Finance minister deserves credit for admitting to mistakes. Now he must push ahead on reform
Finance Minister Pranab Mukherjee has rolled back budgetary proposals that had threatened to scare away foreign investors. Both FDI and FII had been hit after the Union budget proposed to change tax laws,bringing huge uncertainty into the policy regime. Investors,who feared that the GAAR would be used by taxmen as a tool of harassment,had started turning away from India. At the same time,the finance minister has promised that the tax policy will not be changed retrospectively. The damage control was necessary,given that such tax changes are retrograde in general and dangerous at a time when India is facing a large current account deficit. If these steps ensure that foreign investment does not flee India and we do not have to finance a larger part of our current account deficit through debt,it will be beneficial to the economy.
At the same time,the rollback will only ensure that the country takes on less debt to finance its current account deficit. It does not bring down the current account deficit,which is the real problem. This deficit,which implies that India is not saving enough,is primarily due to the rising fiscal deficits. Mukherjee has tried to reduce gold imports by making them more expensive. He needs to do the same with oil. Increase in the price of diesel and fertilisers will also reduce the size of the fiscal deficit. A current account deficit of 4 per cent of GDP is a dangerous level for an emerging economy. This eventually means that the deficit is being financed by obtaining resources from abroad.
Small shocks to emerging economies can sometimes lead to a loss of confidence and result in a withdrawal of debt and equity from the country. That is why the two deficits of the current account and the fisc often go together. For many years,the Indian government seemed to believe that fiscal deficits do not matter. Now it is clear that large government borrowing not only crowds out private investment,but also spills over to the current account. The finance minister has taken steps to reverse the damage of his budgetary proposals. Now he must take a step forward and initiate measures to actually tackle the fundamental problem that has created the large current account deficit.