Budget for a new reality

An alternative source of demand must be created. It requires more spending on health and education

Written by Jahangir Aziz | Published:February 12, 2016 12:11 am

Since August 2014, global oil prices have fallen 70 per cent in dollar and 65 per cent in rupee terms. Imagine that the government had passed on the entire decline in global prices to consumers (after eliminating oil-related subsidies), instead of taxing most of it away. What would this alternative world have looked like?

For starters, diesel pump price would have been one-third lower at around Rs 30 a litre rather than Rs 45. Households’ real income would have been significantly higher and, based on RBI estimates of the direct and indirect effects of oil price, CPI inflation would have been nearly one percentage point lower. Consistent with implicitly targeting real interest rates, the RBI would have likely cut policy rates by one percentage point more.

Obviously, there is no free lunch. The FY16 budget is likely to gain about 0.5 per cent of the GDP from the extra excise taxes. In the absence of this additional revenue, if the government were to keep to its budget target, it would have been compelled to privatise the full amount of the budgeted divestment, raising 0.25 per cent more of the GDP in non-tax revenue, and cut expenditure by another 0.25 per cent.

The net impact on the stock market and growth is ambiguous. While the extra issuance would have exerted downward pressure on stock prices of the privatised assets, the one percentage point additional policy rate cut would have buoyed the prices of other stocks. The net effect on the overall index could have gone either way, but chances are that the impact would have been modest. Similarly, while the 0.25 per cent of the GDP cut in public spending would have lowered overall GDP growth by about 0.33 percentage points, consumer spending and corporate investment would have increased because of the higher real income, wider profit margins, and lower interest rates, once again making the net impact on growth unclear.

But this is not the world we live in because the government chose to tax away most of the oil windfall. What was gained? Not much. Fiscal management was much easier but it is uncertain whether growth was helped or even the stock market buffered much, while both inflation and interest rates are likely higher.

This brings us to next year’s budget and let me focus on what, in the last month or so, has become a debated issue: Should the government keep to its promised deficit reduction path? One can’t believe that we are debating this issue in 2016, given India’s fiscal history and memories of the near crisis in 2013. But be that as it may, here are three reasons why the government needs to deliver on its FY16 budget
promise to cut next year’s deficit by 0.5 per cent of the GDP.

First, think how incredulous the alternative sounds: After breaking its commitment in FY16 and promising to go back to the deficit reduction path in FY17, the government should cite weak global growth to break that promise again, but vow to do so from FY18! And the market, the rating agencies, and the public should believe this because global growth, which has floundered for the last six years, will miraculously recover next year or the added infrastructure spending this year will magically put India on a sustained and higher medium-term growth path? Incredible as this sounds, more troubling is the question that such a breach of commitment raises: If the government cannot cut the fiscal deficit when oil is at $30 a barrel, when can it?

Such an action would seriously erode the credibility of any promised future path of consolidation. Without an anchor for future deficits, government bond yields would rise arbitrarily sharply. As it has done many times before, the RBI would likely come to the government’s rescue with large bond purchases (we have already seen this happen in recent months). This should limit the rise in yields temporarily but would leave the bond market vulnerable to a shock and take away the space for further cuts in banks’ SLR, which is key to expanding the private sector’s access to bank credit and developing the domestic bond market.

Second, we have tried this before with disastrous results. In the aftermath of the global financial crisis, the deficit was increased by 3 per cent of the GDP. While one can debate the timing and efficacy of the stimulus, by mid-2010 it was clear that it needed to be withdrawn urgently. However, despite double-digit growth, runaway inflation, and more than 1 per cent of the GDP in windfall revenue from the
first 3G auction, the deficit was cut at a glacial pace. The continued high fiscal deficit and the rise in gold imports (India’s capital outflows) it triggered as households increasingly lost confidence in the government’s economic management pushed India’s current account deficit to 5 per cent of the GDP by early 2013, setting the stage for the near crisis later that year.

Third, the idea that countercyclical fiscal support will help growth sits starkly at odds with reality. By now it should be clear that the global slowdown is not temporary but long-term and structural; that the old manufacturing export-led growth model stands seriously fractured; that just like other emerging markets, India’s 2003-08 growth miracle, too, was driven by corporate investment chasing manufacturing exports; and with global demand for manufacturing unlikely to recover anytime soon, corporate investment in India isn’t turning around without a new sustainable source of demand to replace exports.

Creating an alternative sustainable source of demand requires radically rethinking the structure of public finances. Strange as it may sound, it requires less infrastructure and more spending on public health and education. Only then will households’ astronomical out-of-pocket expenses on health and education be reduced, lowering their high precautionary savings, thereby boosting consumption on a sustained basis. Without the visibility of sustained future demand, corporates aren’t about to start investing, as they haven’t despite FY16’s experiment with fiscal support. And that’s what fiscal policy (along with structural and regulatory reforms) needs to achieve, not just in FY17 but also over the medium term. The budget needs to recognise and respond to the new reality, not wish it away.


The writer is chief Asia economist, J.P. Morgan. Views are personal