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Insights into Editorial: Will the Budget suspend the FRBM’s fiscal deficit goals?

Insights into Editorial: Will the Budget suspend the FRBM’s fiscal deficit goals?

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Context:

With revenue receipts lagging behind budget estimates and economic growth slowing sharply, there is a real risk of the Centre missing its fiscal deficit target this year.

Finance Minister is set to present her second Union Budget on February 1, 2020.

Fiscal Deficit targets for India:

The fiscal deficit for FY20 and its roadmap for FY21 could be heading towards a recalibration with the February Budget slated to hint at the targeted 3 percent fiscal deficit for the next financial year be pushed to 2022-23.

Fiscal Deficit is the difference between the Revenue Receipts plus Non-debt Capital Receipts (NDCR) and the total expenditure.

Fiscal deficit is reflective of the total borrowing requirements of Government.

FRBM’s goal of reducing the fiscal deficit to 3% of GDP by March 2021:

In principle, the FRBM is basically an expenditure switching mechanism, where you try to switch the expenditure from consumption to capital.

That would lead to higher GDP growth and then lead to reduction in the public debt-to-GDP ratio.

The original FRBM Act had said that you have to bring down the fiscal deficit to 3% and the revenue deficit to 0%.

The 2018 Finance Bill actually did away with the revenue deficit target. So, there is no revenue deficit target any more.

Rather, we have the target of bringing down the fiscal deficit to 3% and at the same time, we expect that that will bring down the public debt to 40% at the Central level.

What we are seeing is not expenditure switching from consumption to capital, but we are actually seeing a switch from capital to consumption. And that would be growth retarding.

Significance of fiscal deficit:

The significance of fiscal deficit is that if the deficit is too high, it implies that there is a lesser amount of money left in the market for private entrepreneurs and businesses to borrow.

The lesser amount of this money will in turn leads to higher rates of interest charged on such lending.

Hence, a higher fiscal deficit means higher borrowing by the government which in turn means higher interest rates in the economy.

Currently, the high fiscal deficit and higher interest rates in India means that the efforts of the Reserve Bank of India to reduce interest rates are undone.

It reveals the overall strength in an economy. Global investors watch the number as they fear a high fiscal deficit may crowd them out from the market and high inflation and high-interest rate regime can impact their profitability.

Consequences of fiscal deficit shoots up:

From a high of 5.9% in 2011-12, fiscal deficit has been brought down to 3.5% in 2017-18.

The target was to achieve 3.3% in 2018-19. During the Budget in July 2019, Finance minister Nirmala Sitharaman reduced the fiscal deficit target to 3.3% from an earlier 3.4% for 2019-20 in a move that signalled the government’s commitment to fiscal consolidation.

The government has to borrow more or ask RBI to print more money.

But the printing of currency has its side effects. It leads to inflation and raises interest rates. Therefore, no government wishes to finance the fiscal deficit by printing money. It prefers borrowing.

There is no set universal level of fiscal deficit that is considered good. In a developing economy, where private enterprises may be weak and governments may be in a better state to invest, fiscal deficit could be higher than in a developed economy.

In India, the Fiscal Responsibility and Budget Management (FRBM) Act requires the central government to reduce its fiscal deficit to 3 percent of GDP.

Therefore, sectors which give fiscal support to the financial services sector in terms of its multiplier impact:

  • It is true in general that capital spending is seen as more productive and better-quality spending than consumer spending.
  • But this year is so unusual that we also need to give a consumption stimulus, including in the form of PM-Kisan, enhanced spending for the MGNREGA, and so on.
  • Growth today is constrained due to a collapse in credit. Bank credit growth has fallen steeply and ironically there is so much excess liquidity, in fact, on a daily basis the Reserve Bank of India finds that there is more than 3 lakh crore of excess liquidity.
  • The reasons for the credit collapse is because of the NPA [non-performing assets] situation.
  • NPAs are actually incrementally rising. Plus the lingering effects of the NBFC [Non-Banking Financial Company] crisis and the still relatively high real interest rates.
  • It is going to help if some kind of a credit enhancer, or anything that can release the credit flow which is required for growth, is done.
  • We need to give high priority for recapitalisation wherever necessary, identifying or isolating bad assets and let credit grow.
  • For GDP to grow at 7-8%, we need credit to grow at 15-20% and that includes bank credit, NBFCs, ECBs [external commercial borrowings], everything.
  • Revisit the FRBM Act, revert to the original FRBM, try to focus more on the revenue deficit and at the same time try to increase capital expenditure. That alone will bring you more growth and fiscal discipline.
  • We should not ignore the quality of spending and cost savings or cost efficiency wherever possible before we embark on fiscal stimulus in terms of increased spending.

Right usage spending by considering Demographic Dividend:

In the Indian context, because of our young demography, our dependency ratio is low.

This means there are more taxpayers than retired people. And this is going to remain like this for the next couple of decades, which means that if we have higher deficit spending today to induce growth, tomorrow’s generation will have to pay it back in the form of taxes.

But per capita tax burden on future generations is going to be relatively low or modest because we have the young demography advantage.

The bottom line is that there is an expectation that the Budget will do something about providing a fiscal stimulus but there will also be a challenge of remaining within the legislative remit.

Also, the legislation itself gives the government some leeway of overshooting by 0.5% in times of rapid fall in GDP growth rate, which is what we are seeing.

Conclusion:

Yes, the budget deficit matters. But, there is no simple answer.

It is reasonable to suggest that over the course of the economic cycle, governments should seek to get close to balancing the structural deficit.

However, there can be good reasons to run a deficit, at least in the short term. – For example, if the government wishes to fund public investment which offers a decent rate of return.

Also, in a recession, a budget deficit can play an important role in managing aggregate demand. In a recession, the traditional fears of a budget deficit – inflation, interest rates, crowding out – often just don’t occur.

But government spending financed by borrowing from the private sector can return the economy to full employment quicker.