher-than expected deficit by the central government will add to the supply in the bond market and will push the risk free rate in the system. This will negatively affect private investment, which the government intends to bring in through higher public expenditure. It will also make transmission of lower monetary policy rates more difficult.
Therefore, on balance, the government would do well to stick to the consolidation path and find ways to push structural reforms, which will not only help increase economic activity but will also help mobilize higher tax resources. Addressing the legacy issues in taxation in the budget and getting the bills related to the goods and services tax and bankruptcy passed in the current session will be a good starting point.
Source - Live Mint