Insights into Editorial: Avoid the Adventurous Path
Data released by the Central Statistics Office (CSO) showed the economy grew 5.7% in April-June, the first quarter of the current fiscal year, slower than the previous quarter’s 6.1% and much lower than the 7.9% growth registered in the first quarter of 2016-17.
Among other things, one factor that stands out is the steady and sharp decline in the investment rate. The Gross Fixed Capital Formation (GFCF) rate has touched the level of 27.5% in the first quarter of 2017-18. A year ago, it was 29.2%, and a decade ago, it was 10 percentage points higher.
In recent years, public investment has shown a small rise. The decline in the investment rate has been largely due to a decline in the private investment rate, both corporate and household.
The real growth of GDP, i.e. after removing the impact of inflation, was only 5.7%, much lower than expected. This steady declining trend in the growth rate is a matter of concern. The policy prescriptions needed to reverse the trend depend on our understanding of the factors responsible for the slowdown. Policy initiatives must be directed towards raising investment.
Is the revenue or the fiscal deficit the relevant criterion?
Deficits add to debt.
The fiscal deficit (FD) includes interest payments and is the total government-borrowing requirement to finance current and capital expenditure net of tax and non-tax revenue.
- Markets are interested in this as an indicator of pressure on market yields, and crowding out of private investment
- It is the focus of most fiscal rules as it caps government expenditure in excess of revenue and possible crowding out of private expenditure.
- Some have argued for a strong fiscal stimulus through an increase in public investment by relaxing the fiscal deficit. But the critical issue over the last several decades is the falling quality of public expenditure.
- Experience with the FRBM shows targets were met by cutting capital expenditure rather than sustainable reform.
- Moreover, they were reset when convenient, as after the Great Financial Crisis.
The revenue deficit (RD), or deficit on current account, which is the amount the government needs to borrow to finance consumption expenditure, therefore becomes important.
- A falling RD will raise the share of investment in government expenditure. It is necessary to protect such asset creating expenditure.
- Research shows this has a higher and more persistent effect in raising GDP, reducing inflation and decreasing the current account deficit.
- So it is the RD that is targeted to reduce gradually towards zero, in line with facilitating high feasible transitional growth.
Why do both FD and RD targets significant?
It is argued that there is no rationale for having a fiscal deficit target. It is also argued that what is relevant is revenue deficit.
There are two problems with this argument.
- First, the focus on fiscal deficit is mainly to ensure that the private sector has sufficient borrowing space. This is clearly set out in the Report of the Twelfth Finance Commission (TFC).
Similarly, the target of debt-GDP ratio at 60% in 2023 from the present level of 70% is supposed to be achieved by limiting the fiscal deficit at 3% of GDP in the first three years and 2.5% in the next two by both the Centre and States.
- Second, over 60% of the estimated fiscal deficit at the Centre in 2017-18 (1.9% out of 3.2%) is revenue deficit.
At the State level, when the impact of loan waivers, additional interest payments on account of Ujwal DISCOM Assurance Yojana (UDAY) and possible impact of pay revision is considered, the revenue deficit may increase by 1% of GDP.
Thus, the problem of proliferation in revenue deficit continues.
History of fiscal laxity
Indian economic history is replete with instances of adverse effects of fiscal expansion on inflation as well as the balance of payments.
- The huge fiscal expansion in the late 1980s, with the fiscal deficit at more than 10% of GDP leading to the macroeconomic and balance of payments crisis requiring the adoption of structural adjustment programme in 1991.
- After substantial improvement in the fiscal situation during the period 2004-05 to 2007-08, the implementation of the Pay Commission recommendation, expansion of rural employment guarantee for the whole country and the introduction of the loan waiver led to derailing the process of adjustment in 2008-09, and the fiscal deficit of the Centre increased from 2.5% in 2007-08 to 6.1% in 2008-09.
- It further ballooned to 6.6% in 2009-10 and the consolidated deficit was 9.4%. This was one of the important reasons for the inflation rate increasing to 10.2% in March 2010, and the average increase in wholesale price index in 2010-11 was 11.1%.
Declining financial savings
The Annual Report of the Reserve Bank of India (RBI) gives the latest estimate of the financial saving of the household sector for 2016-17 at just about 8.1% of GDP.
- The aggregate fiscal deficit at the Central and State levels budgeted for 2017-18 is about 6% of GDP, but this is likely to go up after the impact of loan waivers and increase in house rent allowance at the Centre and possible revision of pay scales in the States are taken account of.
- The annual report also estimates the impact of loan waivers alone at 0.5% of GDP. This leaves less borrowing space the private corporate sector.
- At a time when the need is to stimulate private investment, to restrict the space available for it may be counterproductive.
In such an environment, there is hardly any scope for reducing the interest rates by the RBI, and even if it did, financial institutions would be unwilling to lend at lower rates.
Why does adhering to the fiscal deficit targets set out in the Budgets going to be challenging?
Given the difficulties in the public sector banks, there will be a sharp reduction in the dividends from banking and financial institutions and a shortfall in disinvestment and tax revenue collection, if current trends persist.
- The problem of adhering to the fiscal deficit target is not confined to the Centre alone.
- At the State level, the combined fiscal deficit for 26 States is budgeted at 2.2% of GDP excluding the deficit arising from taking over the power distribution companies (discoms) loans.
- However, the expenditure on account of loan waivers is estimated at about 0.5% of GDP.
- Furthermore, following pay revision at the Centre, some of the States may revise their pay scales which could add to the fiscal pressure. There could be a slippage of about 1% GDP in fiscal deficits.
Road map ahead
Fiscal policy is procyclical since higher revenues are spent in boom times and capital expenditures are cut in lean times.
- The solution to the current slowdown in growth lies in reviving private investment, recapitalising banks to enable them to lend more and speedy completion of stalled projects.
- Fiscal policy can at best play a role in creating the appropriate climate. Fiscal prudence is one of the elements in sustaining growth over an extended period.
- The fiscal deficit rules that we have evolved should be consistent with the level of savings and the demands of the various sectors on those savings. Our adherence to the fiscal rules should be strong.
- An independent fiscal council may be needed to discipline the Centre. A fiscal institution does improve fiscal management and expenditure quality, and reduces the discretion to cut capital expenditure.
The slippage in fiscal deficit by a few decimal points may not matter but any aggressive attempt to widen the fiscal deficit should be avoided.